Hybrid Discretionary Trusts - The final word.

Discussion in 'Accounting and Tax' started by Chris Batten, 22nd May, 2011.

  1. Chris Batten

    Chris Batten Member

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    Important - Read the attached History of Hybrid Discretionary Trusts.

    After many years of uncertainty regarding the ATO has finally released a Private Binding Ruling that provides for a full deduction for the interest expense incurred by unitholders.

    Some preliminary Q & A's:

    Q. Are there any Hybrid Discretionary Trusts OK as far as the ATO is concerned?

    A. No. The ATO believes all HDTs established before July 2010 to have problems.

    Q. What if I don't update my HDT?

    A. Assistant Commissioner informed me on 11 May 2011 those people that didn't amend would have their interest denied as per TD 2009/17.

    Q. If I acquired an MGS HDT why should I pay to have it upgraded?

    A. I don't believe it needs upgrading (see attached History of Hybrid Discretionary Trusts). I believe MGS HDT users are in a better position than Andrew Forrest was. Pay to have the MGS HDT upgraded if you wish to maintain the deduction and avoid taking the ATO to court.

    Q. What if I have a Property Investor Trust?

    A. Read attached "History of Hybrid Discretionary Trusts". I am updating Property Investor Trusts to make them compliant. I have discussed this with Assistant Commissioner.

    Q. What if I have another type of HDT?

    A. Send it to me and I will do a review. It will most likely need updating and I can do that for you.

    Q. What is the future of Hybrid Discretionary Trusts?

    A. At least now we have a position where we can be certain of the tax consequences. The only question is whether it applies to your circumstances.

    Q. Should I apply for a Private Binding Ruling for a HDT I set up 5 years ago?

    A. No. PBRs like all ATO advice is only prospective.

    I will answer questions in relation to all aspects of Hybrid Discretionary Trusts. I have been dealing with the ATO for nearly 5 years on HDTs. The last 10 months were spent getting the attached ruling.

    If enough of you ask the same question and I am unable to answer it or it is specific to the ATO I will put it to the Assistant Commissioner. Even though I feel the ATO is being too tough with everybody with a HDT I do feel they are being fair by allowing people to amend their deed and maintain their interest deduction. This avoids you having your interest denied and waiting while someone fights them to the Full Federal Court. They normally get people to settle and therefore they can't rely if the person wins. Please remember the ATO was wrong with Forrest.
     

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    Perp, JIT and redwing like this.
  2. Terryw

    Terryw Investor

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    Hi Chris

    Thank you for posting this information.

    I have a question, do you think that the amendments of some trust deeds may result in resettlements of the trust occuring?
     
  3. Chris Batten

    Chris Batten Member

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    Resettlements

    Good question Terry. I asked the AC (Assistant Commissioner) the same question. He indicated the ATO is more concerned with people bringing their deeds into line with the ATO view. Even though his personal opinion was that if done correctly an amendment of this type didn't result in a resettlement he did indicate that asking people to amend and then hitting them for the tax consequences that arise from a resettlement could be seen as very unfair. I put to him what a particular client of mine with a PIT was told and he did say that would cause a resettlement. The client was told we are going to convert the units, I assume 'A' Class, to ordinary units. The amendment needs to provide a mechanism for overiding rights contained in an application for units or certificate of units or restricting the trustees powers in relation to certain portions of income and capital gains. You can't just convert units. What does that mean anyway?

    I think it is also less of an issue following the decision in FC of T v Clark [2011] FCAFC 5. In that case the ATO alleged a new trust as the units in a unit trust had changed. Court said no. Attached is a paper from the Taxation Institute of Australia on Clark.
     

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  4. Peter_Tersteeg

    Peter_Tersteeg Finance broker/strategist

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    Also be warned that finance options through HDTs are extreamly limited. Last year both ANZ and ING were willing to finance HDTs. Now they're not even willing to perform topups on properties already funded, which means refinancing to a shrinking pool of lenders.

    Whilst HDTs look great from a structuring and tax planning point of view, only a handful of lenders will still accept them and this pool is likely to reduce in the future.
     
  5. Rolf Latham

    Rolf Latham Member

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    accoridng to many of the lenders this redn is due to the "regulatory risk" associated with HDT et al structures of a similar nature.

    I suspect the truth more to be " we cant be stuffed to allow our sausage factory outsourced credit people to work with anythig non standard".

    While I understand the commercial reality in that it would be nice if the lenders just stuck to the "truth"

    ta
    rolf


    ta
    rolf
     
  6. Chris Batten

    Chris Batten Member

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    HDT Financing

    The financing of HDTs is obviously a critical part of the structure. As I understand lenders had started to reject them as to the tax risk associated with the structure. I lend to you and 4 years later you receive an amended assesment with a large amount due to the Commissioner.

    Now that the ATO has disclosed their position people can establish Hybrid Discretionary Trusts with certainty for both the taxpayer and the Banker. I am preparing Private Binding Rulings for taxpayers for both them and their financiers.

    I think now with certainty the ATO has given the financing of HDTs is going to be less of an issue.
     
  7. JIT

    JIT Member

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    Hi Chris,

    Thanks for the update, good to hear.

    Just a question, if I have a HDT with a property with say 300k in equity, and the special income unitholder wants to get a line of credit of say 200k against the HDT property (or top-up an existing line of credit to 200k)...

    Does this involve issuing more special income units, and is this ok?

    If not how does one access the equity available in a HDT?

    Thanks.
     
    Last edited: 23rd May, 2011
  8. Chris Batten

    Chris Batten Member

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    Good point JIT. That would depend on the trust deed and rights and value of the current unit holders. I would probably suggest new units be issued but the question would be how many and with what rights and at what price? Without knowing your personal predicament I wouldn't know if the issue is to settle more funds on the trust.

    I can only offer so much advice as general advice. Once it gets too specific I need to see the balance sheet of the trust.
     
  9. JIT

    JIT Member

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    Sure, no worries Chris. Thanks for the reply.
     
  10. Mry

    Mry Member

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    Where can we look at the full private ruling? I assume the ATO will publish it on their register at some stage.
    You stated earlier "The only question is whether it applies to your circumstances." What are those circumstances? Are they dependant on a person's situation, intents or other matters?
    Will you be running a test case on your HDTs?
     
  11. Terryw

    Terryw Investor

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    Chris,

    Another question:

    Under what circumstances do you see a hybrid trust being beneficial? Could you please give an example?
     
  12. Chris Batten

    Chris Batten Member

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    Terry

    Happy to discuss, however you will have to do some reading first. Read attached document especially page 4. Give me the heads up when you are done. I am happy to talk about hybrids and maybe other trusts for that matter, however we need to be all up to a certain speed.

    Chris

    PS. Look at the date. I thought this was one of the main reasons to use a hybrid discretionary trust. I had assumed everyone knew about the refinancing principle.
     

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  13. JIT

    JIT Member

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    Hi Chris,

    Does the ATO not mind that a HDT may potentially be used for this other purpose (ie. the re-financing principle), and as such apportion the interest deduction?
     
  14. Terryw

    Terryw Investor

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    Hi Chris

    Thanks for you time explaining this and your articles.

    I have read your paper on the refinancing principle now, and have a hypothetical example:

    A $400,000 property is purchased by the trustee of XYZ Hybrid Discretionary Trust with Mr Smith borrowing $400,000 and being issued with 400,000 units in the trust. Under the terms of the trust Mr Smith must receive all income of the trust and all capital gains of the trust as the unit holder. The ATO should allow the deduction of all interest on the $400,000 loan against the income of Mr Smith.

    After 5 years or so, the property is now worth $1,000,000 with Mr Smith still owning 400,000 units and getting all income from the trust.

    The trustee then decides to redeem the units and needs to borrow money to buy the units back from Mr Smith. However, the units are now worth $1million and so the trustee borrows this amount to buy back Mr Smith (using other property as additional security).

    The trust has now reverted to a discretionary trust. It has a $1million property with a $1million loan. All of the interest on this loan should be deductible because the trustee “replaces funds employed in the entity’s business by financing a payment by the entity in discharge or reduction of an obligation to a person who is entitled to be paid those funds.” (ie the refinancing principle)

    Mr Smith uses his $1million to buy a new house to live in. Essentially this has enabled Mr Smith to use funds for private use and to have the whole loan deductible.

    But the downside is that Mr Smith will have to pay CGT on his gain of $600,000 on the units (CGT TD 40). This could be around $140,000 or so on the top tax bracket.

    Maybe the CGT could be minimised by setting the HDT up (like the Twiggy case) so that the unit holder is not entitled to the CG of the trust, or only part of the CG. I wonder would the ATO allow the deduction of the interest on the loan to buy the units in full?

    Chris, is your example represented in diagram 3 on page 5 still the case? Ie husband owning income units and wife owning capital units. Could the husband still claim 100% of the interest if he borrowed to buy the units as in Mr Smith above?

    Has the ruling TR 2005/12 changed anything? TR*2005/12*Income*tax:*deductibility*of*interest*expenses*incurred*by*trustees*on*funds*borrowed*in*connection*with*the*payment*of*distributions*to*beneficiaries*
    http://law.ato.gov.au/atolaw/view.htm?docid=TXR/TR200512/NAT/ATO/00001


    Thanks
     
  15. Chris Batten

    Chris Batten Member

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    Multiple Response

    [Mry] No I will not be running a test case. The ATO chooses what cases are run as test cases. Following this link.

    [JIT] If you borrow and acquire units in Mirvac Property Trust the interest on your loan is deductible. If you redeem and Mirvac Property Trust borrows to pay your redemption then the interest on that loan is deductible. Mirvac Property Trust do not ask what you are going to do with your redemption cheque. This is not new and isn't tax avoidance.

    [Terry] Your example is spot on. Forget the diagram 3 on page 5. If the unitholder doesn't have a right to both ordinary and statutory income then the ATO will apportion. Maybe the CGT, which is subject to the 50% discount, could be reduced by a super contribution. At the end of the day it is a mathematical equation. What is the interest on a $1,000,000 loan and therefore what is the difference between the interest being deductible and not being deductible?
     
  16. Rob G.

    Rob G. Member

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    Hi Terry,

    It is unlikely the entire $1m (being the market value of the units) would be a 'returnable amount'.

    Examples of a 'returnable amount' from case law on partnership are contributed capital and un-withdrawn attributed net income that has been 'reinvested' for income producing activities.

    Translated to trusts, this would be the capital sum subscribed for shares and amounts of unpaid present entitlements where they can be traced to use for income producing activities.

    Unrealised capital gains in the underlying asset associated with the units would not normally be regarded as such.

    Cheers,

    Rob
     
    Last edited: 23rd May, 2011
  17. JIT

    JIT Member

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    Hi Chris,

    Another question, do the benefits of land tax unit trusts make HDTs somewhat redundant?
     
  18. Terryw

    Terryw Investor

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    Thanks Rob.

    Without ever looking into it I had thought the refinancing principle was killed off by TR 2005/12. But it appears it is still available.

    In my example it would be a huge problem if only the $400,000 was consdiered the returnable amount. This would mean the interest deduction for the trustee would be only on the $400,000 amount, but the CGT would be on the full $1mil.

    Chris, any comments
     
  19. Chris Batten

    Chris Batten Member

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    Tr 2005/12

    Terry and Rob

    Taxation Ruling TR2005/12 came out with the intention of clearing up a few schemes that were being promoted. The schemes used discretionary trusts. I don't think anyone was using hybrids. The scheme being promoted was where you internally generated goodwill (if the trust owned a business) or revalued assets (if the trust owned rental properties) then you made a corpus distribution which would create a significant debt owing to the beneficiary. Corpus distributions are tax-free from a discretionary trust (s.99B(2) ITAA 1936).

    The trust would then borrow and pay the debt to the beneficiary who would pay off their home loan. Using the example by Terry if the trust used the $400,000 to acquire a duplex and one was rented out and Terry and his family lived in the other then only 50% of the interest on the $1million loan by the trustee would be deductible. TR 2005/12 clearly states at para 9 that money or property is a 'returnable amount' if "an individual has subscribed money for units in a unit trust and has a right of redemption in relation to the units and the money is used by the trustee to purchase income producing assets...."

    It will not be deductible or will be partly deductible if there is some private use or the borrowings are for asset revaluation reserves, internally generated goodwill or simply the borrowing to pay out an unpaid present entitlement. None of these are the same as what you gave in your example.

    Chris
     
  20. bene313

    bene313 Member

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    I have been thinking along similar lines.

    Purchasing a property in a unit trust and then transferring the units (years later) to a discretionary trust would seem to have a similar result of using a HDT, but without the headaches of dealing with the ATO and the banks.

    Is there any difference in using a HDT, as opposed to using a UT with a transfer of units to a DT?