The Cost of Discretion - when can investments in hybrid trusts be negatively geared?

'Negative gearing' is a practice commonly used by Australian investors to derive a tax benefit. An investment is 'negatively geared', when the expenses associated with the asset (including interest expenses) are greater than the income derived from the asset. Negative gearing of investments in properties held by discretionary family trusts cannot be used to offset an individual's income, as such losses are required to be quarantined in the trust and offset against any future income of the trust. In attempt to overcome this, some investors seek to use hybrid trusts by investing in units which are classified as 'income units'. 

While there are cases where Courts have held that unitholders of a hybrid trust can claim tax deductions on negatively geared investments - this will depend on the extent of the trustee's discretion to determine income and capital of the trust and determine who will receive distributions.  Where trusts provide the trustee with discretion to distribute the trust's income to individuals other than the actual unitholders, unitholders should not negatively gear their investment in units of the trust. This is because the trustee's discretion means that it is unlikely that unitholders will be able to access tax benefits from negative gearing. However, the trustee may be able to negatively gear the investments of the hybrid trust itself and claim deductions for the expenses associated with trust property.

This article considers why negative gearing is not advisable for investing in a Cleardocs Hybrid Trust structure and the circumstances in which the trust itself may be able to utilise negative gearing.

What is negative gearing?

'Gearing' refers to borrowing money to invest in assets, such as property or shares. Such investments can be geared positively or negatively, depending on whether the income from the investment exceeds their investment-related expenses.

In most cases it is possible to deduct expenses related to acquiring and holding investments from taxable income, reducing an investor's overall tax liability. Where the investment is negatively geared (i.e. the expenses exceed the investment-related income), the losses from the asset can often be offset against other forms of income.

Given the tax consequences associated with negative gearing, it is often used as an investment strategy by investors to leverage investment capital and potentially benefit from capital appreciation of the asset over time. The expectation is that the asset's value will increase, offsetting the initial losses incurred due to negative cash flow.;

In a negatively geared trust, the trustee borrows money to invest in income-generating assets held within the trust. The income generated from these assets is expected to be less than the expenses associated with holding them.

Hybrid Trusts: When can negative gearing be used for investments in the units of a Hybrid Trust?

A 'hybrid trust' generally refers a trust that combines some of the features of a fixed trust with some of the features of a non-fixed trust, to create a new form of trust - generally, the trust seeks to offer the commercial certainty associated with fixed trusts with the distribution flexibility associated with discretionary trusts. Individuals sometimes seek to use fixed unit trusts for negative gearing purposes to overcome the fact that investing in property under discretionary family trusts means individual beneficiaries cannot access a tax deduction. The loss remains within the trust until the trust is able to generate enough income to cover the loss.
 

In the case of Forrest v Commissioner of Taxation:[1]
 

• Mr Forrest borrowed money to purchase units in a trust and paid interest on that loan. He then claimed tax deductions on the amounts paid in interest. 
• The Administrative Appeals Tribunal initially held that the powers of the trustee were so widely drawn under the trust deed that it could not be said that the taxpayer by holding the units, had a 'present entitlemen' to income of the trust. The Tribunal's reasoning was that the entitlement to income could not be known until the trustee exercised its discretion in regards to the classification of amounts as either capital or income. 
• In the Full Federal Court, Mr Forrest argued that the trust was a hybrid trust whereby the income received by the trust was held on fixed trust for the unit holders, and capital gains derived from the trust were held on discretionary trust for the discretionary beneficiaries. 
• The Court overturned the Tribunal's decision, finding that parties' intention was to create a fixed trust for income purposes. Mr Forrest was therefore able to claim tax deductions against the interest.
   

In circumstances where the trustee does have a broad discretion to make distributions, the findings in the above case may not be applicable. For example, negative gearing is not suitable not for investments made in the units of a hybrid trust established under the terms of the Cleardocs Hybrid Trust Deed product. This is because it provides the trustee with discretion to distribute the trust's income both among the trust's unitholders and to beneficiaries of the trust other than the actual unitholders (provided such beneficiaries come within the class of beneficiaries who are 'connected with' the unit holder). Such beneficiaries will include (amongst others) children, spouses, parents and siblings of unitholders of the trust.

This discretion introduces a degree of flexibility to the trust and permits a broader range of distributions than a fixed unit trust. However, it also means that it is unlikely that unitholders will be able to access tax deductions from negative gearing their investments in the units of the trust, as any losses remain 'trapped' in the trust.

Can negative gearing apply to investments made by the Hybrid Trust and when is this strategy appropriate?

While unitholders should not negatively gear investments in the Cleardocs Hybrid Trust, it remains open to a trustee to employ negative gearing within the investment strategy of the trust itself. This would involve the trust borrowing in its own right and claiming a deduction for interest costs against its income.

While it is possible to employ this strategy, it is important to be aware of the risks associated with negative gearing and the circumstances in which it may not be an appropriate strategy. Factors to consider in determining whether negative gearing is suitable for a particular hybrid trust include: 

• Risk tolerance: Where there is a low tolerance for financial risk, negatively gearing a hybrid trust may not be a prudent approach.
• Certainty of income / Cash flow: Relying on negative gearing to offset investment losses may not be advisable in circumstances where the income of the trust is uncertain or unpredictable. Negative gearing generally requires a stable cash flow to sustain the investment until it becomes profitable.
• Investment horizon: Negative gearing is often a long-term investment strategy as it can take time for investments to appreciate in value and ultimately result in positive cash flow. Accordingly, investments with a short term horizon will typically not be suitable for this approach.
• Tax profile: Whether the trust has a tax profile that would actually benefit from negative gearing. The trust needs to have other income that the deductions from the negatively geared asset could be used to offset.

More information from Maddocks

For more information on hybrid trusts and other forms of trust structures, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.

More Cleardocs information on related topics

You can read earlier ClearLaw articles on a range of topics, such as:

• SMSF Trustees: Why Should I Use A Corporate Trustee?
• Why Do You Need To Be Careful When Adding Or Removing A Beneficiary In Your Discretionary Trust?

Order related document packages

• Hybrid Trust
• Discretionary (Family) Trust
• Trusts Documents
   

[1][2010] FCAFC 6