Child maintenance trusts offer a tax planning opportunity where child maintenance payments need to be made in respect of minor children, following a relationship breakdown.

Generally, where one party is required make child support payments, those payments will be made from that party’s after-tax income and are not tax deductible.

As a result, a party on the top marginal tax rate may need to earn almost $200 of pre-tax income, in order to fund each $100 of child support payments.

While the party making the child support payments may have assets invested in a discretionary trust which are producing assessable income, only $416 can be distributed to a minor from a discretionary trust each year without incurring penalty tax rates.

Specifically, any ‘un-earned’ income of a minor above $416 in any given year is taxed at the top marginal tax rate.  Income received by a minor from discretionary trust distributions is treated as un-earned income.

Fortunately, an exception to these rules applies in respect of income derived by a minor which is ‘excepted trust income’ under section 102AG Tax Act 1936.

Section 102AG defines excepted trust income to include, amongst other categories, income derived by a minor as a result of a family breakdown.  Trusts which are established pursuant to this exception are commonly known as ‘child maintenance trusts.’

Child maintenance trusts are usually structured as follows:

• the party who is liable to make the child support payments would establish the trust, with the children of the relationship as the beneficiaries;
• that party would then ‘seed’ the trust with one or more income producing assets, such as an investment property or listed shares;
• the income derived from that asset would be distributed to the minor children each year in satisfaction of that party’s child support obligations. The funds would be used to pay for the children’s education, housing, etc; and
• as the income received by the children would be excepted trust income under section 102AG Tax Act 1936, this means each minor child can receive $18,200 tax free each year until they turn 18, with the adult marginal tax rates applying for any distributions above that amount. This usually results in a significantly better tax outcome than the parent being assessed on the income at the top marginal tax rate and then paying child support from the post-tax income.

In order to ensure the income of the child maintenance trust qualifies as excepted trust income, certain eligibility requirements must be met.

The key requirements are:

• the beneficiaries of the trust must be under 18 at the time the trust is established;
• the income of the trust must be derived from the investment of assets which were transferred to the trust as the result of a ‘family breakdown’. Typically, this would require the binding financial agreement or consent orders to expressly contemplate the establishment of the trust and the transfer of specific assets to the trustee; and
• the minor children must ultimately receive the capital of the trust in equal shares (although this can be delayed for an extended period of time and does not need to vest in them when they turn 18).

Unfortunately, the CGT roll-over in Subdivision 126-A Tax Act 1997 does not apply in relation to the transfer of assets to the child maintenance trust, meaning that CGT may be payable if the asset which is transferred has increased in value since it was originally acquired by the transferor.

Care must also be taken to ensure that the income which is derived by the child maintenance trust satisfies the arm’s length requirement in section 102AG(3) Tax Act 1936.

In particular, the income that is derived from the investment of the asset must not be any more than the amount that would be derived if the trustee and any other party to the derivation of the income were dealing at arm’s length.

This is particularly relevant if the trust enters into arrangements with related parties (such as leasing property to a related party) that derives income.

The Tax Office’s views in relation to child maintenance trusts are articulated in Taxation Ruling 98/4 (TR 98/4), which highlights five areas where it says income derived from a child maintenance trust will not be eligible for treatment as excepted trust income.

Those five areas are where:

• the income is not derived from the investment of property transferred beneficially to the child – for instance, the child is not the ultimate capital beneficiary of the trust;
• the income is not derived from the investment of property at all – such as where the child maintenance trust receives distributions of income from another discretionary trust in the family group;
• the property was not transferred to the trust as a result of a family breakdown;
• the income exceeds an arm’s length return on the investment of the property; and
• the income is derived as a part of a scheme to access the excepted trust income measures. In other words, the trust is established as part of a scheme to avoid tax.

While there are some significant limitations to the child maintenance trust structure, it can result in significant tax savings for the parties in the appropriate circumstances.

For further information, please contact Patrick Ellwood on 0400 503 111 or patrick@cloverlaw.com.au.

• Child maintenance trusts
• clover law
• Tax Planning