Hybrid Discretionary Trusts - The final word.

[Chris Batten]

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

JIT

No. I don’t think one size fits all. If they are understood and used appropriately then I think things are better today with certainty. I basically advise all clients acquiring residential or commercial investment properties the following.
1. All rental properties acquired should be held in a unit trust. The reason behind this:
(a) a unit trust is the only vehicle that you may own residential property and move the asset to a SMSF. (either transferring units or by way of issue and redemption)
(b) Some states provide for no stamp duty where the unencumbered value of the property is less than $2,000,000. This facilitates moving the beneficial ownership to a discretionary trust or self managed superfund without stamp duty.
2. I then look at the situation. If Dad is the high income earner then I’ll have him hold the units and borrow in his name. That way they get the benefits of (a) and (b) above and he receives the land tax threshold. He would have got the land tax threshold owning it direct in his name without the benefits of (a) and (b).
3. If it’s the second rental property then I usually do some calcs of another unit trust (never acquire more than 1 property per unit trust – I’ll explain later) where Mum might hold the units. She receives benefits of (a) and (b) above and another land tax threshold. Otherwise I will consider an SMSF to hold the property on terms of a warrant trust or a hybrid discretionary trust to hold the units in the second unit trust. At this point depending upon the gain on Dad’s units I might recommend some be transferred to Mum.
There are a lot of reasons behind using a hybrid discretionary trust and I would ask that you consider the following. You have Terry’s residential property that he acquired on terms of a unit trust with units on issue to a hybrid discretionary trust. No Special Income Units are on issue and there is no debt. Property is valued at $500,000. The hybrid discretionary trust starts to redeem its units and his self managed superfund starts to acquire units. Terry takes that money out of the trust as corpus distributions and spends the money on his kids. Why wait until he dies. The property needs renovation so Terry who is on a high income and borrows $50,000 and acquires Special Income Units in the hybrid discretionary trust which in turn acquires units in the unit trust which renovates the property. When Terry has repaid his loan he has the option to have the trust borrow and redeem his units or take the money coming from his SMSF through an issue and redemption. At this point Terry is distributing 50% of the income to his kids and the other 50% goes into his SMSF. While Terry had the Special Income Units he would be entitled to about approximately 16% of the net income of the hybrid discretionary trust. Remember the hybrid discretionary trust only receives 50% of the net income of the unit trust. The SMSF has the other 50%.

If the above property was acquired in Terry’s name or a hybrid discretionary trust then it couldn’t be moved to the SMSF and it couldn’t be moved without incurring stamp duty. If the property was acquired in the SMSF you are prohibited from renovating a rental property if there exists a borrowing (section 67A(1)(a)(i). If you didn’t use a hybrid discretionary trust you wouldn’t be able to quarantine the gearing to Terry on the renovation as well as get the benefit of the interest deductibility on the borrowing by the trustee to redeem Terry’s Special Income Units.
It’s about options. Everyone appears overly concerned about capital gains tax. With the 50% discount your top rate is 22.5%. You normally can plan for it and if it’s units in a unit trust you can redeem slowly over years. I think the key is flexibility.
The number of people who ring me with both commercial and residential properties acquired in their own name and either can’t move them to an SMSF (residential) or can move and have to pay stamp duty (commercial). Don’t bother pointing out section 62A of the Duties Act 1997 provides for an exemption for transfers to an SMSF. Look at the section. It is unworkable unless you have a segregated fund that accepts no more members.

So basically I have always gone unit trust and now need to factor in the land tax but I still like some of the features of a hybrid discretionary trust.

Chris

 

[Rob G.]

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...."

Hi Chris,

Sorry to harp on about the 'returnable amount', however this is a term created by the ATO and it is couched in more traditional unit trust examples as you pointed out.

Paragraph 5(c) defines this as 'represents money or property previously transferred by a beneficiary .... to the trustee'.

Given that unit holders now generally have a right to call for redemption at market value, the above definition appears to excise the portion of the proceeds that represents money transferred to the trustee as a settled sum.

Whereas you appear to infer that the very fact that the unit holder has a right to redemption at market value actually extends this definition of a 'returnable amount' to the market value (provided the entire amount was previously used to earn trust income).

This sounds great, however given that the ATO appears to be the creator and keeper of this definition, I would be greatly comforted by at least a pbr confirming that this could be so.

Cheers,

Rob

PS Thanks for the time to give another perspective.

 

[JIT]

If the above property was acquired in Terry’s name or a hybrid discretionary trust then it couldn’t be moved to the SMSF and it couldn’t be moved without incurring stamp duty. If the property was acquired in the SMSF you are prohibited from renovating a rental property if there exists a borrowing (section 67A(1)(a)(i). If you didn’t use a hybrid discretionary trust you wouldn’t be able to quarantine the gearing to Terry on the renovation as well as get the benefit of the interest deductibility on the borrowing by the trustee to redeem Terry’s Special Income Units.
It’s about options. Everyone appears overly concerned about capital gains tax. With the 50% discount your top rate is 22.5%. You normally can plan for it and if it’s units in a unit trust you can redeem slowly over aaaqyears. I think the key is flexibility.

Thanks Chris, that makes sense.

Having these options and this flexibility seems logical for one's long-term financial planning.

Gradually redeeming units and incorporating SMSF strategies can clearly minimse the CGT and income tax burdens.

For people who have a HDT only though... can it be converted into a unit trust without creating a re-settlement??

 

[Chris Batten]

Hi Chris,

Sorry to harp on about the 'returnable amount', however this is a term created by the ATO and it is couched in more traditional unit trust examples as you pointed out.

Paragraph 5(c) defines this as 'represents money or property previously transferred by a beneficiary .... to the trustee'.

Given that unit holders now generally have a right to call for redemption at market value, the above definition appears to excise the portion of the proceeds that represents money transferred to the trustee as a settled sum.

Whereas you appear to infer that the very fact that the unit holder has a right to redemption at market value actually extends this definition of a 'returnable amount' to the market value (provided the entire amount was previously used to earn trust income).

This sounds great, however given that the ATO appears to be the creator and keeper of this definition, I would be greatly comforted by at least a pbr confirming that this could be so.

Cheers,

Rob

PS Thanks for the time to give another perspective.

Rob G

You seem to have a very good comprehension of this. Lets bed the hybrid down and then go for the 'returnable amount'. I understand where you are coming from but I just spent some very painful 10 months getting the private ruling I received. We need to take it slow. I have to admit from a technical point of of view I enjoy when people get it.

Chris

 

[Chris Batten]

Thanks Chris, that makes sense.

Having these options and this flexibility seems logical for one's long-term financial planning.

Gradually redeeming units and incorporating SMSF strategies can clearly minimse the CGT and income tax burdens.

For people who have a HDT only though... can it be converted into a unit trust without creating a re-settlement??

JIT

Unfortunately not. Converting a trust to a unit trust creates a CGT event (section 104.65 ITAA97 CGT Event E3). Good comments and exploring JIT. If we can all learn and benefit from this thread I'm happy.

Chris

 

[Chris Batten]

Forgot Attachment

Apologies

Forgot to add this attachment last post.

Chris

 

[JIT]

Hi Chris,

So at the moment, if lenders are willing, do we have a "green light" to go and buy more properties (negatively geared with SIU's on issue) in a HDT and increase line of credits for HDT properties, or should one just be thankful we got the negative gearing OK at least and buy using other structures until there is any further certainty or clarity from the ATO?

 

[Chris Batten]

So at the moment, if lenders are willing, do we have a "green light" to go and buy more properties (negatively geared with SIU's on issue) in a HDT and increase line of credits for HDT properties, or should one just be thankful we got the negative gearing OK at least and buy using other structures until there is any further certainty or clarity from the ATO?

JIT

I think the position is a lot clearer and with a greater degree of certainty. The ATO has indicated when they will agree to be bound to provide a full deduction for interest on borrowings to acquire SIUs. Regarding existing deeds I think people should be thankful that the ATO has adopted an approach of allowing people to amend their deeds and maintain their deductions. People need to understand that:

1. The ATO has got it wrong many times in the past and will get it wrong in the future (i.e. Forrest, Murdoch, etc),

2. It can be expensive to fight the ATO. The ATO doesn't always have to run test cases. In the past they would offer a settlement where your penalties and/or interest were reduced if you agreed to give up a right to fight the assessment. Therefore if one person fought and won it didn't apply to you,

3. The ATO is effectively saying you can either fight us in court or amend your deed to what we feel is acceptable. I don't agree with what they think is acceptable, however I think it is great that taxpayers have an option.

In the past the ATO just would have amended peoples assessments and say if your not happy you have your rights. I hope my efforts over the last four years and 10 months of getting the ruling played some part in this new approach.

Going forward I see no reason why you would establish a discretionary trust that wasn't a hybrid (ATO compliant variety). If you don't issue units it just operates as a discretionary trust. If you issue units to raise some funds you know the interest on any borrowings is fully deductible. As I have said previously it is about options and having flexability.

I wouldn't be acquiring any further property in an existing hybrid discretionary trust without understanding what effect it may have on the rights of unitholders and the potential taxation effects. There are problems acquiring more than 1 property in an entity where any part of the beneficial ownership is fixed (i.e. unit trusts and hybrid discretionary trusts)

Chris

 

[JIT]

I wouldn't be acquiring any further property in an existing hybrid discretionary trust without understanding what effect it may have on the rights of unitholders and the potential taxation effects. There are problems acquiring more than 1 property in an entity where any part of the beneficial ownership is fixed (i.e. unit trusts and hybrid discretionary trusts)

Hi Chris,

Are you able to elaborate on what the issue is with having more than one property per entity... is this relating to land tax thresholds or asset protection issues?

Thanks.

 

[bene313]

3. If it’s the second rental property then I usually do some calcs of another unit trust (never acquire more than 1 property per unit trust – I’ll explain later)

Chris, similar to JIT I'd be interested in hearing why each unit trust should only hold one property, if you have time to elaborate. Thanks.

 

[Chris Batten]

Are you able to elaborate on what the issue is with having more than one property per entity... is this relating to land tax thresholds or asset protection issues?

JIT and bene313
It is in fact a combination of a CGT issue, stamp duty (NSW, VIC & WA), land tax and SMSF. The most important is the CGT issue.

The CGT Issue

I subscribe for 2,000 $1.00 each units in a newly created unit trust. The trust acquires 2 properties for $1,000 each being property A and property B. Property A does not increase in value over the next 5 years while property B doubles in value. I decide to sell property A for $1,000 due to its poor performance. I wish to get my hands on the $1,000 cash. Each unit in the unit trust is worth $1.50. I would need to redeem 666 units to get the $1,000 out of the unit trust. I make a capital gain of $333.

Therefore I sell a property that didn’t increase in value and want the cash from the unit trust I have to incur a capital gain. It is a result of the value of property B increasing in value and therefore the units increasing in value.

Stamp Duty (NSW, VIC & WA)

The issue and redemption of units in a unit trust that has property worth less than $2million in NSW and WA and $1million in VIC doesn’t attract stamp duty. The more properties you place in each unit trust the more likely you are to exceed those thresholds.

Self Managed Super

You can transfer units in a unit trust to a self managed superfund as long as the unit trust has no debt and there is no charge against the assets. If you have two properties in a unit trust and one still has debt and a charge then you can’t transfer any units until the debt id extinguished. This means it will be longer before you can transfer any units. Maybe 10 years longer. Within that time there will be more capital gain on the units and there is a chance the properties might have gone over the above stamp duty free thresholds.

Land Tax Thresholds

This is also an issue. If a husband and wife own a family home they are possibly entitled to three land tax thresholds in addition to the exemption on their principle residence. If one property was held in a Land Tax Unit Trust and Dad held the units and another in a Land Tax Unit Trust with Mum holding the units then 2 thresholds would be allowed. One for Dad and one for Mum. The final one is if a Land Tax Unit Trust held a third property and a self managed superfund held the units.

Hope that helps.

Chris

 

[Terryw]

Thanks for all your detailed replies Chris,

May I ask about the asset protection issues with a hybrid trust.

The units would be classed as property under the bankruptcy act and could therefore fall into the hands of creditors.

Drafting the deed so that the units could be worthless on bankruptcy would probably destroy the ability to be able to claim a deduction for interest borrowings to buy the units. This would also probably be able to be voided under s302B of the Bankruptcy Act.

So a person holding units in a HDT could be as risky as owning the property in their own name.

 

[Chris Batten]

The units would be classed as property under the bankruptcy act and could therefore fall into the hands of creditors.

Drafting the deed so that the units could be worthless on bankruptcy would probably destroy the ability to be able to claim a deduction for interest borrowings to buy the units. This would also probably be able to be voided under s302B of the Bankruptcy Act.

So a person holding units in a HDT could be as risky as owning the property in their own name.

Terry

The units would definately be property of the bankrupt. Making the units worthless on bankruptcy would definately affect the ability to claim a full deduction for the interest. A person holding units could be as risky as a person hold torrens title property? I don't think so.

A person who holds units in a trust has the entitlement to the net income of the trust and an amount calculated on redemption. The ATO view is that the person has to have an absolute right of redemption. The trustee controls the asset of the trust. The power of appointment isn't property. This was decided in Wily v Burton FED No. 388/94 Bankruptcy (1994) 126 ALR 557. Therefore as my trustee in bankruptcy you cannot make yourself trustee of my trust.

You have to first take possession of my units and request a redemption from the trustee. He must comply with that redemption. If the trustee was to charge market rates for certain functions then that money would be deducted before it was available to be paid as a redemption amount. No one I know goes bankrupt over night with a rental property. It is a slow process which can take anywhere between 6 and 12 months. A trustee could charge market rates for managing the property and carrying out the sale. It is only going to help the person in the range of $10,000 to $30,000 depending on the size of the trust. However I have seen people going bankrupt and $10,000 to $30,000 is like $100,000 to $300,000 for an average person. No money for rent or food. I know a lot of trustees in bankruptcy and they have all indicated they would'nt attempt to run a case if the trustees fees were commercial and didn't go back further then 12 months in terms of accrual.

You do however Terry raise a fantastic point and one I think I'll raise with the Assistant Commissioner.

What if I was to amend the deed such that the trustee could have 6 months or a year to realise the assets on a request for redemption made by a trustee in bankruptcy on behalf of a unitholder. The reason would be to maximise the sale price and not force a fire sale. You could probably stretch it out to 18 months with settlement. The point being I'm not exactly going to be able to pay the capital gains tax on disposal. I'm going bankrupt. I think that won't be too abusive. In the absence of bankruptcy the trustee who is usually the same brain as the unitholder decides when to sell to maximise profits.

Thanks Terry.

PS. None of the above includes Banks. Banks, especially today, want everything and everyone to sign up. It's a risk issue. They lost so much money in the GFC and as you know they are barely turning a profit at the moment.

Chris

 

[Rob G.]

If the bankrupt beneficially held all the units on issue then the argument by a trustee that it must act in the best interests of the beneficiaries as a whole by delaying for a better price is somewhat undermined.

Cheers,

Rob

 

[Chris Batten]

If the bankrupt beneficially held all the units on issue then the argument by a trustee that it must act in the best interests of the beneficiaries as a whole by delaying for a better price is somewhat undermined.

Rob

In terms of a hybrid discretionary trust this has to depend upon the circumstances. You can not put this proposition forward if the person owns all of the units on issue and this represents 50% of the assets of the fund. I assume your point is that the taxpayer has funded 100% of the purchase price and is entitled to 100% of the ordinary and statutory income. The deed that was successful in getting the private binding ruling made the Special Income Unitholder NOT entitled to corpus of the trust. There is a lot of credits in an accounting sense that can be put to corpus of the fund. For example what do you do with money that represents depreciation that does not form the net income of the fund. There is a whole range of ways to credit corpus of the fund. I do not intend to go into them here. I accept you haven't had the benefit of seeing the ruling but your comment, in the absence of a strict fixed trust (i.e. unit trust with only ordinary units on issue) doesn't make sense to me.

The Bankruptcy Act states that a trustee can undo non commercial transactions. Whether I am the sole unitholder or not the commercial market transactions of the trustee cannot be undone. If the trustee of a trust is charging commercial fees and disposing of property within a sensible time period (i.e. 12 months) and that is the right of the unitholder on redemption than I can't see a problem. The Unitholder has to accept what is written in the deed. That is the basis on which he acquired his units. If the bankruptcy trustee can prove I am liberating assets from the trust at non commercial rates or with a means of defrauding my creditors he is free to bring an action against the trustee. It would probably be an injunction.

Otherwise he has to wait and see what the net realisation achieves. The smart ones I have dealt with work with the trustee at the same time as stating they are charging a fee. I have only had this go bad where the trustee wasn't going to receive all his fees. Then it turns really ugly. However where you work with the trustee in bankruptcy and don't overstep the mark I would suggest you are OK if you don't charge excessive fees as trustee. It is sad to say but it all depends on the trustee in bankruptcy receiving his fees. If you charged $50,000 for trustee fees and the trustee in bankruptcy who got paid in full thought it should have been $25,000 then he has to seek from the creditors funds to mount a court case to fight for the additional $25,000. The majority of times (i.e. 99%) people don't want to pay lawyers to fight for 2 years and get them 5 cents in the dollar.

I didn't say the trustee must not act in the best interest of unitholders or in that case beneficiaries. What I said was that a trustee in bankruptcy can't undo commercial transactions. Every trustee must act in the best interest of the beneficiaries of the assets which he is entrusted. Whether that be a hybrid discretionary trist, discretionary trust or unit trust. What I am saying is that the clawback provisions only go so far. I would even say this if you are the sole unitholder of ordinary units in a unit trust. The equity division of the Supreme Court will recognise the expenses and risks associted with being a trustee of a trust and the remuneration afforded same. Most people and advisors don't think that way because it is Mum and Dad as trustee and beneficiaries. When the gloves come off and it gets serious that thinking stops.

Chris

 

[Rob G.]

Hi Chris,

Yes I was using the context of the mum & dad HDT holding passive assets.

However, even if a special income unit was merely something akin to a right to an income stream then it would still have a present value, also affected by the right to call for a redemption.

I am wondering if such a beast is wandering more into the realms where contractual rights become more important which would give a court ammunition to claim there is something other than a trust.

The issues you have raised have given me quite a bit to think about. I wish it weren't such a busy time of year !!

Cheers,

Rob

 

[Chris Batten]

Apology

I accept that 3.5% of people that invest in residential real estate, either through a hybrid discretionary trust or otherwise will go into bankruptcy.

I apologise for the 96.5% that want questions answered regarding the other elements and features of hybrid discretionary trusts including income deductions, corpus distributions, and the role of the trustee, which this thread is about.

RobG lets keep it on topic and cater for the majority. I'll keep answering posts as best I can as long as they apply to the majority.

If you get yourself in financial difficulty you need a lot more than posts on a forum. Get yourself a good advisor.

Sorry if the last post distracted people.

Chris

 

[Terryw]

Chris, while we are at it can we talk about the laws against perpetuities.

Do you see having a trust come under the laws of South Australia enabling the trust to continue on past 80 years?

Its too long for me to 'wait and see'.

(SA is the only state in Australia without legislation against perpetuities)

 

[Chris Batten]

Do you see having a trust come under the laws of South Australia enabling the trust to continue on past 80 years?

Terry

You are asking me to comment about people that built the Property Investor Trust (refer first post and the "History of Hybrid Discretionary Trusts") and you will see why I can't post.

You are asking me to give coment on the people that allegedly trademarked the name "Enduring Family Superannuation Fund".

Terry, You tell me why I can't sign the "Enduring Family Superannuation Fund" and I will anwer the SA Perpetuity Period for you.

I will give you a hint. What ATO document do you sign when you sign an SMSF that makes the "Enduring Family SMSF" a joke?

These guys are out of control. They are the only ones that promote the SA Perpetuity Period concept. I know partners at Mallesons, Henry Davis York and others. They missed a major point in their we are SMSF experts.

What is it? Tell me. It's not that far from the SMSF principles.

Chris

 

[Terryw]

Hi Chris

I had never heard of that super funds before your post. I don't know anything about it and don't know much about SMSFs at all. So I don't know the answer to your question.

Maybe it is the trustee declaration form?