Uncommercial use of hybrid trusts: Taxpayer Alert 2008/3 | ClearLaw Legal Bulletin

April 2008

The ATO on SMSFs and related party acquisitions

SMSFs borrowing through Instalment Warrants: the ATO's views

ClearLaw April 2008 summary

SMSFs and compliance: A new urgency

Uncommercial use of hybrid trusts: Taxpayer Alert 2008/3

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Lawyer in Profile

Chris Beeny
Partner, Commercial Group
Phone: 03 9288 0555

Chris Beeny is a partner in the Maddocks Corporate Commercial group. His principal areas of practice are superannuation, trusts, taxation, general corporate advice, company secretarial law and the law of charities and non-profit organisations. He also has extensive experience in private client work - wills and estates.

A special focus for Chris has been superannuation, where Chris has been involved in related tax, trust, Corporations Act and regulatory advice for more than 17 years and is recognised as one of Australia's leading legal practitioners.

Before joining Maddocks, Chris was a partner in the Melbourne office of Mallesons Stephen Jaques for 23 years.

The 1996/97 edition of Legal Profiles described Chris as an "outstanding expert on drafting and compliance matters". In the 1998/99 edition he was described as having an "in depth knowledge of superannuation, a strong customer focus" and being "proactive and responsive"; while in the 2000/01 edition he was described as "highly regarded in the area of superannuation law and having demonstrated a high degree of commerciality". In the most recent edition he is referred to as having the "ability to consider what are often difficult legal issues and recommend a course of action that is clearly understood by board members who have varying levels of business experience" and for his "knowledge of super matters beyond simply legal issues".

Chris's professional memberships include:

Member of the Commercial Law Section of the Law Council of Australia
Member of the Superannuation Committee of the Law Council of Australia
Founding member and current Chairperson, Superannuation Committee of the Law Institute of Victoria
Member, International Pension and Employee Benefits Law Association
Fellow, Taxation Institute of Australia
Member Association of Superannuation Funds of Australia
Member Australian Institute of Superannuation Fund Trustees.

As well as writing numerous articles and speaking at many conferences, Chris is a joint author of "Superannuation: A Practical Approach" (Leo Cussen Institute), a contributor on superannuation topics to "The Employment Factbook" (Centre for Professional Development) and a member of the Editorial Panel of "Australian Superannuation Law Bulletin" (Prospect Media).

The ATO has issued a warning to taxpayers who borrow to invest in trusts and then claim tax deductions, even though the trust distributes income and capital to third parties.

Julian Smith

The relevant circumstances

In this Taxpayer Alert (which you can view here), the ATO expresses its concern about taxpayers claiming deductions for interest and other borrowing costs when the borrowing produces (or may produce) income for other people.

Here is an example of the relevant circumstances:

The taxpayer borrows to purchase interests in a trust (the hybrid trust);
The taxpayer (with or without associates) effectively controls the relevant trustee;
The taxpayer and his or her associates are trust beneficiaries;
Under the trust deed, the taxpayer's entitlement to income and capital is not fixed. This is a common and prominent feature of hybrid trusts. (Remember, the taxpayer's entitlement is not fixed even if the default position is that the income and capital is fixed, but that default position can be overcome at the trustee's discretion).
The trustee uses the funds contributed by the taxpayer (usually as subscription moneys for units) to purchase a rental property and earns income from that asset;
Beneficiaries other than the taxpayer may or may not be entitled to trust income (or capital) from the trust while the trust owns the rental property.

The ATO's concern: It's simple

The ATO's concern is straightforward. Basically, the taxpayer is claiming costs associated with a borrowing that is used to produce income for other people. Consequently, the taxpayer is not entitled to a deduction for the taxpayer's interest and other borrowing costs.

What other circumstances are at risk?

The ATO extends its reasoning to circumstances where:

If the trust deed excludes the taxpayer from receiving capital distributions, then the ATO sees this as a problem as it restricts the taxpayer from being able to fully recoup his or her borrowing costs. It does that because capital gains can be distributed to beneficiaries other than the taxpayer; and
If the trust deed permits the issue of units to the taxpayer's associates for no consideration or less than market value, then the ATO sees this as a means by which the income derived from the borrowing can be diverted to people other than the taxpayer.

Solution — Understand your hybrid trust

It is essential that taxpayers and their advisers understand these fundamental aspects of tax planning and the full effect of the trust deeds which they use. Of particular importance in this area is that there is no single type of hybrid trust. Each one operates differently and must be assessed in view of the taxpayer's objectives.

Questions?

If you have any questions in relation to this article, or trusts, superannuation or tax generally, please call Maddocks in Melbourne on (03) 9288 055 or in Sydney on (02) 8223 4100 and ask for a member of the Maddocks Commercial Team.

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