AAT Case on Hybrids where trustee has discretion

Interest not deductible and payment was ETP
24 April 2008


Case 2/2008 2008 ATC ¶1-001

The AAT has held that interest payments on loans taken to purchase units in a trust were not deductible, and that payments received by a taxpayer were eligible termination payments despite being in the form of donations to a charitable trust.

Facts

The taxpayer was a director and chief executive officer of an exploration and mining listed company, ABC Limited (ABC) (now known by another name).

In 1999, a trust was established. Under the trust deed, the beneficial interest in the fund was divided into the unit component (held on trust for unit holders) and the discretionary component (held on trust for discretionary beneficiaries). The trustee could, in its absolute and uncontrolled discretion, determine the proportion of either component. The discretionary powers of the trustee applied to a wide range of amounts, including income, profits and capital gains or losses. The trustee could make decisions as to whether any such amounts were capital or income, and whether expenses were to be paid out of capital or income.

The taxpayer held units in the trust and, subsequently, raised several loans to purchase additional units in the trust in the expectation that the trust would acquire shares in ABC and, in some future time, that ABC would pay dividends on its issued shares.

In 2001, after a public battle with the Board, the taxpayer resigned from office in consideration of a $3.5m redundancy payment together with other severance entitlements. In November 2001, the taxpayer and ABC entered into a deed in full and final satisfaction of all claims relating to the taxpayer’s resignation.

In December, under the taxpayer’s direction, ABC paid the $3.5m to the trustee of a charitable trust established by the taxpayer. The trustee then used this amount to acquire shares in ABC from the taxpayer at a price of $0.85 per share while, on the day of this transaction, the closing price of the shares was only at $0.74.

The taxpayer claimed deductions for interest payments totalling over $850,000 for the various loans used to acquire additional units in the trust for the 1999/2000 to 2001/02 income years on the basis that the payments were incurred in gaining income. Further, the taxpayer argued that the payment of $3.5m from ABC was not an eligible termination payment (ETP) because it was made in consequence of the resolution of a dispute between ABC shareholders over the control of ABC. Even if it was found to an ETP payment, the taxpayer argued he was entitled to a deduction having donated the $3.5m to the charitable trust.

The Commissioner disallowed the interest claims on the basis that the trust was a wholly discretionary trust (contrary to the taxpayer’s claim that the trust was a hybrid trust with a fixed trust and discretionary trust component), which meant that the taxpayer had no fixed or present entitlement to income derived by the trust. Therefore the interest payments were not incurred in gaining or producing income. The Commissioner also argued that the $3.5m constituted an ETP payment pursuant to s 27A(1) of ITAA 1936, and that s 78A(2) of ITAA 1936 prohibited the gift to the charitable trust from being deductible. The Commissioner also imposed penalties.

Decision

The AAT denied the interest deductions and rejected the taxpayer’s argument that the objective intention of the parties was to create a fixed trust. Upon examining the trust deed, the AAT held that the taxpayer’s entitlement was entirely contingent and represented a mere expectation. The AAT said that a beneficiary was not entitled to deduct interest expenses incurred in acquiring units in a trust if the beneficiary was not presently entitled to any part of the trust. This was because the beneficiary had at most a mere expectation of deriving income which was insufficient to establish a connection between the outgoing and the gaining of income.

The AAT agreed with the Commissioner that the November deed made it clear that the payment of $3.5 m was made in consequence of the taxpayer’s termination of his employment and therefore was an ETP.

The AAT found that the acquisition of shares by the trustee for the charitable trust constituted “an act, transaction or circumstance” that occurred as “ part of, in connection with, or as a result of” “the making or receipt of” the gift. Therefore, s 78A(2) applied to preclude an allowable deduction in respect of the gift.

On the matter of penalties, the AAT varied the penalties to nil with respect to the interest deduction claim on the basis that the taxpayer could not be said to have acted without reasonable care or that his conduct was not reasonably arguable. However, the AAT found that the taxpayer was reckless in respect of the ETP issue and affirmed the penalties imposed.

AAT ref: [2008] AATA 325 (R Nicholson, Deputy President), 18 April 2008, Perth.

See the CCH Australian Federal Tax Reporter at ¶38-512 and CCH Australian Federal Income Tax Reporter at ¶31-050.
 
OK, Julia, I'll ask the possibly silly question: what are the implications (if any) for those who've purchased property via hybrid trusts to attempt to gain negative gearing benefits? (I'm not in this situation, but I'm maintaining an eager watch on this.) Is there any potential difference in the implications for "regular" hybrid trusts, and the so-called "property-customised" hybrid trusts?
 
Julia may have a crusade against HDTs - I don't know her and haven't got any great investment in this topic myself - but Rolf, your response seems a little harsh when all Julia has done is posted a ruling without any commentary! :confused:
 
The trustee could, in its absolute and uncontrolled discretion, determine the proportion of either component.
I think this was probably the issue in that case. If the trustee has absolute discretion in deciding what's attributable to the units, then obviously the unitholder has no fixed right to anything.

GP
 
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