Why I think aspects of the HDT will fail!

Dale, thanks. You're a scholar and a gentleman!

Your comments about managed funds are not quite correct. With a managed fund not only does the investor receive income but also constantly benefits from a revaluation of the units, reflecting the increase in capital value (shown daily). I'm not aware that there are any hybrid trusts which having issued 500 units for 500k goes back to the investor and tells him a year later that his units are now worth 600k... However, that is exactky what a trustee in bankruptcy is going to argue! (see below)

As for people who hold forever...well good luck to them because they may have found the only loophole I can see :) I have no intention of holding forever, believing in opportune moments to extract maximum profit. I must clarify that I have NEVER said that the interest is not tax deductible - it is IF the person claiming the tax relief also realises the capital gain. Therein lies the dilemma facing the ATO - this is a 2 stage process where the 2nd stage MAY negate the first. I believe they would only act at Stage 2.

With regards to asset protection, the creditor can take the income units entitling him to the income. He can also argue that those units have a capital value, based on the method of and value at acquisition...

I must also add that if HDTs were indeed such unique instruments then the principle would apply just as well for shares. To my knowledge, based on knowing the broad investment strategies of some extremely wealthy people this is not a strategy that is popularly employed. I mean why not buy $1 million worth of income units in a HDT, have the trust by $1m worth of shares and then pass all the CGT to the wife and kids??

Finally, I haven't dismissed the PBR. Will look at it during the week and drop you a line then.

Cheers
 
Hi Ronin,

I've read this thread with interest. I wonder, though, why you consider that negative gearing must necessarily be related to an expectation of capital gain?

My understanding is that you've bought an income asset. If that income producing asset actually cause a loss, then them's the breaks. You claim the loss on your tax return and move on.

I don't believe the necessary nexus exists at the ATO between negative gearing and capital gains. Sure, there are components of a loss making investment which are capital related, but for most, the large part of is purely income not meeting expenses.

With that in mind, it appears to me that the basis of your argument falters a little. Of course, I am here as much for education as anyone else here. Your thoughts, as everyone elses, is welcome.
 
Hi

I must apologise. You see, I am not as clever as most of the people on this forum and so I have to keep things incredibly simple to be able to cope in a complex world.

My apology is because I did not keep things simple when discussing this topic. I tried to be clever and so did not do as good a job as I would have liked.

I hope this post makes up for it though…..

The main sticking point in the perceived problem that Ronin has with a HDT is the issue of the Special Income Unit holder’s entitlement to the capital.

However, I have been thinking about this and realised that it is not an issue at all worth considering. Why?

Because Section 8-1 of the 1997 ITAA says that for an item to be tax deductible it must be incurred in earning your income.

No mention of acquiring capital is made whatsoever.

So, if the tax act is not concerned with whether you have a right to the capital of the trust, or not, why should it be an issue? Please note, I believe that I have addressed the issue of Capital Gains in relation to a HDT below, but, if this needs clarifying please let me know.

The only other issue to do with the tax deductibility of the interest is whether the unit holder is presently entitled to the income of the trust.

As James correctly mentioned below, this fact is determined by the wording, rules and content of the trust deed along with the minutes and resolutions created when the trust issues the Special income units and the unit certificates etc.

The fact that the trust deeds are drafted by some of the brightest minds in the country gives me assurance that this entitlement is kept firmly in mind.

Perhaps these two points are why the Tax Office is aware of the HDT and yet have chosen not to show any real interest in it? Surely, the facts speak for themselves and the issue of deductibility should not be questioned.

I will address the Part IVA issue in a separate post rather than make this a long winded one.

Ronin, I understand and deeply respect your concerns and fears; and I agree wholeheartedly that the HDT is not for everyone. Hopefully though, we can get you to see that it is not being used illegally or in anyway inappropriately.

I hope that this helps in some small way.
Have fun

Dale
 
There has been a mention that Part IVA could be a deterrent to considering a HDT…..

I tend to agree with James on this point. Most times that we see Part IVA mentioned it is because an accountant does not understand something properly; wishes to protect his/her own bum; or just wishes to sound clever and smart.

Rarely is it a real issue when your intention is to stay within the guidelines of the law, and, when I consider a HDT, I think this is the case. Why?

For the Tax Office to attack the HDT under Part IVA, he would need to prove:

1. There was a scheme
2. A tax benefit was obtained in connection with that scheme
3. That the party who entered into the scheme did so for the dominant purpose of obtaining that tax benefit.

Now, without going into a great long legal debate on these various points, I think we can safely conclude that the courts would not agree with the Commissioner should he attack a HDT under these principles because:

The option of choice of structure is well entrenched within tax law and even Kerry Packer told a senate enquiry that you would be a fool not to use the law to your advantage so that you paid less tax. So, choosing to use a HDT instead of a discretionary trust, or, to owning the properties in an individual/s names is not a scheme. It is merely a choice.

As to obtaining a tax benefit from using the HDT…perhaps a couple of examples would best explain my thoughts:

• The tax benefit obtained by using a HDT is no more than the tax benefit that an investor would obtain by investing in their own name. In fact, one of this forum’s most respected members, Duncan Margetts, suggested that it was distinctly possible for someone using a HDT to get less of tax benefit than an individual would where the depreciation wiped out the net income. In this instance, the excess losses created by the depreciation inside the trust are of no immediate tax benefit to the individual and some tax credits pr benefits could be lost; or deferred at best.

• Moreover, an investor buying a property in the ACT can claim the stamp duty as an immediate tax deduction. A HDT buying in Canberra would not receive this same negative gearing benefit at all as the losses would stay within the trust and be carried forward to future years.

• In most states you pay a higher rate of land tax for the privilege of using a trust to own your investment properties.

Could we really say that the trust provides a tax benefit? And, if we still claimed that there was a tax benefit, would that benefit be any more of a benefit than an investor buying properties in their name would receive?

How could the Commissioner of Taxation argue that the dominant purpose of using a HDT was to receive that tax benefit, given the above thoughts? And, given the asset protection (OK, I’ll agree that this can be seen as flawed, if you wish it to be) provided by using a trust.


Part IVA should never be taken lightly and should never be scoffed at; but, if more professionals thought about their answers first rather than throwing this “threat” into a discussion, I am sure that we would see more intelligent arguments and thinking.

I hope that this helps
Have fun

Dale
 
Some of these points have been covered earlier but for the benefit of those who are just skimming through it is worth repeating:

1. I have never said that the interest on the borrowings in not tax-deductible. It is a fundamental principle of tax law that if you borrow to make a GENUINE investment, you may claim the cost of borrowing as a tax deduction.

2. I have never said that there HAD to be an expectation of capital gain. Indeed, when you invest in a fixed interest investment, you usually get income only and then your original capital returned.

What I have said is that IN THIS INSTANCE, where you are NOT DEALING AT ARMS LENGTH with a third party, and where the fate of the special income units is pre-ordained (by yourself) to eventually be worthless, then you have a problem. When purchasing property from a related party, for example, an independent valuation is required. In this case, an independent valuation will show that the value of the special income units is far removed from the purchase price. As a result of THAT, the only redeeming factor would be the expectation of capital gain, failing which it must be considered a structure designed to evade tax.
 
With regards to the application of Part IVA -

I've said above, several times, that the ATO should have no problem with Phase 1 of the operation, the borrowing to invest part. They will obviously have no issue at Phase 2 (sale) IF the CGT is paid by the investor who claimed all the tax benefits.

A simple example. Investor purchases a property for 500k using the typical HDT structure. Over 5 years he receives a total of 100k net negative gearing benefit. Property is sold for $1m at the end of 5 years. Income units were redeemed prior to sale for $5. 500k of capital gain is streamed to investor's wife who pays $40k in CGT. In the investor's hands (assuming maximum tax bracket), CGT would have been more like $97k.

The ATO challenges and asks:

1. Was there a scheme? UT and HDT controlled by investor. Special income units purchased for $500k then redeemed for $5. All tax relief claimed by investor, all benefit streamed to wife. Well, certainly looks,smells and feels like a scheme to me...

2. Was a tax benefit obtained from this scheme. Well, in the above example that benefit is in the order of $57k, so yes again;

3. Was the tax benefit the DOMINANT purpose? Certainly,since my opinion remains that there is no initial asset protection offered possible by this scheme and that while there may be some other incidental benefits, they would not be considered dominant.

In general, 90% of HDTs will fall into the above scenario. More sophisticated application may obfuscate the issues sufficiently to place them in the too hard basket, so there will always be exceptions.
 
Ronin

I'm curious as to who you are and why you are here.

Your nick , ronin carries interesting implications :)


See Change
 
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Part IVA only applies where the "sole or dominant purpose is to obtain a taxation benefit". For most of my clients the sole or dominant reason for the use of a HDT is not to obtain taxation benefits. It is to provide asset protection and more important estate planning benefits (through trust cloning, change of trustees, etc). Yes taxation benefits are provided however it is not the sole or dominant reason for establishing a HDT. The client wants the benefit of negative gearing through a trust but also wants asset protection as they have other high risk business ventures (e.g. developers) and want to pass their assets along to their children, to provide for their future, without the significant stamp duty and CGT/income tax implications.
 
Ronin,

You indicate that the units are redeemed for $5 when purchased for $500,000. Those of us who recommend and implement the use of HDT's do not recommend this strategy at all. In fact if you paid $500K for the special income units then the trustee is required to repay you your initial capital of $500K. I agree that if these were redeemed for $5 then you would have a taxation problem as you would technically have a capital loss.

I'm not quite sure who you have been speaking to but the people I recommended to you do not recommend the strategies you are suggesting.

Not quite sure why you think asset protection would not be a reason for adopting the structure. If you held your business assets in one discretionary trust and your residential properties in a hybrid discretionary trust then you have good asset protection. Say you have two same sex couples. Both are high income earners. One works as an orthopaedic surgeon, the other as an accountant for one of the major companies. A decision is made to issue the special income units to the accountant as he is at low risk of being sued and wants the benefits of negative gearing. Ortho is sued and the creditors go against his business assets. The properties held in trust and the special income units held by his partner are safe. How could you argue that the above was not entered into for the reasons of asset protection.
 
DaleGG said:
It is also my understanding (and I am happy to be corrected if I am wrong) that the trust has no choice but to distribute the CG to the unit holder and that should the trust redeem its units then a CGT event will occur anyway for the unit holder.

Dale
i am definately not a knowledgable accountant - an ordinary investor giving my opinion on what i have been advised.

when i set up our hdt, dale's example above is exactly what i believed from my accountant to be the structure. there is only one beneficary from the trust, and that is the unit holder - completely different from a dt where you can nominate anyone to be beneficaries.

can i also please give some more advise ... go back to the post where you personally attacked jamegg, hit the edit button and take out all the aggressively general comments and personal slandering - the see what is left. there is no place on this forum for such general personal attacks unsupported by facts.
 
Hi Gang,

I can't recall it ever being recommended on this forum and certainly not by the accountant who advises us that the units be redeemed for a lesser amount than their original value.

It does become annoying at times that any of us who setup a HDT are assumed to be overly agressive or dishonest from a tax perspective. We (I'm sure like numerous others) merely setup the HDT for asset protection and to be able to afford to hold negative cashflow assets. After the recent property boom there is no way we could afford to buy an inner city growth properties and have the losses trapped in a Disc Trust for many years.

Cheers - Gordon
 
Good morning Ronin

I think that one of the reasons why so many of us are struggling with this issue is that you describe potential situations that are not just not possible for a well written and well used HDT.

Believe me when I say that none of us are interested in breaking the law.

The unit holder will receive the CG from the sale of the property.

And as Mike said, if the units are redeemed the trust must pay at least what was paid for those units.

I genuinely believe that someone has misled you and if they have painted such a picture as you describe then no wonder you think it will fgail and no wonder we cannot understand.

Dale
 
On closer examination I should clarify that the $5 redemption appears to have been suggested as a way to defeat creditors in the event of a lawsuit. Otherwise redemption at the purchase price of the units appears to be the norm.

This still begs the question - how is it commercially justifiable to borrow 500k at say 7% in order to derive income at say 2,5% if it is pre-ordained that you will simply get your money back?

I doubt whether Private Binding Ruling 28993 (referred to by Dale) affords any protection to users of this strategy. It simply confirms that under ordinary constructs the interest expense is deductible and then ONLY to the extent that the interest is incurred in producing assessable income. However it goes on to caution, quoting Fletcher's case, that interest claimed beyond the income may have to be 'determined by weighing up the whole set of circumstances, including the direct and indirect advantages which the taxpayer sought in making the outgoing'.

Further, supporting my views if the lack of commercial rationale in the HDT is accepted, IT 2684 is quoted: 'An interest expense in 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 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'.

Now, is that not a fairly significant obstacle? To my mind in 90% of HDTs the special income unit holders will never earn more income that the interest expense for the cost of those units and consequently never be commercially viable. I maintain my position that anyone not declaring the full capital gain in their income is going to run into some pretty nasty ATO re-calculations.
 
Hi

I guess the nature of the property investment is your answer.

Rents might start at a 4 to 5% yield, but, over time the rents will rise and the SIU holder will receive more and more distributions because of this rent rise and because the depreciation deductions will fall away.

For example, two of my properties are now yielding abt 27% of the purchase price in rent. And, the depreciation claims against these properties is quite minimal.

The rent was not anywhere near 27% when I bough them inside a trust.

And, I have other properties yield well above 10%.

Ronin, you will get no argument from me in terms of people potentially getting into trouble by not declaring the CG attributable to them from the trust.

Have fun

Dale
 
see_change said:
Ronin


Your nick , ronin carries interesting implications :)


See Change

The masterless samuari, or direct translation "Wave Man". A warrior cast out.

There are pros and cons of every structure and it is important to do your own due dilligence on and investing stratagie you use.

Cata
 
i guess, what everyone is trying to say, is that the tax office rulings all comes down to the intent of the purchase (the "whole set of circumstances").

if the intent is to invest purely for tax advantages, with no forseeable profit, then that is defrauding the tax system and the ato will eventually catch up with you - and i think that is where ronin's confusion in this thread lies. i don't believe you will find anyone seriously on somersoft invests purely for the intention of tax advantages only, we will take advantage of the tax rules to make the investment more desirable - but at the end of the day the invest has to stand on it's own.

i believe that all of us honest investors are investing with the intent of making money/profit at the end of the day on which to support a healthy lifestyle upon retirement - and to achieve that we have to earn more than we are paying out. so therefore, our intent is to make profit.

however, in the meantime, if the tax office declares that we are able to claim against tax paid - this is the icing on the cake, but definately not tax evasion/fraud.

the same rules apply with any ato tax payable on property - including cgt and/or a negatively geared property - if the intent of the purchase is to buy an eventual self-funding investment property than various tax rules apply. if the intent is otherwise, ie, to buy a ppor that is sold before it is used as a ppor, then other tax rules apply.

as long as we honestly work within the tax structure there are plenty of advantages, and it is up to the ato to determine what these structures are, and how they can be utilised - not us. it is up to us to understand them an use them to our advantage.

as dale pointed out - the cg or positive gearing does come back to the unit holder, or (so i believe) can be held in the trust to offset the losses incurred on the next purchase within the trust, so if the property is making a profit (cg or pos geared) and these funds come fully back to the unit holder or held in the trust to counter another negatively geared purchase, what is your arguement?

this is no different than a neg geared property in a personal name, except that you have greater asset protection. the only difference between a dt and hdt (as i believe) is that the dt carries the losses forward until the trust makes a profit, whereas with the hdt the unit holder can claim the loses as it goes along not having to wait until it makes a profit - yet when it does make said profit tax is payable at that stage ... so basically one claims the tax refund in the future and the other claims the tax refund now.

as we are here to learn - i would be very interested, ronin, to find out what was the scenario of you friend that got stung by the ato with? (i assume) an hdt. was it, as dale may have alluded to, because they tried to put their ppor thru the trust? or was it something different? what was their intent? what reason did the ato give as to why it did not pass their guidelines? why are you so aggressively against hdt's when they have the ato's blessing?
 
i'll suddenly had a lightbulb moment - amazing what happens when one is up the ladder painting eaves. this is all my own understanding, so if i get this wrong or confusing, dale or james, please clarify ...

i think what ronin is trying to get at is the stage of a hdt when it can morph into a simple dt - and hence, when becomes a dt, distribution can be given to whomever the trustee chooses.

so we take the scenario to purchasing a house for $500k. mrX borrows $500k to buy units in the hdt and the hdt purchases a property. for the hdt to become a dt the hdt must pay out the units of $500k back to mrX. if this occurs by the sale of a property then the cg from said property is also attributed back to mrX and cgt is payable.

if the $500k is paid out by the way of income from the properties in the hdt, and the hdt still holds the properties, then mrX would have had to pay either tax on the $500k as income to keep the trust as an hdt, or he needs to pay off the underlying loan as payout of the units for the trust to become an dt.

if then the hdt paid back the units and the underlying loan was paid out so the hdt became a simple dt, and then sold the property, cgt could be attributed to whomever the trustee chose - but only if the units were paid out of profit, not from sale.

i hope this makes sense - is clear in my mind, but then that does tend to be a bit of a jungle.

one point to remember - the government chooses to give many incentives for people to buy ip's because they know if the private sector doesn't invest in ips then there is no way the government can provide housing for the renting masses - 30% of the population rents. there is no way the government can provide 30% of the reasonable rental housing required in this country. one only has to look at the instances when negative gearing was removed - the government couldn't put it back on fast enough!!
 
i think i might be a little slow and need some futher examples :)

Taking Lizzie's example, say rather than selling the property, the property has increased in value.

can the HDT then borrow a further $500k against the property (assuming an appropriate bank valuation etc) and pay out the unit holder MrX for their initial $500k worth of units purchased?

Given their has been no CGT event on the property at that point in time, does that mean no capital gain needs to be distributed (I assume this is the case) - or would you need to revalue the units based on the increased value of the property and pay out $1m for the 500k units to MrX? (oh and would this be the same for shares which have a ready market valuation?)

If you did not have to revalue the units, and paid MrX $500k, and then later on when the HDT did sell the property, the CG could be distributed to any beneficiary? or would it still be restricted to the prior unit holder MrX?
 
Ronin said:
Otherwise redemption at the purchase price of the units appears to be the norm.
My HDT deed explicitly states that redemption must be for no less than the purchase price.

DaleGG said:
it is my understanding that the unit holder of the special income units will receive their share of the CG that is attributable to the units issued to them. It is also my understanding (and I am happy to be corrected if I am wrong) that the trust has no choice but to distribute the CG to the unit holder
Really? I was under the distinct impression that a special income unit holder had no entitlement to capital gain whatsoever - that's why they're INCOME units.

Cheers,
GP
 
Hey GP

A capital gain is defined as part of the income of the trust and therefore if the trust has issued SIU's then that CG will also be distributed to the unit holders as part of the overall trust income.

This is as opposed to the trust distributing its capital (IP's; shares and other assets) to the unit holder.

Does this help?

Dale

GreatPig said:
Really? I was under the distinct impression that a special income unit holder had no entitlement to capital gain whatsoever - that's why they're INCOME units.

Cheers,
GP
 
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