Units in hybrid and unit trusts: deductibility of borrowing expenses
New draft Tax Determination

If borrowed money is settled by the borrower on trust to benefit both the borrower and others, then the interest can only be deducted to the extent that the taxpayer has used the borrowed money to gain or to produce assessable income for the taxpayer themselves — examples below
 

New draft Tax Determination: Summary

The draft Determination[1] asks whether interest on a loan is fully deductible under Section 8-1 of the Income Tax Assessment Act 1997 when the borrowed money is settled by the borrower on trust to benefit both the borrower and others.

In summary:

  1. The answer is no. The interest can only be deducted to the extent that the taxpayer has used the borrowed money to gain or to produce assessable income for the taxpayer. (The meaning of "to the extent that" is analysed below, after the table.);
  2. The conclusion as to whether others will benefit from the borrowed money settled on trust will be determined objectively from the trust's terms (the Deed);
  3. The Deed will also govern whether the borrowed money is applied for the purpose of gaining or producing assessable income;
  4. If the borrowed money is used for the purpose of gaining or producing assessable income, but both the taxpayer and others benefit, then the deduction available to the taxpayer will be apportioned; and
  5. The Determination builds on a brief Taxpayer Alert (TA 2008/3) concerning the "uncommercial use of hybrid trusts".
    1. 5.1.    You can view a previous, short, ClearLaw article on this Taxpayer Alert here.
      5.2.    You can view the Determination here.

Examples

Assumption

Each of the four examples below are based on the assumption that:

  • Paul borrows $1,000,000 from a bank, in his own name;
  • Paul settles that money on the trust in return for the issue of units;
  • The trustee uses the $1,000,000 to purchase a rental property, in the trust's name;
  • Paul arranges with his accountant for these steps to be taken to establish the trust; and
  • Paul and his wife control the corporate trustee.
No. Structure Trust's terms ATO view on deductibility of interest
1.

Paul holds 500,000 units.

Wendy holds 500,000 units.

Unit holders share proportionately in trust income.

Units are redeemable at the trustee's discretion, valued on a net asset value basis.

Answer Only 50% of Paul's interest expenses are deductible.

Reason The Deed indicates that Paul uses the borrowed money partly to be benefit his wife and partly to produce his own assessable income.

2.

Paul holds 1,000,000 units.

Wendy, and Paul and Wendy's children, are the trust's discretionary beneficiaries.

Paul is entitled to the following amount of income: the lesser of:
(a) the total trust income available for distribution, and
(b) the amount equal to Paul's interest expenses plus a nominal amount.

The balance of income is distributable among the discretionary beneficiaries at the trustee's discretion.

Units are redeemable at the trustee's discretion at the original issue price.

Answer Paul's interest expense is not deductible in full.

Reason The Deed indicates the Trust's main purpose is benefiting Paul's family. The interest will largely not be incurred in gaining or producing assessable income for Paul.

Answer Paul is entitled to a small deduction.

Reason The trust has a subsidiary purpose of producing some assessable income for Paul.

3.

Paul holds 1,000,000 units.

Paul, Wendy, and Paul and Wendy's children, are the trust's discretionary beneficiaries.

The trust's income is held by the trustee for the benefit of the unit holders. The trustee can appoint realized capital gains to the trust's discretionary beneficiaries.

Units are redeemable at the trustee's discretion at the original issue price.

Answer Paul's interest expense is not deductible in full.

Reason The Deed indicates the trust's main purpose is benefiting Paul's family.

Answer Paul is entitled to a deduction on some of the interest.

Reason The trust has a subsidiary purpose of producing some assessable income for Paul.

The deduction is likely to be greater than under example 2.

4.

Paul holds 1,000,000 units.

Paul, Wendy, and Paul and Wendy's children, are the trust's discretionary beneficiaries.

The trust's income is appointed by an exercise of the trustee's discretion in favor of the trust's discretionary objects.

If no discretion is exercised, then no beneficiaries are presently entitled to income.

Unit holders are entitled to share in amounts attributable to realized capital gains in proportion to their unit holdings

Units are redeemable at the trustee's discretion at the original issue price.

Answer Paul's interest expense is not deductible at all.

Reasons The Deed indicates the trust's main purpose is benefiting Paul's family.

There is no connection between Paul's interest expense and generating assessable income for Paul (other than net capital gains). It is not sufficient that it is merely possible that the trustee may make a gift of income to Paul in a future income year.

Meaning of "... to the extent that": Interest expenses and apportioning

How is the interest expense characterized?

Deductions of interest are allowed "to the extent that" the interest is incurred in gaining or producing a taxpayer's assessable income, see section 9-1 of ITAA 1997.

The essential character of interest expenses is derived from:

  • the purpose of the borrowing; and
  • how the borrowed funds are used or applied.

If borrowed money is used to gain or produce assessable income, then this creates the connection between the interest paid by the taxpayer and the income the taxpayer derives from using those borrowed monies.

This connection is diminished if the objective facts indicate that the borrowed money has been used to benefit the taxpayer and other people. What needs to be assessed is the connection between:

  • on the one hand, the money borrowed and applied, and
  • on the other hand the taxpayer's rights and the other beneficiaries' rights.

What if the borrowing is used for a dual purpose?

If borrowed funds are used to benefit other beneficiaries through mechanisms stated in the Deed, then this affects the characterization of the relevant interest expense. See examples 1 to 3 above in which the use of the borrowed funds has a dual purpose — both benefiting family members and producing assessable income for the relevant taxpayer.

Apportionment

If there is a genuine dual purpose, then apportionment of the interest expense between purposes and taxpayers is possible — indeed, it is required. The ATO states that the appropriate apportionment will essentially be a question of fact.

In some cases, the Deed will provide the appropriate basis. See example 1 above in which:

  • different unit holders hold separate units each of which have similar rights to income; and
  • that income is shared in proportion to the unit holdings.

Where the Deed leaves decisions to a trustee's discretion then the appropriate apportionment "will depend to an even greater degree upon a finding a fact as to the extent to which the expenditure is incurred in gaining or producing assessable income[2]". If gaining or producing assessable income is only a minor object of the taxpayer's borrowing, then this must be reflected in the apportionment.

What if there is no perceived connection between the interest expense and the assessable income?

If the reasons the taxpayer borrowed the money were largely other than to produce assessable income for the taxpayer, then it may be that there is no relationship between the interest expense and the production of assessable income.

In that case, the ATO's view is that there will be no perceived connection and therefore no deduction is allowed. That is also the ATO‚??s view if the taxpayer has only a mere possibility of receiving income in the future and only after a favourable exercise of discretion by the trustee, see example 4 above.

Invitation for comments

The ATO has requested comments on the Determination by 19 December 2008. These can be submitted to the ATO by email to simon.haines@ato.gov.au

Further information

If you have any questions about this article, contact Maddocks on (03) 9288 0555 and ask for the Cleardocs Help Desk: they will put you through to the relevant member of our Commercial Team.

[1] Draft Taxation Determination The 2008/D16
[2] TD 2008 D16 p. 42