Hybrid Trust Income Unit Valuation

Hi all,

a quick question

When a hybrid trust redeems (buys back) income units held by an individual or borrower how is the value or price of these units calculated?

Do the 'income units' simply retain their original purchase value regardless of the capital gain of the property or potential increase in the income over time?

If the income unit does change, what is the capital gains tax consequences of the trust redeeming the income units.

Thanks in advance

Blake

I was about to ask the same question, but I decided to search... and here it is...

Does Anyone know the answer to this?

muppie said:

I was about to ask the same question, but I decided to search... and here it is...

Does Anyone know the answer to this?

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I haven't looked at a HDT Deed in detail, and I am not a lawyer, but I assume* that the units provide a right to income, not to capital. If they provide a right to capital, then the units would increase in price as the house increased in value as the unit holders are entitled to more $$$ if the property were sold. As the units only provide a right to income, the valuation of the units would a complete mess (how does one bring to net present value a variable income stream?), and most people would be inclined to value them at their cost price only.

Someone may be able to provide more info.

*Assume is another word for "I don't know, but may be it is this-."

I also am very interested in this answer. The MGS deed does not specify it and rather says it is wholely at the trustees discretion. I've had informal advice from an experienced trust lawyer (who seemed to know a lot about hybrid trusts) who said that these units must be valued, and that it is the job of an accountant. There must obviously be a defendable basis for the valuation. When I asked if the units could just be redemed for their original ssue price, the answer was a firm *NO*, as even though the deed allows it the ATO would not consider it arms length (at least I think that was the reason she said).

mdk92 said:

I've had informal advice from an experienced trust lawyer (who seemed to know a lot about hybrid trusts) who said that these units must be valued, and that it is the job of an accountant.

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Accountants aren't valuers, and I suspect that almost all accountants would refer the valuation work on or attached a mile long disclaimer. That is a very strange comment coming from a lawyer.

mdk92 said:

There must obviously be a defendable basis for the valuation. When I asked if the units could just be redemed for their original ssue price, the answer was a firm *NO*, as even though the deed allows it the ATO would not consider it arms length (at least I think that was the reason she said).

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I can't see any defendable basis for any valuation of income units. Any potential valuation would merely be statistical academic guesswork. You, the ATO, the valuer and your accountant would end up squabbling over averages, theoretical budgets, realised and unrealised expenditures, potential future redemptions and the value of pi to the 16th power over y minus x.

Mry, would you suggest then that $1 dollar units just get redemed for $1 (even years down the track)? Actually when I said "defensible", the lawyer may have said "reasonable", ie, at least have something which documents on what the calculations are based, even if not everyone agrees with the method.

Which reminds me of a related question. I've read about the refinancing advantage of trusts where once the units are redemed the cash can be used by the individual to buy whatever, but the debt remains tax deductable. However what I don't understand is how the original loan to buy the units in the first place can remain tax deductable if the trust has redemed the units. How can the ATO allow this? Isn't it like borrowing to buy shares, then selling the shares and spending the funds on whatever instead of repaying the original loan, then continuing to claim a tax deduction on the original loan.

I asked this very question to Chris Balalovski from MGS about 3 weeks ago. Apparently special income units will be valued according to the Net Present Value of the future income streams. Therefore an NPV calculation will need to be undertaken when the income units are purchased and also when the income units are sold. This may or may not result in a small capital gain on redemption but it will certainly be much less than the capital gain on redemption of units which have a right to capital as opposed to the right to income only.

I agree with Mry I think that it really is an exercise in mental masturbation. Technically the income units are not worth the value you attribute to them (usually $1). Using an NPV calculation they may have a market value of 0.02 (based on their NPV) and then when they are redeemed (yes you could redeem them for $1 for each unit) and then the ATO will use the market substitution rule and they may have a market value of 0.03 (based on their NPV).

As Mry suggests by the time you calculate the Weighted Average Cost of Capital, projected future earnings, vacancy rates, factor in inflation, etc the capital gain is going to be tiny (provided that rent hasnt increased disproportionality to every thing else). I am planning on doing a basic NPV calculation for all clients when redeeeming special income units just to keep the ATO happy.

coastymike said:

I agree with Mry I think that it really is an exercise in mental masturbation. Technically the income units are not worth the value you attribute to them (usually $1). Using an NPV calculation they may have a market value of 0.02 (based on their NPV) and then when they are redeemed (yes you could redeem them for $1 for each unit) and then the ATO will use the market substitution rule and they may have a market value of 0.03 (based on their NPV).

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Here's an unpopular take on this as I know most are gung-ho on HDTs.

After more advice it appears to me that this aspect of HDTs creates the key risk of buying property through an HDT. This part, of buying something for $1 when its market value is much less than $1, is where the whole claimability could be shot down in the courts. It is not an arms length transaction and this fact is potentially enough (or has been in past cases) to bring the transaction into question.

It appears that the precedents stated in facts sheets on HDTs to support various benefits of HDTs are based on cases involving discretionary and/or unit trusts, not HDTs. Now an HDT is neither so the precedents don't necessarily apply.

IMHO its a case of buyer beware, HDTs are not on the firm grounding that they are sometimes portrayed here.

Bump...

Just bumping a few HDT threads...

I agree with Twitch's comments below, and this is now the subject of discussion on the 'Why don't big firm's sell HDT's?' thread...

Any more comments on this subject?

Coastymike, Mry, would you still agree with this NPV calculation for calculating redemption price?

Is it arms length/commercially viable...does it make financial sense for the SIU holder???

GSJ

Twitch said:

Here's an unpopular take on this as I know most are gung-ho on HDTs.

After more advice it appears to me that this aspect of HDTs creates the key risk of buying property through an HDT. This part, of buying something for $1 when its market value is much less than $1, is where the whole claimability could be shot down in the courts. It is not an arms length transaction and this fact is potentially enough (or has been in past cases) to bring the transaction into question.

It appears that the precedents stated in facts sheets on HDTs to support various benefits of HDTs are based on cases involving discretionary and/or unit trusts, not HDTs. Now an HDT is neither so the precedents don't necessarily apply.

IMHO its a case of buyer beware, HDTs are not on the firm grounding that they are sometimes portrayed here.

Click to expand...

GSJ,

As said in my previous thread not going into the theory of valuation methodologies (someone else with an MBA can do this) but NPV also includes a terminal value. I use terminal value in my NPV calculations. Happy to keep using NPV with a terminal value.

I agree with Coasty, in that the SIUs should be valued at their net present value, which is the correct way to value an income stream. I do not anticipate any capital return being given to the unit holders. Any contemplation of capital value increases in the trust should only affect the SIUs by the increased income that is expected to be made.

Coastymike, Mry,

Thanks for your replies.

Still doesn't make sense to me, as a layperson, but I'll leave this topic for now.

GSJ

Rights to capital?

Back again, just can't help it, I'm hooked on this topic!

Mry said:

I do not anticipate any capital return being given to the unit holders.

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Mry,

Regarding the above...I guess this stems from a trust deed that would say the the SIU holder has no rights to the capital of the trust, only to income...?

As an example, say you have 200k of SIU's used to buy a 200k IP, and in 10 years the IP is worth 600k and is then sold, before any redemption occurring in earlier years. So here the CG of 400k would go to the SIU holder, who would puts 200k on their tax return (after the 50% CG discount). Also, out of the 400k, 200k is used to redeem the SIU's (assuming their 'market value' at this time is still 200k).

Then, what happens to the other 200k proceeds from the sale of the IP? Does this represent part of the 'capital' of the trust, so the SIU holder is not entitled to it, and it remains in the trust?

Hence, from an asset protection perspective, even if a creditor manages to force redemption of the units, they cannot get this 200k, as it remains inside the trust? - which is a better outcome compared to if the IP had been purchased in one's own name???

Is this understanding correct???

My next question then would be, with this 200k capital in the trust, can it be distributed discretionarily to beneficiaries, and if so would they then still have to pay tax on it (minus 50% CGT discount)? If so, this would appear to be a worse outcome than having purchased the property in ones' own name, as potentially more of the 600k sale proceeds are taxed???

Is this understanding correct???

Thanks for the clarification...

And, I know I have made this point before, but for the SIU holder to negative gear, and give up rights to capital, is the main bit that doesn't make sense to me, or, am yet to fully understand. In hindsight, this is probably a more important issue to the HDT debate, than that of redemption price/market value, that I have commented on previously - as this is entirely dependent on whether you believe that the SIU holder should have any rights to capital or not, in the IP examples described.

So the bigger question would be: How would one justify negative gearing with SIU's, where there are no rights to capital?

One thought I recall from another thread (Mry's post I think): over a long, long time period, rents will eventually rise well above the interest expense, and more so if part or all of the loan principal is paid off too...

If I can convince myself about this, then I would probably feel better about the HDT - although, the fact remains that SIU's are still purchased at a price far above their real value, with respect to their income stream only. And that, if the SIU's are redeemed before the property is sold, or at a time when the income is still much less than the interest expense - will the interest expenses incurred then be considered not tax deductible? I still can't reconcile these things...???

GSJ