HDT example in Trust Magic

[AdamN]

Hi all,

For those that have read Trust Magic, would someone be able to answer the following query for me :

For the HDT example on pgs 118-120, where the trust makes a profit which is then offset against the interest paid by the individual, is this only possible for HDTs ? Aren't all trust types capable of operating this way ?

Or is the point that if you borrow money personally and lend to a family trust, you are not eligable to claim that interest as a tax deduction, whereas with a HDT you can ?

I've put this question to Dale himself, but I'm happy for anyone else to set me straight :)

Thanks in advance.

[quiggles]

The key is that borrowing money must be done in order to earn an income if it is to be tax deductible. If you borrow money and lend it to your trust you need to be careful that you have a claim on the income, or a return from your trust.

It's more traightforward with an HDT where your borrowings are clearly in order to secure the entire income of the trust. don't forget, income from a normal disretionary trust is at the trustees' call, which is therefore not the same as unitholders in a unit trust.

[GreatPig]

The primary difference is that with a loan to a trust (including an HDT) your income is fixed at the interest rate you charge the trust, while with units your income is potentially open-ended.

With a loan, if the fixed income from the trust is less than the bank interest you're paying, it's a bit hard to say that the money is being borrowed for a valid investment, since you'd have a guaranteed personal loss irrespective of how profitable the trust was. With units though, your income would increase as the trust profit increased, therefore making it a valid investment (although it may also depend to some extent on what the trust does with the money).

GP

[Mry]

In order to claim interest as a tax deduction, you need to show a connection (also called a "nexus") between the borrowed money and its use in acquiring an income producing asset. Now, if an individual borrows money in order to buy units in a HDT, it is quite simple to see that the individual has borrowed money to purchase units in an income producing trust. The same principle applies to unit trusts.

Now if an individual has borrowed money to loan to a discretionary trust in order for it to buy an investment property, what has the individual purchased? If you said nothing, you are correct! It can't sell or create a capital interest in itself for acquisition so you have nothing substantial you can point towards to claim the interest against. The individual would probably be forced to charge interest to the trust at the rate they are being charged and make the trust claim the deduction for interest in itself so that the deductions are not lost. By doing so though, negative gearing benefits are lost since trusts cannot distribute losses.

An individual would have a problem proving to the tax office that the income they received was earned by the individual when it was the discretion of the trustee, not the actual holding of an asset itself, which resulted in them receiving the income.

Of course, operating a straight unit trust allows you to avoid those problems, but you don't gain the benefit of income splitting later on.

[NigelW]

An individual would have a problem proving to the tax office that the income they received was earned by the individual when it was the discretion of the trustee, not the actual holding of an asset itself, which resulted in them receiving the income.



Mry's spot on. But I'd put it a little more robustly than that. The beneficiary of a discretionary trust has no more than the mere right to say "Hey Mr Trustee, make sure you administer this trust properly!". That's it. If the Trustee, in their discretion, determines not to distribute any money to that beneficiary - tough luck.

It follows that you can't "Buy" your way into being a beneficiary of a discretionary trust with or without borrowed money because there's no asset to buy, just the mere PERSONAL right described above. Accordingly, no deduction for any interest on borrowed money with which you purport to "buy" an interest in a discretionary trust.

What follows from the fact that the beneficiary doesn't own anything is the two-edged sword of basic discretionary aka family trusts. On the positive side assets in the trust are safe because the beneficiary does NOT own the assets in the trust (subject to some exceptions).

Unfortunately the flipside is that you can't negative gear into a discretionary trust. A major problem if you're using some borrowed money (like most of us!) to buy property or other assets but want the assets held in a trust. Thus, it's inefficient from a tax perspective. Let me explain why.

The basic premise of negative gearing is that you're earning salary/wage or other income and paying a lot of tax. To reduce your personal tax you borrow to acquire income producing assets.

If you borrow so as to get the deduction there are then two problems:
1) how do you get the money into the trust?
2) what income producing asset have you acquired with the money so as to render the interest deductible.

You can:
1) gift it to the trustee - But no good with borrowed money. You've borrowed to acquire no asset.
2) lend it to the trustee - Conceptually this is what banks do, borrow money cheap and lend it out at an interest margin above their own cost of funds. Problem here then is you're still earning income, ie the interest margin and thus are not negatively geared at all. Okay you say - I'll just charge no or a minimal amount of interest. NO GOOD. Your deduction will be denied in all likelihood as it's uncommercial and tax avoidance - who would borrow at 7% and lend at 3% - may as well burn $100 bills instead of going through this charade (and getting no tax benefit anyway).

The way around this is to use a hybrid discretionary trust. Where you subscribe for (buy) units with your borrowed money. In this way you get $ into the trust and you acquire an income producing asset (namely the units). The trust then uses that money to buy the IP, shares, managed funds etc... Of course this compromises you asset protection slightly because you now own something, ie the units, but they're of much less use to a potential creditor and are far less visible than an IP.

Hope this is of some help "Beaker" :D

it's time to start the music...it's time to light the lights...

Cheers
Nigel.

[DavidMc]

Scenario - High income earner (48.5%) investing via a HDT...

Would it be fair to say that it is ideal for:

interest charged by bank to individual = interest charged by individual to trust?

Is it possible for an individual to lend money to the trust and charge 'the interest that is incurred by the individual' or do you have to state a fixed amount (i.e. 6.32%)?

[NigelW]

Scenario - High income earner (48.5%) investing via a HDT...

Would it be fair to say that it is ideal for:

interest charged by bank to individual = interest charged by individual to trust?

Is it possible for an individual to lend money to the trust and charge 'the interest that is incurred by the individual' or do you have to state a fixed amount (i.e. 6.32%)?

Yes but why would you do that?

Let's look at the income and the deductions on say $100k loan (to make the sums easy for me :rolleyes: )

Interest paid is $7k per annum. Thus you get at best $3395 deduction

BUT you've earned $7k on which you'll pay (at worst) $3395 additional tax.

Whereas, if you were to buy income units the net return from the property to the trust which is in turn available for distribution to you will I suspect be somewhat less than $7k...(eg rates, insurance, repairs, advertising, gardening, depreciation, etc...)

I don't think it's ever a good idea to lend money to your trust. The loan is a liability to the trust but an asset to you - which is available to your creditors. Whilst it's true that an income unit is also an asset available to your creditors there are ways and means of making it less valuable to prospective creditors...

Cheers
N.

[Glebe]

Some great posts there Nigel. People should read and re-read them.

[sheiks]

How would the following scenario be viwed by the tax office?

Assume that if one purchased 250k units in a Hybrid discretionary trust (and the trust then goes out to buy an investment property);

The individual at some stage sells back any given allocation of units (say 20 K for argument sake) to the trust . The trust borrows money from the individual and repays them at commercial rates to fund the purchase.

If in this scenario the trust does not accumulate losses but has less money to distribute (might be an advantage if most beneficiaries are on high tax brackets). Is this allowed or is this tax avoidance?

[Mry]

How would the following scenario be viwed by the tax office?

Assume that if one purchased 250k units in a Hybrid discretionary trust (and the trust then goes out to buy an investment property);

The individual at some stage sells back any given allocation of units (say 20 K for argument sake) to the trust . The trust borrows money from the individual and repays them at commercial rates to fund the purchase.

If in this scenario the trust does not accumulate losses but has less money to distribute (might be an advantage if most beneficiaries are on high tax brackets). Is this allowed or is this tax avoidance?

Woah, lot of related party transactions there.

More like an exercise in futility. I can't see any tax savings there so I can't see why you would do it. Sure the trust gets a deduction for the interest incurred, but the individual declares income earned on the funds loaned to the trust. The income and deductions cancel each other out.

It might also make it a bit messy because you just swapped units for a loan so you start earning income from a loan rather than units and claiming interest deductions against interest earned, and you'd have to make sure that the interest you were charging was the same as what you were charged.....

[sheiks]

Mry

Makes sense now.I feel like a real dil. Didn't read earlier posts carefully and of course as you say lots of related party txns which I did not give much thought to.

Cheers