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Editor: An issue has arisen which we believe requires the urgent attention of any members who may have arranged for their clients to, wittingly or unwittingly, become involved in Hybrid Trust arrangements, many of which rely on some form of negative gearing.

The Tax Office has issued a Private Binding Ruling which, we believe, correctly limits the deductions allowable, for some negative gearing hybrid trusts, to the income received. In effect, this may well negate the promised benefits of the whole arrangement.

First off – what is a hybrid trust?

The term ‘hybrid trust’ can be used to describe any trust containing elements of both discretionary and unit trusts.

Generally, hybrid trusts combine aspects of:

• a traditional unit trust which entitles unitholders to a fixed entitlement to income and capital of the trust; with
• a discretionary trust that gives the trustee a degree of control over how some of the income and capital of the trust should be distributed.

What kind of "uses" of hybrid trusts may be under threat?

Although hybrid trusts can be used for a variety of purposes, for this article, let's continue with the negative gearing scenario. Commonly:

• a primary income earner wishes to invest in an appreciating asset;
• they want to claim negative gearing losses to reduce tax on their high income;
• they don't want to show any net income or capital gain in their own name; and
• a hybrid trust is interposed between them and the investment.

How the arrangement "works"

A high income earner – let's call him John – becomes aware of an $800,000 investment property which has an excellent prospect of capital gains.

He wants to buy it in the most tax effective way and is advised to use a hybrid trust.

Basically, under this arrangement:

• the taxpayer borrows the $800,000 to buy units in the hybrid trust;
• the trust uses these funds to buy the property; and
• the bank takes a mortgage over the property to secure the borrowings.

For tax purposes, the trust earns rental income and pays all the associated expenses.

The trust deed provides for all of the income to be distributed to the unitholders – in this case, our taxpayer, John.

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 negative gearing loss which can be offset against John's other income.

A feature of this type of hybrid trust is that distributions of income to other members of John’s family can only be made when he ceases to be a unitholder and there are no other unitholders*.

Note(*): It is usual with these types of arrangements that, when it is convenient, the units may be redeemed by the trust at their initial face value.

If after some time has passed, John has paid off a substantial amount of the loan, the income from the investment may start to exceed the interest being paid on the loan (i.e., it becomes positively geared).

It is at this time that it may become convenient for John to redeem the units for their face value.

To do this, the trust could either refinance the property, or sell it.

Whichever happens, either:

• future income could be distributed to the members of John’s family who pay tax at a lower rate; or
• the capital gain could be distributed to them.

Why negative gearing works . . .

Negative gearing has received a green light tax-wise because, 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 it is not of a capital, private or domestic nature".

The High Court held in Fletcher* that, expenses exceeding the income received in the early years of an investment, can be deductible.

(*) Fletcher & Ors v. FC of T 91 ATC 4950

However, the Court held that while a deduction was available immediately, there had to be 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.

What is critical for a taxpayer entering into a negative gearing arrangement is that there must be an objective intention that the investment will run 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.

And why this arrangement may fall over

Using a hybrid trust to enter into a negative gearing arrangement is likely to strongly suggest that the arrangement was not intended to run its natural course.

Depending on the deed, the ATO may well infer that the arrangement was only intended to run for a 'defined or pre-ordained period' because:

• the deed allows the unitholder to redeem their units (in a relatively easy manner);
• they are redeemed at cost, rather than market value – for no good reason; and
• anecdotal evidence indicates that, in most cases, the redemption of units occurs at the most convenient or tax advantageous time – i.e., just as the arrangement becomes positively geared.

Unfortunately for the unitholder, the onus is on them to prove that when they went into the arrangement they intended that it would run its natural course and, one day, become positively geared.

Where the unitholder is unable to do this, the ATO can limit any tax deduction on the interest on the basis of Fletcher and Ure*, without having to rely on Part IVA.

(*) Ure v. FC of T 1981 ATC 4100

ATO's approach to investments that don't run their full course

The following is based on Example 1 in TR 95/33:

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 his dominant purpose in entering the scheme is to incur the outgoings in order to minimise his tax liability.

As total anticipated allowable deductions will far exceed the 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.

Last nail in the proverbial – an unfavourable private ruling

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 the arrangement above:

• a unitholder had an entitlement to all the income of the trust;
• the trustee had the power to make capital distributions to the discretionary beneficiaries; and
• discretionary income distributions could only be made to the beneficiaries after all issued units were redeemed.

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 conclusion because the expected return to the unitholder (both income and capital) was much lower than the interest expense incurred, with the resultant conclusion that the arrangement was not entered into solely to produce income.

This was especially so since entitlements to capital distributions were discretionary. The ATO stated:

"An interest expense is not fully deductible in those cases where the expected return from the units for 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 would be compounded by any provision which ensured that the proceeds for the redemption of units was limited to their initial subscription price (as in the arrangement outlined above).

Comment

This article has been prepared thanks to the interest this issue has caused at our Hot Spots seminar and our desire to protect our members from entering into arrangements that may soon be targeted by the ATO and could be the subject of an income tax ruling.

A copy of the chapter of the notes is available to all members free of charge. Please go to www.ntaa.com.au. Then go to our "Media & News" area and look under the topic "Your Association at Work." The seminar notes are called "Using hybrid trusts - advanced tax planning or tax nightmare?"