Julie,
I agree with your advisers remove all the hype and there is nothing to gain and they have not been tested enough in the courts to be sure they will achieve what we are told. The following is my two bobs worth.
So Why Choose A Hybrid Discretionary Trust?
A Hybrid Discretionary Trust is a combination of a Unit Trust and a Discretionary Trust. Initially, the trust is run as a unit trust. This allows the high income earner to borrow money to purchase the units in the trust effectively allowing the units to be negatively geared because the income stream from the trust is, less than the interest on the loan. The unit holder has a fixed interest in the trust so they are entitled to claim a tax deduction for interest on money borrowed to invest in the trust. On the other hand in a discretionary trust there is no fixed entitlement to income, as a beneficiary, so interest on a loan to invest in the trust is only deductible if it is on lent to the discretionary trust at the same or higher interest rate. These conditions on the loan mean it can never be negatively geared.
Getting back to the unit trust situation. The trust buys a rental property with the money subscribed for the units. This rental property is normally the security for the loan. Be careful here as the rental property will need to be held in the name of the trust and the loan will need to be in the name of the unit holder who will be the high income earner in the family.
Eventually the negative gearing advantage will be lost either because rents have increased or the property is sold for a capital gain. After all, that is why you got into the investment in the first place so to plan for this not to happen is to plan to fail. At this point in time the Hybrid trust redeems the units by paying back either the original amount invested or the unit’s share of the current market price of the assets in the trust. Which, depends on the terms of the trust deed. Though there is a chance that CGT would deem the pay back price to be the market value of the units. Some argue that if the units only entitle the holder to an income stream, not the capital growth component, the value of the units is less than the unit’s portion of the value of the assets held in the trust. Whether the units are redeemed at their original cost, the market value of the future cash flows or at an amount equal to the units share of the trust’s assets, each out come has its own self defeating problems.
If the units in the unit trust have to be redeemed for the market value of their share of the assets in the trust, either as required by the deed or by CGT law. The high income earner will receive taxable income from the trust. If the property investment has gone according to plan this income will exceed the benefit of the negative gearing in previous years. There is the advantage of the capital gain receiving the CGT discount but this would have been available had the property been held in the high income earners name anyway, so at this point in time no advantage has been gained by having the unit trust. After the unit is redeemed there maybe some benefit in the future if the property is not sold ie the reason for redeeming the units was because the property had become positively geared due to rent increases. Now the discretionary members of the trust (low income earners) will receive this income but it has come at the cost of the high income earner having to realise a capital gain that would have not been necessary if he or she had simply held the property in his or her own name. Or even if they did this until it was positively geared then paid the same capital gains tax to transfer it to a low income spouse. The only advantage the trust gives them in these circumstances is that they don’t have to pay the stamp duty on this transfer. There are stamp duty concessions for transfers between spouses. It is also possible that the stamp duty on the transfer, necessary if the property is not held in a HDT, may be less than the cost of establishing and running the trust all those years anyway.
If on the other hand the units can be redeemed for the amount that was originally invested, the investor never made a profit on the investment and with the advantage of hind sight the ATO can say the investor never intended to do so. In TR 95/33 particularly paragraphs 30 to 35 and 47 to 51 the ATO discusses how arrangements that have no chance of making a profit cannot be negatively geared. Paragraph 34 discusses how in Fletchers case the AAT found that the taxpayers never intended to stay in the arrangement for till it became profitable. Further with all the PR about HDTs giving a tax advantage the ATO could use Part IVA to claim the whole arrangement void as a scheme to avoid tax.
On the final hand as the units are only an entitlement to an income stream, even if the market value substitution rule comes into play their value would be considerably less than the value of the underlying assets in the trust. This strategy puts the investment on very shaky grounds in the early years when it was negatively geared. Again TR 95/33 states that if an investment is made with no real intention of making a profit at some time in the future it cannot be negatively geared. Caught this way is the worse case scenario because the negative gearing advantage to the high income earner is lost and you still have incurred all the costs of setting up and running a HDT.
Now the final blow to HDTs. Their objective is to stream negative income streams to the high income earner and later positive income streams to the low income earner. For this to be necessary in a family arrangement it normally means the high income earner is a wage earner. If the family was in business they have probably utilised other methods of income streaming. In a wage earner situation our salary sacrifice kit is a much better and cheaper solution than a HDT. Not only has it been proven in the courts, you can easily apply for an ATO ruling giving you confidence about the arrangement. The salary sacrifice kit is intended for rental properties owned by a couple where one spouse is on a high income and the other on a low income. The high income earner salary sacrifices all the cash flow rental property expenses such as interest, rates, insurance, agents fees and repairs. The high income earner’s employer does not pay FBT on these reimbursements because of the other wise deductible rule. All that is required is that the high income earner be jointly liable for the expense with their spouse. So the spouse could own 99% of the property yet the high income earner would get 100% of the deduction. The couple then only return in their tax return their individual share of the rental income of the property, the depreciation expenses and anything not reimbursed by the employer. This will probably make the property positively geared in both tax returns but the high income earners taxable wages will now be considerably less. As the reimbursement is an exempt fringe benefit it is not included in the reportable benefits box on the high income earners PAYG summary and as the property is no longer running at a loss it does not have to be added back for Centrelink purposes. Also your employer would be entitled to claim a GST input credit for any GST on the expenses the employer reimburses, something you could not do if it is a domestic rental property, so your costs are less.
The kit explains and helps you enter into this arrangement correctly and with an ATO ruling. Yet it only costs you $150 probably less than the cost of the initial interview regarding a HDT.
If you are looking at a positively geared property there is no advantage in a HDT. Instead go for a normal every day discretionary trust if you need flexibility of distributions in the future. If you don’t need the flexibility in the future just buy the property in the low income earner’s name.
If the property won’t become positively geared or be sold until the high income earner retires simply hold it in the high income earners name and save a fortune in set up costs of a HDT.
Note in both the last two examples the rental property kit can still an improved tax situation when a HDT wouldn’t but the property would have to be held in the name of two spouses who are in different tax brackets.
Julia
www.bantacs.com.au
