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Hybrid trusts - Julia Hartman's comments

Comments from Julia Hartman, CPA and founder of BAN TACS Accountants Pty Ltd

Now remember this is a taxpayer alert, not a ruling. It's the ATO saying that it doesn't think these arrangements can provide the tax benefits they claim and warning that it will be looking into it.

There are many ATO rulings that address hybrids. The trouble is a hybrid is a trust that isn't quite a normal fixed trust but isn't fully discretionary either, so there are numerous variations of them. It's not as simple as saying hybrids aren't effective for a specific reason. But I can give you a list of the particular rulings and the points I consider relevant in them. If all these points combined eliminate any benefit you had hoped to achieve from a hybrid then I don't need to address every type of deed. And don't worry, I won't leave you in the lurch. I'll show you other methods of achieving your goals.

Firstly, here's a list of some of the factors the ATO considers relevant in the alert.

1) The trust is effectively controlled by the high income earner and the deed will allow lower income earners in the family to receive, in commercially unrealistic circumstances, some of the income or capital of the trust generated by the assets purchased (or replacement asset) by the high income earner's financial contribution when purchasing the units. This can happen either by the trustee having the discretion to not always distribute income to the high income unit holder or the trustee can issue units to the low income earners for less than the market value.

2) The nature of the arrangement shows that it's intended that the high income earner's rights to profit from the investment will diminish before the initial outlays are recouped and a profit is turned. This could be achieved by the trustee redeeming the units from the high income earner for less than the market value. A redemption at less than market value would include one at CPI or a fixed rate of growth rather than the value of the underlying assets or units being issued to low income earners.

3) The high income earner's units not being entitled to any distribution of capital gains.

The two points I take from the taxpayer alert are:

If a hybrid trust is controlled by the taxpayer then it will be subject to stricter scrutiny than public trusts, so arguing that something is commercially realistic just because similar arrangements exist in public trust will not suffice (para 1).

Units must be redeemed at the market value of the underlying assets in the trust (para 12).

In Private Binding Ruling (PBR) 65710, PBR 66594 and PBR 71023 the ATO found the hybrid trust arrangement described in the application wasn't effective for tax purposes and that none of the interest on the loan was tax deductible.

The ATO's view appears to be that if the trustee had some discretion while the units were on issue, then it was a discretionary trust and taxpayers aren't allowed a tax deduction for interest on borrowings invested in a discretionary trust unless the trust pays a market rate of interest (i.e. no negative gearing).

PBR 66298 was a little different in that the unit holders were only entitled to the income, not capital, so for that reason they weren't permitted to claim a deduction for any interest that exceeded the income from the trust but could at least claim enough of the interest to offset the income they received from the units. The point I take from this ruling is:

If the unit holder is entitled to less than all the income and capital produced by the funds received for the units then interest is only deductible up to the limit of the actual income received.

It seems from these PBRs that the only way that negative gearing will be permitted is if the trust operates like a traditional unit trust with fixed unchanging rights (though the units can still be redeemed) to all income and capital growth distributed on the basis of the unit holding. For the unit holders to have such rights asset protection is lost because creditors will be entitled to the units; similar to the situation if the property was personally owned by the high income earner. Having said that, in a hybrid there may be a marginal advantage (when the units are redeemed) of the benefit of the asset effectively being transferred to someone else without stamp duty costs. Note, the redemption will trigger a capital gains tax (CGT) event to the high income earner, based on the actual increase in value of the trust's assets. The CGT would be the same as if the high income earner held the property in his or her own name and later transferred it to a discretionary trust or low income spouse. The stamp duty saving has to be weighed up against the cost of running a hybrid.

Further, if the high income earner owned the property in their own name and later transferred part of the ownership of the property to a spouse the transfer may attract stamp duty concessions.

In PBR 28993, the ATO says the interest on borrowings to buy units is tax deductible but in the last paragraph it states: "Therefore while you continue to hold all the issued units of the trust and all of the income derived by the trust is directed to you, you will be able to claim 100 per cent of the interest expense. If the income from the trust is directed to other taxpayers by way of the discretionary clauses in the trust or through the disposal of some of the units on issue then the interest will need to be apportioned to reflect the portion of the total trust income received".

The point I take from this is interest is only going to be 100 per cent deductible if the deed doesn't have any tricks in it that are going to redirect some of the return on the investment to someone other than the unit holders.

So far I have only quoted PBRs and a Taxpayer Alert. These are useful because they're recent and are specifically about hybrid trusts but they're not binding on the ATO.

Here are some rulings that are binding on the ATO and the particular paragraphs in them that I feel are applicable to hybrids.

Let's look at Income Tax ruling 2684 paragraphs 9 and 10 which in summary say:

If the total expected return (both income and capital) on money invested in the trust is less than the interest expense and less than commercially realistic, then the interest on the borrowings will only be deductible up to the amount received. Such an arrangement suggests there is an additional private reason (streaming income to others or asset protection) or manufacturing a tax deduction so the interest will need to be apportioned between these purposes.

Now if the return is going to be more than the interest expense you're not negative gearing, so this is a catch 22. This leaves the question of commercially realistic. My opinion is it isn't commercially realistic if the trust does nothing to value add yet the unit holder receives something less than what they would have if they held the asset personally. Asset protection in this case wouldn't be a value add, as the ATO takes the view that asset protection is a private benefit.

In NAT 4913 the ATO states in example 5.5.2 that later modifying a deed that qualified for negative gearing to now be discretionary will be considered a resettlement, thereby triggering a CGT event. This is simply because the rights of the beneficiaries have changed.

The point here is that changing a deed that allows negative gearing to one that will distribute to low income beneficiaries when suitable for tax purposes won't allow the high income earner to avoid paying CGT on the full amount of the gain in the trust's underlying assets, no matter the method used.

Taxation Ruling 95/33 considers that the taxpayer's subjective purpose, intention or motive in making the investment is relevant in determining whether he or she is entitled to a tax deduction for the expenses.

The point I take from this ruling is if the arrangement results in the investor receiving something less than the return that direct ownership would achieve then there is some other purpose in entering into it and interest must be apportioned.

Now some may say the ATO has got it wrong in its rulings. There is very little case law on the matter and the courts have the final say. I consider the tax case Fletcher & Ors vs FC of T 92 ATC 2045 to be relevant to hybrids. To quote the judgement:"the outgoings of interest were incurred by the partnership on the basis and in the expectation that the 15-year plan would not, in fact, run its full course'. For the reasons given above the Tribunal finds that the adjusted partnership outgoings of interest are not deductible".

The point I take from this is that if it can be shown there was no intention that the investment would one day make a profit for the person who is negative gearing then the interest isn't tax deductible.

If you accept these points above then you can't combine negative gearing, asset protection and redirecting future returns to lower income taxpayers.

It's important to point out that each deed would have its own methods and wording so there will always be an argument that a particular deed isn't caught. And so you end up trying to compare varying professional opinions. Don't bother trying, that's why we have a ruling process. Ask the ATO for its opinion instead.

Now what?

If you're considering purchasing one of these trusts I recommend you wait and see what the ATO decides, or apply to the ATO for a ruling that your deed will pass its scrutiny before you go to the expense of transferring any property into the trust as it would be expensive to unwind if you had to.

If you already have property in a hybrid trust you may be tempted to put your head in the sand and hope that there are so many people in the same boat, the ATO may never get around to looking at you. Trouble is property is a long-term investment. It isn't just one year's tax return that you're hoping will pass through unnoticed. You're going to have this worry for many years and the longer it goes on the higher the costs of unwinding, penalties and lost deductions for trust deeds that are non-compliant. And based on the above if your trust deed is compliant you aren't combining negative gearing, asset protection and shifting future income to a low income spouse.

There will no doubt be considerable costs in dropping the whole arrangement now just because you're unsure whether it's acceptable, so the way I see it is you're really left with no choice but to unwind the trust or risk drawing attention to yourself and applying to the ATO for a private ruling on your particular deed. At least the latter approach may result in the ATO being far more lenient with you should the deed not pass.

When preparing your ruling request, it would be worth consulting the firm that prepared your trust deed for an opinion on the areas where they think their deed will pass. If you do get a negative response from the ATO you can object and you can even challenge it in court, quite possibly with ATO financial support so they can mount a test case.

I don't recommend that you accept that your hybrid is okay because it has always passed (i.e. gives the unit holders the right to income and capital and required redemption at market value). Before you go accepting this, think back to why you bought it in the first place. Wasn't it to give you tax advantages? And of course there's still good old Part IVA of the Income Tax Assessment Act that can void the whole arrangement if the dominant purpose was a tax advantage.

I can't dissect every deed and argue every point here. We wouldn't have a need for a court system if the law was that clear cut. All I want is for you to see that there is uncertainty and that there may be other methods of achieving your goals.

Let's take a look at the common perceived benefits.

Asset protection

A discretionary trust will give you asset protection but you can't negative gear against your own income. If you have a business that operates in a trust it could distribute before-tax profits into the property discretionary trust to offset the loss which is as good as you getting the negatively gearing benefit.

If you need to hold the asset in your name to negative gear consider setting up a mortgage trust that will protect any equity you hold in the property with a second mortgage.

Assets held in superannuation are generally safe from creditors so now that superannuation funds are permitted to enter into limited recourse loans a self-managed super fund may be your best form of asset protection, though they are costly.

Negative gearing

As discussed above negative gearing can be achieved if your other source of income is in a trust that can distribute to the entity that owns the rental property. Negative gearing in its simplest form is achieved by holding the property in the high income earner's name but this lacks asset protection and flexibility when the property starts to become positively geared or is sold for a large gain. However this wouldn't be a problem if the high income earner has retired by this stage.

The ultimate negative gearing is now achievable through salary sacrificing into your self-managed super fund. The superannuation contributions are as good as a tax deduction and if the property is negatively geared the fund won't even have to pay the 15 per cent contributions tax. Further, depreciation (which is an extra non-cash flow deduction) can be used to offset the contributions tax on payments made to the self-managed super fund that cover the repayment of principal on the loan!

Reducing the CGT

Simply waiting until you retire will achieve this , as will putting the capital gain into superannuation either directly or by salary sacrificing your wages.

Being held in your own names maybe useful to take advantage of the main residence CGT concessions (refer page 64 of March 2008 API)

Succession planning

If you intend on never selling the asset then you don't have to worry about how you'll be taxed on the capital gain. If you hold the asset in your own name so you can leave it to your heirs in your will and they in turn do the same, no CGT will arise until someone sells it. The rollover relief on death can allow a property to pass down through generations indefinitely, without CGT consequences. You can't pass assets in a trust to your heirs through your will because you don't own the asset, the trust does. If you'd prefer your heirs to hold the property in a trust, set up a testamentary trust (a trust created in your will) and achieve the added benefit of allowing your heirs to distribute income to their minor children without incurring the higher rates of minors' tax.

There are other methods of combining asset protection, negative gearing and succession planning so why go out on a limb by using a hybrid?

 

Source: Julia Hartman

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