Tax Efficient or Efficiently Taxed? The Hidden Questions that Show We Might Be Too Trusting in Trusts

When establishing a testamentary trust or seeking estate planning guidance, the goal is to conserve and grow assets. Specifically, we want an instrument that will provide the flexibility to distribute assets and income to our dependants and to capitalise on tax benefits after death. But are trusts always suitable? The recent decision of Soo v Soo shows that we should take caution when trusting trusts.

Testamentary Trusts and the ability to stream capital gains and franked distributions

A trust relationship occurs where someone (the trustee) holds assets in the trustee’s name (legally) for the benefit of someone (the beneficiary). A testamentary trust is a trust established by Will. In a testamentary trust, the trustee (often the deceased’s spouse) holds the deceased’s assets for the benefit of different categories of beneficiaries such as nominated persons, dependants, and even their companies or trusts, on the terms of the trusts established by the deceased’s Will.

Trusts can, under the guidance of the trustee, hold commercial or residential property, generate income, file tax returns, and particularly in family situations, take advantage of marginal tax thresholds when distributing income.

Provided it has the power, a trustee may also, for tax purposes, stream capital gains or franked distributions to beneficiaries, by making them specifically entitled to the amounts. This allows beneficiaries to offset capital gains with their capital losses, apply discounts and get the benefit of franking credits attached to a franked distribution.

Overall, testamentary trusts can be as small or large as you make them and they can be an efficient entity in which to hold assets or generate income.

So, what’s the problem?

Trusts need to be set up correctly, and the trustee needs to have the necessary power. Occasionally, we find that they do not and, if so, it can be an expensive solution.                                           

So simple says Soo v Soo [2016] NSWSC 1666

In this case, the trustee-spouse of the deceased sought advice from the court. She wanted the court to state that she could stream distributions to particular beneficiaries under the terms of a testamentary trust and if not, whether she could vary the trust’s terms to do so.

The Will establishing the trust did not have a power to stream and important terms such as ‘income’, ‘net income’, and ‘year’ were expressed generally and not specifically defined. However, the Will did give the power to ‘calculate net income in accordance with taxation, accounting or other definitions or concepts’ and the court gave a judicial opinion that this gave the trustee the power to define net income.  

The court ruled that the trustee did not have power to amend the terms of the trust. The Will gave the trustee the power to vary the trust but only “to the extent permitted by law, and subject to this clause, the Trustee may amend the terms of the trust”.

Unfortunately for the trustee, the court determined that NSW law applied, and that under NSW law, the Trustee Act provides that a trustee has no power to unilaterally vary trusts. Rather, where there is no effective mechanism in the Will or Trust Deed, variations to a Will or Trust Deed can only be made by court order or (theoretically) with the consent of all beneficiaries who are presently entitled to trust assets and over 18 years.

Several thousands dollars of legal costs later, the court ruled that the terms of the trust gave the trustee a sufficiently broad discretion to stream franked dividends and interpret the terms of the Will consistently with taxation laws.

Things to take away

Soo v Soo emphasises the importance of giving trustees:

1. The power to stream;
2. Sufficient power and discretion to interpret trust provisions broadly and in a tax efficient manner; and
3. The ability to vary the terms of the Trust Deed.

Trusts (in Wills and Deed) should have:

1. Streaming powers, allowing the trustee to separately account for distinct classes of income or capital, and to relate those classes to beneficiaries’ entitlements, and allowing the trustee to distribute income or capital in its absolute and unlimited discretion; and
2. Variation powers to vary the terms of the Trust .

Ensure that your testamentary trust is capable of flexible application. Luckily for Mrs Soo, as the court found, where there’s a Will, there’s a way.

Contact Peter McNamara today for your estate planning and trusts advice.