Hybrid Trusts

A bit of info on Hybrids my accountant sent me if anyone is interested. They seem to be becoming less and less attractive and the ATO seems to be saying NO No No


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Using hybrid trusts – advanced tax
planning or tax nightmare?
Introduction
Generally a hybrid trust combines aspects of a traditional unit or fixed trust entitling unit holders or
entitlement holders to a fixed entitlement to income and capital of the trust with aspects of a
discretionary trust giving the trustee a degree of control over how the income and capital of the
trust should be distributed to potential beneficiaries.
The term ‘hybrid trust’ is a general term which can be used to describe any trust containing
elements of both discretionary and fixed/unit trusts, or indeed any trust containing some unusual
elements. In these seminar notes we will focus on three categories of taxpayer and evaluate
whether a hybrid trust may give that taxpayer the asset protection, tax effectiveness and
structural flexibility that is purportedly on offer.
Each category of taxpayer may place, depending on their own circumstances, a greater emphasis
on one these benefits over another.
The three categories of taxpayer we will be considering are as follows:
1. High income salaried professionals looking to access negative gearing losses with flexibility to
vary their arrangements going forward;
2. “High risk” professionals or businesses operating in an environment where litigation is a
reality whether it be for professional negligence or other, and where asset protection is
paramount.
3. Taxpayers looking to conduct a business with unrelated parties and wanting a flexible vehicle
to allow the introduction of new equity participation.
The analysis of each category of taxpayer will be done by way of a case study and will include:
• a description of the type of taxpayer in the category;
• a description of how the arrangement works;
• the tax consequences of the arrangement;
• the level of asset protection the arrangement may have.
1. High income salaried professionals
CASE STUDY 1 – High income salaried professionals
Joanne is a successful merchant banker, employed by Macarthur Bank, earning $340,000
per year. She is married with 2 children and her husband is a stay at home dad.
Joanne is concerned about the high level of tax she is paying, and her inability to split any
income she earns with her husband. In the past she has acquired investments in her own
name, and although it gives her negative gearing deductions initially, she eventually ends up
with a significant capital gain.
She plans to invest $800,000 in acquiring a new property, and would like to know whether
there are any better options aside from her buying the new property in her own name.

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A certain type of hybrid trust known as a negative gearing hybrid trust is useful in the situation
where there is a high-income earning individual who does not otherwise have the ability to split
income with their spouse (or other close associates).
1.1 How the arrangement works
Under the arrangement, the negative gearing hybrid trust is used to purchase assets, which might
include shares or, as in this case, real estate.
The arrangement is structured in the following way:
(a) Joanne borrows $800,000 from the bank in her own name. Rather than acquiring the
property in her name directly, she will use the borrowed funds to subscribe for units in a
hybrid unit trust (i.e., a negative gearing hybrid trust).
Joanne has no equity in the units as she has fully borrowed to acquire them (nor will Joanne
ever have equity in the entity – see below);
(b) The hybrid trust is established with a corporate trustee. The nature of the hybrid trust is
normally such that the individual unit holder’s family are automatically included as
beneficiaries (both as to income and capital) of the trust on the basis that they are related
beneficiaries of the unit holder;
(c) The trustee of the unit trust uses the proceeds of the funds received from Joanne to
purchase the assets – in this case a property. The unit trust does not have any borrowings
in its own name, although it may be necessary for the asset to be used as security for
Joanne’s borrowings. In other words, the bank takes a mortgage over the unit trust’s asset –
the property – in order to secure the borrowings made by Joanne to subscribe for units; and
(d) The trust earns the income on the assets (in this case by letting the house) and pays all the
associated expenses. The unit trust deed provides for all of the income to be distributed
proportionately to the unitholders. In this case, Joanne is the sole unitholder, and receives
100% of the net income. This income from the unit trust is returned by her in her tax return,
and she claims a deduction for the interest on the borrowings used to acquire the units.
Ordinarily the net income from the trust will, in the initial years, be less than the interest
incurred on the borrowings, giving rise to a net deduction (a negative gearing loss) which can
be offset against other income. It is a feature of this type of trust that distributions of income
to other members of Joanne’s family can only be made when Joanne ceases to be a
unitholder and there are no other unitholders.
This arrangement can be illustrated as follows:
Should Joanne pay off a substantial amount of the loan, be it by way of standard repayments or
extra capital repayments and/or the rental income increases, a situation might develop whereby
the income from the investment exceeds the interest being paid on the loan (i.e., it becomes
positively geared). When this arises, it may be possible for Joanne to redeem the units, typically
for their face value.
Negative gearing
hybrid trust Property
units/
distributions $800,000 security
Joanne Bank
Interest
$800,000
acquires
rent

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TAX WARNING – Market value substitution rule
It is usual for these types of arrangements to provide that the units are to be redeemed only
at their initial face value.
It is intended as a consequence that the unitholder neither realises a capital gain or loss
when the units are redeemed.
This will not be the result however if the market value substitution rule in S.112-20 and
S.116-30 applies to either reduce the unitholders cost base of the units or increase the
consideration on their redemption. In that case, a capital gain may arise.
The unit trust would either finance the property itself, or realise the property. If it refinances the
property, future income could then be distributed to the members of Joanne’s family who pay tax
at a lower rate on their income as the trust deed allows discretionary income distributions to
family members once any issued units have been redeemed.
Similarly, if the assets were sold, the capital gain could be distributed to Joanne’s family, rather
than Joanne.
TAX WARNING – Part IVA
It should be noted, that the arrangement outlined above may attract the application of Part
IVA of the ITAA 1936 if it does not stand on ‘all fours’ with a standard negative gearing
arrangement. To come within this general anti-avoidance provision, the Australian Taxation
Office (‘ATO’) needs to establish:
• there was a scheme (due to the very wide definition of scheme it would be fair to assume
that any arrangement or transaction is a “scheme”);
• there was a tax benefit (this is where the counterfactual is important – i.e., what would
Joanne have likely done if she did not enter into this hybrid trust arrangement, and would
her tax position be as a result? It is only if she has a better tax position that she has a tax
benefit;
Based on the facts, and with an onus on Joanne to have evidence to establish this,
Joanne would have acquired the property in her own name and therefore would have
been entitled to a full deduction on any interest in respect to her borrowings. Arguably
there is no tax benefit as a result and Part IVA would have no application.
However, where the units are ultimately redeemed and income and capital distributions
made to family members rather than to Joanne, Part IVA may have application in respect
to the income that Joanne has not included in her assessable income (i.e., the
counterfactual to the redemption of the units is that Joanne would have remained the unit
holder and would have been assessable on such income); and
• the sole or dominant purpose of entering into the arrangement must be to derive a tax
benefit. This is where an asset protection purpose is important and this is discussed
below.
As to whether the ATO would apply Part IVA to cancel any of the tax benefits associated with
a negative gearing hybrid trust arrangement remains unclear. However, as will soon become
clear, this may well be a moot point.

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1.2 Asset protection as the dominant purpose
Although asset protection may not be ‘top of mind’ for Joanne, the negative gearing hybrid trust
does, in effect, provide her and her family with asset protection. If Joanne were ever sued or
bankrupted, her only asset in relation to the arrangement is her interest in the units. She does
not have a direct interest in the asset held by the trust. Whilst she could call on the units to be
redeemed, generally the arrangement would be structured so that the redemption is for the initial
issue price of the units (i.e., $800,000). (As there is a corresponding liability to the bank for this
amount Joanne has a net equity position of nil in respect of the units). This redemption would
require the trustee to either refinance, or to sell the underlying property. In either case, any
increase in the value of the property is effectively retained in the unit trust, and is then capable of
being distributed to the other related discretionary beneficiaries. At that point, Joanne also is a
discretionary beneficiary, and as such her entitlement has no value (it is a mere expectancy).
TAX TIP – Asset protection as dominant purpose
The difficulty in arguing that the sole or dominant purpose was not to derive a tax benefit but
rather to achieve asset protection is twofold:
1. In Tabone v FC of T 2006 ATC 2211 the taxpayer (who was an employee) argued that the
dominant purpose of the arrangement he entered into was the accumulation and protection of
assets for the future benefit of his children.
The arrangement involved the establishment of a unit trust which owned property. The
taxpayer owned the units in the unit trust and thus did not have direct ownership of the
property, thus purportedly achieving a level of asset protection.
The Court rejected the taxpayer’s argument providing the taxpayer and his spouse were
employees of arms’ length employers with little likely risk of litigation. (Employers are
vicariously liable for the actions of their employees).
Further, the arrangement still left the taxpayer with property available to any potential
creditor, i.e., units in the trust replaced a direct ownership in the relevant assets (both are
a form of property).
It would be reasonable to conclude that employees would find it difficult to establish that
their dominant purpose was asset protection rather than to derive a tax benefit, especially
where they have merely exchanged one form of property for another (both of which are
potentially available to the trustee-in-bankruptcy).
The “capping” of the redemption price of units to their initial issue price (which is a feature
of a negative gearing unit trust) should assist a taxpayer’s asset protection purpose as a
taxpayer should have no effective equity in the units (the initial subscription price of the
units having been funded with a bank loan).
The position for the taxpayer should be improved where the taxpayer is not an employee,
and is therefore potentially more genuinely at risk. The ATO has acknowledged in
Taxation Ruling TR 2006/2 that:
“when determining whether there is a scheme to which Part IVA of the ITAA 1936
applies it would be necessary to have regard to any objective asset protection
benefits that may be obtained by any of the participants in the arrangement. The
Commissioner accepts that asset protection does make objective business sense
where an arrangement has the effect of protecting assets …”
However, the ruling also provides that the Commissioner does not accept the asset
protection alone can explain an arrangement where other factors are at play.
The expected redemption of the units once break-even is achieved may be one such
factor.

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2. Where an asset protection purpose is accepted by the Commissioner, (so that Part IVA
does not apply because the taxpayer’s dominant purpose was not to derive a tax benefit),
the interest deduction to the taxpayer may be limited to the trust distribution they receive.
This is because it is arguable the purpose of the interest outgoing is twofold –
(i) to derive assessable trust distributions; and
(ii) to achieve a level of asset protection (being a private purpose).
There is certainly precedent in the decisions of Fletcher & Ors v FC of T 91 ATC 4950, Ure v
FC of T 1981 ATC 4100, TR 95/33 and IT 2684 to see this as a real possibility.
1.3 Deductibility of borrowings used to purchase units in
a negative gearing hybrid trust
Under S.8-1 a taxpayer is entitled to claim interest as a tax deduction to the extent to which it is
incurred in gaining or producing assessable income and is not of a capital, private or domestic
nature. In determining the deductibility of interest, the purpose for which the money has been
borrowed and the use to which it is put needs to be considered.
Any investment must be made in the expectation that the returns received will ultimately exceed
the total of the deductions claimed against assessable income.
In particular, even where the amount of interest is greater than the assessable income and this
persists for a number of years, so long as the interest has been incurred to produce assessable
income, the interest will remain fully deductible (refer IT 2684 at paragraphs 28 to 30).
In this regard, it is generally accepted that the income from an investment need not necessarily
be derived in the same year as the interest expense is incurred.
The High Court held in Fletcher that expenses exceeding the income received in the early years
of an investment can be deductible.
The Court held that a deduction was available immediately so long as there was an expectation
that positive income would be generated in later years and it was clear that the ‘arrangement’ was
intended to run its natural course.
For example, interest incurred on borrowed moneys as part of a ‘standard’ negative gearing
arrangement is deductible. This is confirmed by the ATO in TR 95/33. However a ‘standard’
negative gearing arrangement does not extend to those arrangements that have a ‘defined and
pre-ordained period to run’. Refer paragraph 46 of TR 95/33.
What is critical for a taxpayer entering into a negative gearing arrangement is that there must be
an objective intention that the investment will runs its natural course. This is true whether the
negative gearing is achieved through direct ownership of property or by investing in a hybrid or
unit trust. Objective intention will be determined by reviewing all the circumstances surrounding
the investment.
Entering into a negative gearing arrangement though an investment in a negative gearing hybrid
trust may, by its very nature, attract a greater level of attention. The terms of the trust deed will
be very important. Specifically, the provisions in the hybrid trust deed allowing the unit holder to
redeem their units (and in a relatively easy manner) combined with the substantial tax
advantages of doing so before the arrangement becomes positively geared, may be
misconstrued to infer that the arrangement is only intended to run for a ‘defined or pre-ordained
period’.
The onus is on the unitholder of a hybrid trust to establish that the objective intention of entering
into the arrangement was for it to run its natural course and ultimately become positively geared.
This would mean in practical terms that there was no intention that the units would be redeemed
once negative gearing benefits were exhausted. This will be particularly difficult due to the
inference referred to above together with the anecdotal evidence that in most cases the
redemption of units occurs at the most tax advantageous time.

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Where the unitholder is unable to discharge this onus, the ATO would be able to limit any tax
deduction on the interest borrowings at the unitholder level to the distribution from the hybrid trust
on the basis of Fletcher and Ure, without reliance on Part IVA. This approach is also followed in
Example 1 from TR 95/33 which is adapted below:
EXAMPLE – Interest deduction limited
Mr Chancer, a high income earner, borrows and invests $100,000 in a cattle breeding project
with a 16 year life. It is expected that substantial losses will arise in the first 5 years, small
losses in the next 6 years and large net incomes over the final 5 years.
Over the 16 years, it is anticipated that the assessable income will exceed the total interest.
However, investors are free to exit the project before the large net incomes arise without
incurring personal liability on any outstanding borrowings.
It seems clear that the project is not expected to run its full course and Mr Chancer’s
dominant purpose in entering the scheme is to incur the outgoings in order to minimise his
tax liability. In the circumstances, as the total anticipated allowable deductions will far
exceed the total assessable income reasonably expected to be derived until the time of exit,
the excess of the outgoings over the assessable income will not be deductible under S.8-1.
1.4 ATO issues unfavourable private ruling on hybrid
trusts
The ATO’s views on interest deductibility on borrowings to buy units in a hybrid trust are
contained in Private Binding Ruling 66298.
The hybrid trust arrangement in that Ruling had similar attributes to our arrangement above i.e., a
unitholder had an entitlement to all the income of the trust, the trustee having the power to make
capital distributions to the unitholder and/or the discretionary beneficiaries.
Discretionary income distributions to the beneficiaries could only be made if no units were on
issue, i.e., only after all issued units were redeemed.
In effect the arrangement provided that the unitholder had a fixed entitled to all income whilst he
was a unitholder (he was the sole unitholder) but only a discretionary entitlement to capital.
The interest deduction allowed to the unitholder in the hybrid trust arrangement was limited by the
ATO to the income received from the distributions in respect of his units.
The ATO came to this position of apportionment for the following reasons:
1. the expected return to the unitholder (both income and capital) was insufficient. This was
especially so since entitlements to capital distributions were discretionary. The ATO
provided:
“An interest expense is not fully deductible in those cases where the expected return from
the units both income and capital growth, does not provide an obvious commercial
explanation for incurring the interest. This may arise in situations where the total amount
of income and capital growth which can reasonably be expected from the units is less
than the total interest expense, especially if the amount of assessable income expected is
disproportionately less than the amount of the interest expense.”
The discretionary nature of capital distributions (which was enough to lead the ATO to
apportion the interest deduction) is compounded by the provision in our hybrid trust
arrangement which ensures that the proceeds for the cancellation/redemption of units is
limited to their initial subscription price. Whilst this mechanism may assist with achieving a
level of asset protection it further ensures a full tax deduction is not available (in fact this asset
protection purpose causes a problem in itself as it demonstrates that the taxpayer had a
purpose other than deriving assessable income) .
2. The interest expense was incurred for multiple purposes – i.e., deriving assessable income
and achieving a level of asset protection.

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As the capital return under the trust remains discretionary, the expected capital return from
the units cannot be quantified. (The taxpayer’s ruling application made it clear the
arrangement would be negatively geared – i.e., the return from the unit trust would be far less
than the interest expense on the borrowing).
A stated purpose in establishing the hybrid trust and issuing units with discretionary capital
distribution entitlements and a limited or fixed redemption value was asset protection. This is
a private purpose or motive.
The existence of the large negative gearing losses to the unitholder necessitates a further
examination of the taxpayer's subjective purpose. Where this purpose can be explained by
the unitholder’s desire to achieve asset protection (which is private in nature and evidenced
by the ‘capped’ redemption price and the discretionary nature of capital entitlements) this
leads to the conclusion that the interest expense will only deductible up to the level of income
actually received from the trust.
TAX WARNING – Taxpayers should consider a private binding ruling
Taxpayers entering into a hybrid trust arrangement the same as, or similar to, that described
above should expect to be have their interest deductions (on borrowings to fund the
purchase of units) limited to the income received in respect of their unitholdings, i.e., no
negative gearing loss can arise or will be allowed.
The NTAA strongly recommends obtaining a private binding ruling before entering into the
arrangement if the taxpayer intends to claim a full interest deduction on borrowings.
1.5 Accessing the SBC
A negative gearing hybrid trust is typically used for holding passive investments and not active
assets.
As such the SBC are not relevant. Where a business is operated through a hybrid trust, and this
is considered later in these seminar notes, access to the SBC becomes a live issue.
Ordinarily a distribution of a non-assessable amount to a unitholder would trigger event E4, which
either has the effect of reducing the cost base of the units, or where the cost base is exhausted,
will give rise to a capital gain. However, under the negative gearing hybrid trust, the trustee in all
likelihood would redeem the units prior to any distribution of a non-assessable amount. This
would mean that the non-assessable amounts can be distributed to the related discretionary
beneficiaries to avoid CGT event E4 happening.
The unitholders on redemption of their units attract CGT event C2. CGT event E4 has no
application where CGT event C2 happens (refer S.104-70(1)(a)). There will purportedly be no
capital gain or loss as a result of CGT event C2 as the consideration on the
redemption/cancellation of the units is, under the trust deed, always equal to initial subscription
amount. As the consideration equals the cost base no capital gain or loss arises. However, refer
to earlier tax warning on market value substitution rule.
1.6 45 day holding period rule
As the trust in this example does not derive dividend income the 45 day rule is irrelevant to it.
However, should the trust own shares it acquired after 3pm on 31 December 1997 in companies
giving rise to franked dividends, it would be advisable that the trustee make a FTE. Refer to page
174.
In Interpretative Decision 2003/1105, the ATO confirmed that the beneficiary of a non-fixed trust
(i.e., discretionary) trust will not be able to access any imputation credits unless the trustee has
made a FTE, subject to the ‘small shareholder exemption’ in S.160APHT. In addition, ID
2005/172 decided that a unit holder in a unit trust whose trust deed permitted the issue of new
units at the trustee’s discretion and at a price determined by the trustee was not a ‘qualified
person’ in relation to dividends that flowed indirectly. The facts on which the decision was based
included that the trustee had held shares at risk for more than 45 days and that no family trust
election had been made.

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TAX TIP – Hybrid trust owning dividend paying shares
The same limitations apply to beneficiaries of a hybrid trust, unless the beneficiary can show
that the terms of the trust were such that the beneficiary had a fixed interest in the shares.
This is an important consideration in drafting the terms of any hybrid trust that will hold
significant share assets, especially in circumstances where it would be undesirable for the
trust to be locked into making a family trust election.
1.7 Trust losses
A negative gearing hybrid trust arrangement does not give rise to any losses at the trust level in
normal circumstances.
However there may be situations where a loss may arise, for example, the property in the trust
was not let, whilst fixed costs such as rates, insurance etc., were still incurred.
For purposes of the trust loss provisions in Schedule 2F of the ITAA 36, a negative gearing hybrid
trust is a non-fixed trust.
As such, it would be advisable to make a FTE to limit the application of the trust loss rules to the
income injection test. Refer to page 177.
In the absence of this election, the various tests are not only complex but are extremely difficult to
pass.
2. ‘High risk’ professionals or businesses
CASE STUDY 2 – High risk professionals/businesses
Lydia is an obstetrician who borrowed $500,000 to buy units in a negative gearing hybrid
trust. The trust then used these funds to buy a rental property. Her husband and three
children are named as related beneficiaries of the trust. Three years later, as a result of the
‘property boom’ the rental property experiences significant capital growth and is now worth
over $750,000.
When Lydia becomes bankrupt as the result of a malpractice claim against her, the trusteein-
bankruptcy has an interest in Lydia’s units in the trust, but not in the actual assets of the
trust. Accordingly, the trustee can redeem Lydia’s units for $500,000 (the amount of the
initial investment to purchase the units and the amount any redemption of units is limited to),
but has no claim against the additional growth in the trust’s assets, being the rental property.
At this point, the trust can borrow $500,000 in its own name in order to pay the trustee in
bankruptcy, whilst retaining the assets for the benefit of the related beneficiaries.
This can be illustrated as follows:
Negative gearing
unit trust Bank
redeems
units
borrows
Uses proceeds from
redemption of units to
Lydia repay bank
pays
$500,000
for units
$500,000

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The use of a negative gearing hybrid trust is again the most appropriate for us to analyse in this
scenario as it offers asset protection advantages for Lydia and her family. Lydia is in a high risk
occupation. She has a significant income. Her concern is to use that income in a tax effective
way, but also in a way that ensures that any capital gain on her investments is preserved for her
family’s welfare.
2.1 How the arrangement works
To confirm, the arrangement is structured in the following way:
(a) Lydia borrowed $500,000 from the bank in her own name. Rather than acquiring the rental
property in her name directly, she used the borrowed funds to subscribe for units in a hybrid
unit trust;
(b) The hybrid trust was established with a corporate trustee. Lydia’s family are automatically
included as beneficiaries of the trust on the basis that they are related beneficiaries of the
unit holder;
(c) The trustee of the unit trust used the proceeds of the funds received from Lydia to purchase
the assets – in this case a property. The unit trust does not have any borrowings in its own
name, although it may be necessary for the asset to be used as security for Lydia’s
borrowings. In other words, the bank takes a mortgage over the unit trust’s asset – the
property – in order to secure the borrowings made by Lydia to subscribe for units; and
(d) The trust earned income on the property and paid all the associated expenses. The unit
trust deed provides for all of the income to be distributed proportionately to the unitholders.
In this case, Lydia is the sole unitholder, and receives 100% of the net income. This income
from the unit trust is returned by her in her tax return, and she claims a deduction for the
interest on the borrowings used to acquire the units. Ordinarily the net income from the trust
will, in initial years, be less than the interest component on the borrowings, giving rise to a
net deduction which can be offset against other income.
2.2 What happens when the trustee-in-bankruptcy is
appointed?
When Lydia is bankrupted, the trustee in bankruptcy redeems her units. The units, however, are
redeemed at face value ($500,000). Bear in mind, however, that Lydia is indebted to the bank.
The bank may call in its security and force the sale of the property, which realises $750,000. The
trust must then pay Lydia $500,000 on redemption of the units, which must then be paid to the
bank. The balance $250,000 remains within the hybrid trust. It is not an asset of Lydia’s, and
therefore not available to the trustee-in-bankruptcy.
This is illustrated as follows:
Negative gearing
unit trust Bank
redeems
units
Uses proceeds to pay
Lydia bank
receives
$500,000
$500,000
Property
sells property
for $750,000
receives
proceeds of
$750,000
releases security

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Note: In normal commercial practice the Bank would require to be paid out before it releases the
title to allow settlement on the sale.
This requires $500,000 of the sale proceeds on settlement to go directly to the bank. This
effectively discharges the bank loan owed by Lydia and as a consequence Lydia’s units are
redeemed/cancelled.
An appropriately worded clause in the trust deed is required to empower the trustee to deal with
the proceeds for the redemption/cancellation of the units directly by discharging Lydia’s
outstanding bank loan).
2.3 Redemption of units if no bankruptcy
Had Lydia not suffered bankruptcy, then in the ordinary course, she would probably redeem her
units, repay the loan, leaving the hybrid trust to either refinance the property itself, or realise the
property. If it refinances the property, future income could then be distributed to the members of
Lydia’s family who pay tax at a lower rate on their income.
Similarly, if the assets were sold, the capital gain could be distributed to Lydia’s family, rather
than Lydia, where those distributions would otherwise be exposed to future claims.
TAX WARNING – Part IVA
The same concerns arise as to the possible application of Part IVA of the ITAA 1936,
although here quite clearly Lydia is in far better position to establish her dominant purpose is
to provide asset protection. However, this possibly weakens her argument that the interest
was incurred wholly for the purpose of producing assessable income.
2.4 Other tax consequences
The same analysis in respect to:
• interest deductibility on borrowings to acquire units;
• accessing the SBC;
• 45 day holding period rule; and
• trust losses
applies here as in Case Study 1.
3. Hybrid trust as a flexible business structure
CASE STUDY 3 – Hybrid trust as a flexible business structure
Jack and Jill have decided to set up a new book shop business together. Jack is married
and Jill is married with one child. Jack and Jill are unrelated.
Jack and Jill each own one unit in the hybrid trust, (referred to as a related beneficiary hybrid
trust) and their immediate family members are related beneficiaries under the deed.
The trust deed is drafted to allow discretionary income and capital distributions to these
related beneficiaries. Ultimately they want to distribute any profits to their family members
using a hybrid trust structure.

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For the first two years, the trust incurs a loss as a result of excessive start-up costs.
Unfortunately, the trust may have extreme difficulty in utilising the tax losses without making
a family trust election (‘FTE’) in favour of one of either Jack and Jill’s separate families. Such
an election would make any distributions made to the other unit-holder’s family members
subject to family trust distribution tax (’FTDT’).
Jack and Jill should have considered using a partnership of discretionary trusts rather than a
related beneficiary hybrid trust.
The related beneficiary hybrid trust is often considered as an alternative to a partnership of
discretionary trusts in circumstances where a single entity is seen as more desirable.
Using a ‘standard’ unit trust where the units are owned by discretionary trusts can be problematic
in circumstances where non-assessable payments are to be made to unitholders. These
payments would ordinarily attract the operation of CGT Event E4. A related beneficiary hybrid
trust does not attract the operation of event E4 because the trust is not a unit trust, and capital
distributions are made to discretionary beneficiaries.
Related party unit trusts can also be problematic when it comes to dealing with losses or with
utilising franking credits attaching to dividends earned by the trust, as the requirement to make a
FTE would severely impact upon the ability of the trustee of the trust to make distributions tax
effectively. These issues are discussed in further detail below.
A related beneficiary hybrid trust deed allows the trustee to pay, apply or set aside all or part of
the share of the income to which a registered unit holder would otherwise be entitled in any year,
to any related beneficiary of that unit holder. The trustee is also allowed to make an interim
distribution of capital of the trust to any related beneficiary of a registered unit holder.
It is accepted that there is no deduction for interest incurred on borrowings by either of the
unitholders above as the units give no fixed entitlement to income or capital, i.e., the unitholder’s
interest in the trust is no different to that of a beneficiary of a discretionary trust
TAX TIP – Unitholder should charge interest
Where the unitholder borrows and on-lends the money to the hybrid trust the beneficiary will
not be entitled to an interest deduction unless they charge an equivalent interest rate to the
trust.
This has the effect of transferring any interest deductions from the individual unitholder to the
hybrid trust.
If there is insufficient trust income, the resulting loss in the trust will be deferred (or even lost)
rather than being immediately available to the unit holder.

Practice Hot Spots Seminar 2007
166 © National Tax & Accountants’ Association Ltd: March – April 2007
3.1 How the arrangement works
The structure is illustrated as follows:
The related beneficiaries do not have any specific or fixed interest in the trust fund – all they have
is a right to be considered for a distribution of income or capital (not unlike a standard
discretionary trust) and only with the consent of the particular unit holder to whom that beneficiary
is ‘related’.
In terms of distributing income or capital to a related beneficiary of a registered unit holder, there
are two main options when drafting the trust deed. They are:
(a) to distribute to the related beneficiaries of registered unit holders strictly in accordance with
each unit holder’s unit holding in the trust; or
(b) to have the capacity to distribute to a related beneficiary of a registered unit holder, with the
unanimous consent of all unit holders, amounts other than in accordance with the unit
holder’s proportionate unit holding in the trust.
Jack and Jill preferred the related beneficiary hybrid trust arrangement because they believed it
would be simpler to manage than a partnership of discretionary trusts. It only required them to
set up one trust, and one trustee company, rather than setting up two discretionary trusts, with
each trust having its own corporate trustee. It would have given them similar flexibility to a
partnership of trusts by allowing each of Jack and Jill to determine who amongst their related
beneficiaries would receive income or capital distributions from the trust. It would also have
made entry of new participants easier, as they would not have had to deal with their various
partnership interests, but instead only had to deal with the issue of units to the incoming
unitholder.
3.2 Accessing the SBC
A hybrid trust will be treated the same as a discretionary trust when establishing whether a
significant individual and in turn a CGT concession stakeholder exists under the SBC. It would be
important to ensure appropriate distributions are made to beneficiaries where it is necessary to
establish the existence of a significant individual.
Distributions of trust income or corpus to a unit holder can have CGT implications under CGT
event E4.
If the above conditions are met in respect of any payment from a unit the taxpayer is treated as
making a capital gain if, and to the extent that, the non-assessable amount received in the year of
income exceeds the cost base of the unit or interest, and the cost base is reduced to nil.
Capital assets and income held
for unit holders and/or related
beneficiaries depending upon
terms of the trust deed

Jack’s related beneficiaries

Jack – 1 Unit
Hybrid Trust

Jill – 1 Unit

Jill’s related beneficiaries
Corporate
Trustee

Practice Hot Spots Seminar 2007
© National Tax & Accountants’ Association Ltd: March – April 2007 167
If the non-assessable amount is less than the cost base, the cost base is reduced by the amount
of the non-assessable amount under S.104-70(4)-(6).
Appropriately structured hybrid trusts can avoid CGT event E4, in that any non-assessable
amount is distributed to discretionary beneficiaries (who do not have the requisite “interest” in the
trust to attract CGT event E4).
In Jack and Jill’s case, using the hybrid trust suited them, as they expected to build up the value
of the business, and eventually realise a profit on the sale of the business. They wanted to be
able to effectively distribute the small business CGT 50% active asset concession (and can do so
by distributing the non-assessable amount to family members to whom CGT event E4 does not
apply.
3.3 How are tax losses treated?
A trust may incur a loss arising out of borrowings or operating a business. Losses are
‘quarantined’ in the trust, that is, only the trust (and not unit holders or beneficiaries) may offset
losses against future income of the trust. Trusts can only deduct tax losses in limited
circumstances, depending on the particular type of trust.
For a standard fixed unit trust, the following tests must be satisfied:
(a) the continuity of beneficial ownership or stake test; and
(b) the income injection test.
Further tests apply in the event a unit trust is a non-fixed trust (i.e., a hybrid trust), where the unit
trust has both fixed and non-fixed entitlements.
In the event that a trust is a hybrid trust, the following tests must be satisfied:
(a) the continuity of beneficial ownership test;
(b) the pattern of distributions test;
(c) the continuity of control test; and
(d) the income injection test.
For obvious reasons the effect of the above tests is that most hybrid trusts will be unable to
deduct tax losses. This means consideration will need to be given to making an FTE (discussed
below) if the hybrid trust is wishing to utilise its losses. If, however, the unitholders are unrelated,
making a family trust election may be undesirable as it might effectively limit the beneficiaries to
one unitholder and their family, or alternatively give rise to FTDT.
In Jack and Jill’s case, they ought to have given some consideration to the likelihood of losses,
particularly in early years. In some cases, participants will be willing to forgo the benefit of the
losses if these are small. However, with any new venture, it can be difficult to predict the likely
level of losses. If there are significant losses, the participants run the risk of losing the benefit of
those losses if they opt to use a related beneficiary hybrid trust.
In hindsight, the added complexity and cost of using a partnership of discretionary trusts may in
the long run prove more beneficial if it means that substantial losses can be carried forward and
offset against future profits once the business becomes well established.
TAX TIP – Start up losses
This type of hybrid trust arrangement is probably not suitable where the business undertaken
by the trust is expected to generate substantial losses in its start up years.
These losses will effectively be lost as it is unlikely the trust will satisfy the trust loss
provisions. A partnership of discretionary trusts may be preferable as the discretionary trust
can each make a FTE and would only need to satisfy the income injection test in order to
satisfy the trust loss provisions.

Practice Hot Spots Seminar 2007
168 © National Tax & Accountants’ Association Ltd: March – April 2007
TAX WARNING – Family control test must be passed
A trust becomes a family trust if it makes a FTE. However, in order to do so, it must first
satisfy the family control test.
Even if a FTE were able to be made in Jack and Jill’s case – and there is some doubt that
the trust would pass the family control test – the making of an FTE will necessarily restrict tax
effective distributions to either Jack or Jill’s family, and result in FTDT being payable on
distributions to either Jack or Jill’s family.
3.4 Other issues – converting a discretionary trust into a
hybrid trust
The ATO’s Statement of Principles (‘SOP’) on resettlement of trusts sets out general principles
where a new trust arises.
A new trust may arise where there is:
(a) any change in beneficial interests in trust property;
(b) a new class of beneficial interest (whether introduced or altered);
(c) a possible redefinition of the beneficiary class;
(d) changes in the terms of the trust or the rights or obligations of the trustee;
(e) changes in the nature or features of trust property;
(f) additions of property which could amount to a new and separate settlement;
(g) a depletion of the trust property;
(h) a change in the termination date of the trust;
(i) a change to the trust that is not contemplated by the terms of the original trust;
(j) a change in the essential nature and purpose of the trust; and/or
(k) a merger of two or more trusts or a splitting of a trust into two or more trusts.
Of particular relevance here, a new trust arises under the SOP when there is a ‘fundamental
change to the trust relationship’. The change is in the ‘essential nature and character of the
original trust relationship’ [Paragraph 4 of the SOP].
More specifically the SOP sets out variations under a power in the deed (for a trust established by
settlement) and variations by agreement (for a unit trust established by agreement between unit
holders) which raise the question of whether a new trust has been created (refer paragraph 4 of
the SOP).
In each case the issue will be whether the variation is ‘a mere variation of a continuing trust’ or
alternatively whether there has been a fundamental change in the ‘essential nature and character
of the original trust relationship’ [refer paragraph 4 of the SOP]. The SOP identifies a number of
scenarios in which the essential nature and character of the original trust relationship will be
fundamentally changed, and a new trust created.
The following example is adapted from the SOP.
Practice Hot Spots Seminar 2007
© National Tax & Accountants’ Association Ltd: March – April 2007 169
EXAMPLE 2 – Conversion of a fixed trust to a ‘hybrid’ discretionary
trust
The deed of a fixed trust is amended to give the trustee a discretionary power of appointment
over the income of the trust (in effect making it a hybrid trust with both fixed and discretionary
elements).
Although the new discretionary beneficiaries may not have a proprietary interest in the trust
fund (they have only a mere expectancy), the rights of the unitholders are radically changed.
Previously unitholders would be presently entitled to, and accordingly have a right to
demand, payment of all income. Now any rights they have would only be in respect of any
income remaining after discretionary distributions have been made.
In this situation the essential nature and character of the trust relationship changes and a
new trust estate comes into being.
Following the same argument, a resettlement is likely to occur when a discretionary trust is
converted into a hybrid trust. This is because the variation will fundamentally redefine the
relationship between the trustee and beneficiaries, notwithstanding that the trustee and
beneficiaries may remain unchanged.
It is important, however, to recognise that the SOP is not a public ruling and therefore, is not
legally binding on the ATO. It is merely a guide in determining whether a new trust is created.
The significance of a resettlement is that one trust is terminated (the old trust) and another trust is
created (the new trust). The consequences of that happening include:
(a) any losses in the old trust are trapped in that trust and cannot be carried forward to offset
income in the new trust. This is quite apart from any consideration of the trust loss rules
which govern the carrying forward of losses by a continuing trust. Where one trust ceases
and another is created there are two separate and distinct trusts with no possibility of
carrying forward losses.
(b) all assets are treated as having been disposed of by the old trust and settled on the new trust
(i.e., CGT event E1 occurs). This results in pre-CGT assets losing that status and having a
market value cost base in the new trust. Capital gains on post-CGT assets will be realised,
and a corresponding CGT liability will arise in the old trust if an asset’s market value exceeds
its cost base. Alternatively, where the asset’s reduced cost base exceeds its market value, a
capital loss will arise in the old trust.
(c) in the case of a unit trust each of the beneficiaries (i.e., unit holders) will be deemed to have
disposed of their interest in the old trust and to have acquired an interest in the new trust.
Where a disposal of a beneficiary’s interest occurs, it is deemed to be at the market value of
that beneficiary’s interest and will result in pre-CGT interests losing that status and having a
market value cost base to the beneficiary. Capital gains on post-CGT interests will be
realised, and a corresponding CGT liability will arise for each beneficiary, if the interest’s
market value exceeds its cost base. Alternatively, where the interest’s reduced cost base
exceeds its market value a capital loss will arise to the beneficiary.
 
Hi battle on,

That's the NTAA document you posted, which was discussed already in a recent thread. I think Mry posted it here a few weeks back.

GSJ
 
i thought the consensus was that as long as the trust deed is properly done and worded, it should be still ok to claim those tax.

I use Chris Batten's. What do you guys think about his trust deeds?
 
i thought the consensus was that as long as the trust deed is properly done and worded, it should be still ok to claim those tax.

I use Chris Batten's. What do you guys think about his trust deeds?

Doesn't matter what we think. It's up to the courts. If they make a political decision to kill off hybrids, then they'll find a way. The problem is, which way are the political winds blowing on this?
Alex
 
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