New intestacy rules and the 3 year rule trust - tax implication of the Succession Act

The NSW Succession Act was recently amended to enact new "intestacy laws" for persons who die on or after 1 March 2010 (see Bartier Bulletin Wills & Estates March 2010). The intestacy laws provide the rules that deal with the distribution of a person’s estate in circumstances where:

(a) the person dies without a Will; or

(b) the person’s Will does not deal with all of their estate assets – a partial intestacy.

One of the main practical implications of the changes involves the distribution of a person’s estate where they die leaving a spouse and a child or children from that relationship. Under the old rules the spouse and children would have shared the estate according to a statutory formula. Under the new intestacy rules, however, if the person dies on or after 1 March 2010 the entirety of the deceased’s estate passes to the spouse.

An Unintended Tax Consequence

One of the unintended tax consequences of these legislative changes to the intestacy rules affects the tax planning opportunity known as the "3 Year Rule Trust".

The 3 Year Rule Trust is a creature of Division 6AA of the Income Tax Assessment Act 1936. In short, Division 6AA imposes a severe penalty tax regime on "unearned income" of minors. Unearned income includes income distributions to minors from trusts.

There are a few exceptions to this penalty tax regime. The exceptions allow income derived by minor beneficiaries of certain specified trusts to be taxed in accordance with the ordinary adult marginal tax rates rather than the Division 6AA penalty tax rates. This income is called "excepted trust income" because it is an exception to the usual Division 6AA penalty tax rates.

The exceptions to the Division 6AA penalty tax rates include income distributions to minors from:

• testamentary trusts;
• superannuation proceeds trusts;
• insurance proceeds trusts;
• special disability trusts; and
• "3 Year Rule Trusts".

The 3 Year Rule Trust has always been the "poor cousin" to the testamentary trust and in reality, is only used to salvage some tax planning benefits for the family of a deceased person where the deceased, unfortunately, did not have a testamentary trust established under their Will.

The 3 Year Rule Trust applies in the following circumstances:

• assets ("estate assets") pass to a person (the "estate beneficiary") under the Will of a deceased person;
• the estate beneficiary transfers estate assets to a trust within three years of the date of death of the deceased - depending on the nature of the estate assets in question, this transfer could have CGT and stamp duty implications;
• the trust is structured such that the minors who have received the "excepted trust income" distributions will receive the assets of the trust when the trust comes to an end – this is often unattractive for a surviving spouse; and
• the amount of "excepted trust income" that the minor beneficiaries of the trust can receive is limited to the amount of income that the minors would have received if the deceased died without a Will.

There are a lot of conditions that must be satisfied and a lot of restrictions that apply with this estate planning strategy. The last bullet point above means that the tax effectiveness of the 3 Year Rule Trust is dependent upon a notional mathematical calculation applying the intestacy rules. This is best explained by example.

John dies on 1 March 2010 leaving a spouse, Janette, and two young children born of their marriage. John and Janette own their residential home as joint tenants, have a joint bank account and John’s superannuation death benefit is paid directly to Janette in accordance with John’s superannuation binding death benefit nomination.

The only assets that will form John’s estate are his rental property (valued at $500,000 with a CGT cost base of $250,000 being the original purchase price) and his listed share portfolio (valued at $500,000 with a cost base of $750,000).

In order to take advantage of the tax planning benefits of the 3 Year Rule Trust, Janette decides to transfer the rental property and all of the share portfolio to a Division 6AA compliant 3 Year Rule Trust.

The transfer to the Trust of the rental property gives rise to a stamp duty liability of $17,990 and a capital gain of $250,000. The transfer to the Trust of the shares does not give rise to any stamp duty liability (listed shares are not dutiable property) and gives rise to a capital loss of $250,000 which Janette can offset against her capital gain on the transfer of the rental property.

Even though John died with a Will, the rules in Division 6AA require a notional calculation of what John’s children would have received assuming John died without a Will. Under the new intestacy rules, all of John’s estate would pass to Janette. John’s children would not have been entitled to anything under the intestacy laws and, as such, cannot benefit from any "excepted trust income" under the 3 Year Rule Trust.

Under the previous intestacy rules, because the children would have shared a proportion of the intestate estate of John they would have been able to gain some "excepted trust income" benefit from the 3 Year Rule Trust.

Conclusion

The 3 Year Rule Trust has always had significant limitations. However, the lawyers at Bartier Perry have been able to use this opportunity to provide some clients with significant benefits in circumstances where the deceased did not have a testamentary trust established under their Will.

Unfortunately the changes to the intestacy rules will now restrict even more the opportunity to benefit from the 3 Year Rule Trust. More than anything the changes to the intestacy rules reinforce the importance of planning an estate to take advantage of the significant tax planning benefits of the testamentary trust.

Author: Andrew Frankland