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.
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.