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Hybrid trusts - Ed Chan and Ken Raiss' comments

Comments from Ed Chan, chairman, Chan & Naylor Pty Ltd, and Ken Raiss, head of Chan & Naylor Platinum Services

The use of trusts and in particular hybrid trusts has been under the spotlight in recent times. Speculation as to their effectiveness has been on the increase both from the ATO and from a bankruptcy perspective.

In some instances practitioners haven't necessarily fully explained the consequences of using a trust, nor have they kept their clients updated with changes in thinking.

There are many out there who are now preaching the ineffectiveness of hybrid trusts on a number of fronts without carefully considering a person's specific requirements. There seems to be a blanket reaction that it's now all too hard or that trusts haven't been as effective as described.

Whether you should hold your property through a trust or in your own name is a personal thing that depends on your circumstances.

There's certainly no "one size fits all" and we would be the first to argue that some people shouldn't have a trust for their circumstances. One must weigh up the advantages versus the disadvantages before going forward with a Trust.

The next thing to determine is what sort of trust is best for the client's individual circumstances, as there are many different types of trusts and they're all used for different things.

In general there are three broad reasons why a trust structure is chosen over, say, individual names or a company. These are.

1. Income generation
2. Asset protection
3. Estate planning

Investors should also understand that if their intention or dominant purpose for pursuing a certain strategy is for a tax benefit, then that is tax avoidance and they may have their deductions disallowed by the ATO.

Let's look at some current opinions, starting with an analysis of the ATO position, then bankruptcy and then hybrid trusts from a more practical usage point of view.

Income generation

The ATO's tax alert TA 2008/3 and subsequent media release 2008/13 express concern (and rightfully so) about deeds that have restrictions which "may result in the taxpayer being unable to recoup their costs of investment. When the assets are sold, it may be expected that any capital gain will instead be distributed to one or more of the trust's other beneficiaries, who may be on a lower tax rate."

The ATO is highlighting the fact that the uncommercial use of certain trusts will deny a taxpayer a deduction for expenses such as interest. In essence it's pointing to arrangements which don't provide a sufficient connection between the expenditure (buying units in the trust) and the production of future income and/or capital gains, which may be distributed to other beneficiaries of the trust, who may have a lower tax rate.

The ATO isn't saying the use of hybrid trusts in themselves is unacceptable, it's saying that an arbitrary use of a hybrid trust which has no commerciality in its set-up and use which is there to effectively give negative gearing to a high tax rate individual and push all profits to a lower taxpayer individual may give rise to taxation concerns which will deny the taxpayer a deduction.

The media release, in the section on uncommercial trust arrangement, states "People should be cautious before claiming negative gearing deductions for borrowings used to fund interests in trusts with discretionary features". The release goes on to say "before making such deductions, people should make sure the relevant expense is sufficiently connected to the income and capital gains they could reasonably expect to receive from their investment". It concludes by stating, "The Tax Office is not concerned about all discretionary or hybrid trust arrangements. Rather, we are concerned about negatively geared trust arrangements which involve the taxpayer incurring interest expense or borrowing costs which all or a proportion of the borrowed funds could be used for the benefit of the beneficiaries, or where the taxpayer's interest in the trust could be brought to an end before their costs of investment have been recouped."

Therefore to give the taxpayer some level of comfort that their arrangement is commercial they must pass several hurdles which may include, but aren't limited to, the following.

1. The trust deed must be worded to comply with the requirements of the ATO.
2. The taxpayer must enter into the transaction/arrangement having carefully considered the commercial benefits and found them to be positive.
3. The taxpayer's dominant purpose must be for commercial benefit as opposed to any taxation driven outcome.
4. The taxpayer's benefits must be based purely on the income and costs expectations of the arrangement and not other potential benefits such as asset protection or estate planning (private in nature).
5. The taxpayer's commercial benefits must necessarily include the expectation that positive results will be achieved as opposed to expecting a negative cash flow for the term of the investment.
6. The taxpayer must have the intention to "stay" in the arrangement and recoup all their costs.
7. To support the above the taxpayer would be advised to have prepared some sort of analysis to show their intentions and expectations. If they're unable to do this then they should seek specialised advice starting with their accountant.

There have been several private binding rulings (PBRs) on trusts and they have in several cases denied the taxpayer their deductions, but on closer examination of these rulings we can see that failure to gain the deduction wasn't due to the ATO taking the position that a deduction wouldn't be granted if the taxpayer was using a hybrid trust but other factors.

For instance we see in PBR 65710 the deduction was denied because on inspection the deed wasn't drafted correctly. The ATO found "The trust deed provided by you is a discretionary trust". Therefore the structure of the deed as used by this taxpayer never allowed them to use it as they had wanted. They were doomed before getting to the starting gate.

In PBR 66298 the deduction was limited. In this ruling the ATO determined the taxpayer had several reasons for the trust which were private or capital in nature (i.e. asset protection as well as income). According to the PBR, the application states the estimated income return to the taxpayer as a unit holder would be around 2 per cent per annum. The ruling advises that the anticipated income return in itself doesn't provide an obvious commercial explanation for incurring the interest. Therefore in this PBR the taxpayer had several other reasons for using the hybrid trust and in the income component no commerciality was evident.

As you can see from the above it's critical to have a properly drafted deed and to have a commercial basis for the transaction (i.e. you must have a reasonable expectation that your investment will recoup your costs, in other words the rent you receive over time will become greater than your expenses). Any arbitrary change in the use of the trust which ceases to give you this expectation could jeopardise your past and/or continued ability to claim expenses. This could include a premature redemption of units so as to redirect cash flows to a lower tax-rate related party.

The drafting of the deed takes on additional importance when we look at possible commerciality, in that many hybrid trusts only allow the unit holder (normally identified as the income unit holder) to a fixed or present entitlement to the trust income (i.e. rent after expenses) without any possible capital component at any time. The deeds in essence will allow a redemption of the income units at cost, irrespective of what has occurred to the market value of the asset and/or the income derived from holding the asset. Therefore, as often happens on redemption, the income unit holder only gets back the initial amount they paid for the income units, thereby reducing the possibility of ever recouping their costs. We believe this is a standard error which a lot of trusts have built in. The deeds must allow for a capital component even on income units if the unit holder doesn't directly have capital units.

People often ask what level of capital component should be built in. A fixed amount may be the answer but in reality this figure should have some relevance to the market place, as we often see that even with good planning not all assets appreciate as expected and the reality may be that no capital gain has been achieved. It's also an issue if the trust asset isn't in itself sold, thereby crystallising a gain. Therefore other methods must be adopted within the deed which can take all these factors into account at the time of the trust asset sale or the redemption of the income units.

Asset protection

Trust law has, as part of its central core, the fundamental principal that ownership is by the trust and beneficiaries or indeed unit holders (in most trusts) don't have a right or ownership to the underlying assets of the trust. As such, creditors normally wouldn't have a right to trust assets if a beneficiary and/or unit holder was in bankruptcy as they only have an expectation to receive a distribution of assets, unless they hold units to give them a fixed or present entitlement. The most recent court case on this subject is Richstar Enterprises Pty Ltd vs Cary which reiterated this long standing view. This case surrounds litigation against a director of the failed Westpoint group.

In the above case, the court went further than previous cases and for the first time determined that beneficiaries have at least a contingent interest and if a beneficiary both controls a trust and is the beneficiary then they have a form of property in a commercial situation.

The initial reaction to the outcome of this case is to highlight the need to properly structure the trust and trustee, and on initial review may in some people's view limit the effectiveness of discretionary trusts in relation to asset protection. Given the nature of the case, it is said to be arguably limited in its application even to a similar set of circumstances, and it's relatively unchallenged at this stage as the matter was only heard by one judge. In this case the judge ruled that the trust assets were to be frozen until the issue of the bankruptcy was completed. As a matter of course it would be prudent to have more than one trustee (if a company then multiple directors) and more than one appointor (the position which appoints the trustee).

Given the proper set up of your trust (i.e. trustees and appointors) a hybrid trust still achieves the benefit of asset protection, as the unit holder doesn't "own" the trust assets. They however "own" the units. If the trust deed is properly drafted then there may not be any value in the units themselves.

The need to understand the Bankruptcy Act, especially as it relates to the claw back provisions, is important as a trustee in bankruptcy may still be able to unravel this benefit. But what is sure is that if the individual owned the asset in their name then there is no asset protection. The trust at least builds a wall.

Estate planning

Trusts can be useful tools when looking at estate planning needs. In essence a trust is a structure whereby the "family" can control its assets for the benefit of the family now and into the future. They may not have any interest in asset protection or income generation but are focused on this primary issue. As such we saw a deficiency in the way most trusts are structured in that they had an 80-year vesting period (i.e. after 80 years the trust assets would need to be disposed whereby CGT was paid and if the asset was desired to be retained by someone then stamp duty [property] would be payable). This didn't support one of our firm's principles of "generation to generation". For this reason we worked with our lawyers to not have a vesting date in our trusts. To our surprise this has been possible for more than 10 years, with both legislation and court judgments (Augustus v Permanent Trustees, Chellaram v Chellaram as well as certain components within the Hague Convention) to support the view. We therefore "upgraded" our hybrid trusts to delete the reference to an 80-year vesting period. We notice a growing number of lawyers and other practitioners now adopting this position. Care must be taken however to ensure the total requirements to achieve this outcome is implemented and we've seen several deeds prepared without a vesting date but lacking in other requirements which therefore doesn't result in achieving this.

It has also been stated that when assets are passed to your children after one dies there are no stamp duty and capital gains tax issues which is correct. However you would have to die first to be able to make use of these provisions. Many people would like to have the option and the flexibility to be able to decide what they want to do with their assets without having to die first. This you can achieve using the following provisions:

1. Trust splitting

You may have three properties in a trust and you may want to pass one to each of your three children before you die. Through a properly constructed hybrid trust this can be done without stamp duty and capital gains tax. You can't do this if the properties were held in your own names. Trust splitting allows you to achieve the effective change.

2. Transferring control

You maywant to transfer control of your property to someone else without triggering stamp duty and capital gains tax. This can't be done if the property was held in your own name but under a carefully constructed hybrid trust one can transfer control without paying stamp duty and CGT.

Land tax

Many states of Australia, such as Queensland, allow trusts to have separate land tax thresholds, thus saving thousands of dollars in land tax. You won't achieve this if the properties are accumulated in one's own name.

Conclusion

It's absolutely imperative that your accountant knows how to use the trust deed as well as having the right trust deed. It's the 'use' of the trust deed that invariably lets people down.

As the above comments show, the proper drafting of the hybrid trust deed is essential as the first step. The second and third steps, and in our opinion the most important aspect, is how the deed is used and completed when the assets are purchased. We recognise three stages in the set-up of a trust:

1. The initial set-up (the skeleton). This takes into account the type of trust required and a review to ensure you have the necessary intention and purpose in the use of the deed to achieve your objectives.
2. Completing the deed after assets are secured.
3. The ongoing accounting and taxation to ensure continued compliance.

This information is of a general nature only and does not constitute professional advice. Readers should not act on the basis of any matter on this website without taking professional advice with due regard to their own particular circumstances. The authors and publishers expressly disclaim all and any liability to any person, in respect of anything and of the consequences of anything done or omitted to be done by any such person in reliance, whether in whole or in part, upon the whole or any part of the contents of this website.

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