Cleardocs' New Hybrid Trust Deed

'Hybrid trust' means different things to different practitioners. Cleardocs, with its lawyers at Maddocks, has recently launched the Cleardocs Hybrid Trust. Leigh Baring and Julian Smith

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The Cleardocs Hybrid Trust structure

When setting up a hybrid trust, it is essential to understand the structure and its implications — as there is no single accepted definition of a 'hybrid trust'. The Cleardocs hybrid trust is structured as shown in the following example:

The diagram above gives the Cleardocs hybrid trust the appearance of a unit trust: yet there are important differences.

The trust is settled by an independent third party settlor‚ this is an important element of the hybrid trust structure as discussed later below in 'Taxation and Revenue Implications'

Who are the beneficiaries?

The diagram refers to the 'Various Unitholder Beneficiaries'. Choosing who is to be a unitholder is important - not because, as with a unit trust, it is the person or entity who has a proportionate entitlement to the income and capital of the trust. But rather, because that person defines the group of 'eligible beneficiaries', as follows:

• If the unitholder is an individual, the eligible beneficiaries are the unitholder, that person's spouse, children, siblings (and so on), and companies and trusts in which those persons have an interest.
• If the unitholder is trustee of a trust, the eligible beneficiaries are the unitholder and the beneficiaries of that underlying trust.
• If the unitholder is a company, the eligible beneficiaries are the unitholder, the company's directors and shareholders, and directors' and shareholders' spouses, children, siblings (and so on).

Distributing Income and Capital: generally in proportion ... but not necessarily

Distributions in proportion to number of units

In the Cleardocs version of a Hybrid Trust, the general rule is that if the trustee makes a distribution of income and capital, then that distribution must be to each class of beneficiary in proportion to the number of units the relevant unit holder owns in the trust. (However, in certain circumstances, the trustee can make distributions that are not in proportion to the number of units the unit holder owns, see the next paragraph.)

For example, if a unitholder holds 30% of the units in the trust, then 30% of all income and capital that is distributed will go to that unitholders' eligible beneficiaries. However, the trustee has a discretion as to which of the eligible beneficiaries the distributions are made‚ for instance, it may be the case that no distributions are made to a beneficiary, or 100% of distributions may be made to a beneficiary.

Distributions NOT in proportion to number of units

In the Cleardocs version of a Hybrid Trust, the trustee may determine to make a distribution otherwise than in proportion to the number of units held by a unit holder. However, if the trustee determines to do this, then:

• the trustee must first give written notice about the proposed distribution to all the unit holders; and
• any unit holder (or person who is a joint unit holder) may veto that distribution and so prevent it from being made.

Beneficiaries of more than one unitholder accommodated

A hybrid trust is less likely to be used if the unitholders are closely related, because in these circumstances a discretionary trust would normally be preferred. However, it is possible that if the unitholders are somehow related, a person may be an eligible beneficiary of more than one unitholder. The Cleardocs deed therefore requires the trustee to nominate in what capacity a beneficiary is receiving a distribution ‚for instance, as a beneficiary of unitholder A or of unitholder B.

What are some of the benefits of the Cleardocs Hybrid Trust?

Elements of certainty: The hybrid trust provides the certainty of entitlement and control one normally associates with a unit trust, through the unitholder structure. Decisions such as the appointment and removal of trustees, amending the trust deed and winding-up the trust are all reserved to the unitholders.

Greater flexibility than a unit trust — including income splitting: Yet the hybrid trust provides greater flexibility than a unit trust in that:

• the deed enables distributions other than in proportion to the unitholders' unitholdings; and
• when distributions are being made, there is essentially the option for the trustee to make distributions among the eligible beneficiaries in a manner akin to a discretionary trust. This, like a discretionary trust, enables income splitting between beneficiaries _ which helps to reduce the overall tax liability of a unitholders' eligible beneficiaries.

Asset protection outcomes: There are also similar asset protection outcomes for those eligible beneficiaries below unitholder level as those beneficiaries have no vested interest in the assets of the hybrid trust. However, it is likely that the units themselves may be targeted:

• if a unitholder becomes insolvent; or
• in litigation because a trustee in bankruptcy or potential litigant would consider the proportionate entitlement attached to a unit to constitute an asset of the unitholder.

Reduced set-up and administration costs: Essentially, the hybrid trust provides a single structure which can be used in preference to the traditional 'unit trust with discretionary trust unitholders' structure. This means that the participants save on the establishment and administration costs associated with having an additional trustee and trust for each unitholding.

Taxation and revenue implications

Stamp duty savings: Flowing from the simplified structure of only one trust (rather than the head trust and separate trusts for each unit holding) there is a saving on initial stamp duty. If, for instance, $200 is payable on establishment for each trust, then the stamp duty bill for the hybrid trust with 3 unitholders is $200, as opposed to $800.

No section 102 ITAA36 issues: The Tax Commissioner may assess the trustee to pay income tax if a person (the settlor) has created a trust and either:

• that person can revoke or alter the trust to acquire a beneficial interest; or
• income is, in the relevant year of income, payable to or accumulated for, or applicable for the benefit of a child or children of that person.[1]

The tax payable in these circumstances is the amount the settlor would have paid if that income been paid directly to him or her — in addition to their other income for the relevant financial year. The hybrid trust avoids this because it is a settled trust: the settlor cannot revoke or alter the hybrid trust and the settlor and the settlor's children are excluded from benefiting under the trust.

Simple to change proportional entitlements without resettlement issues: The Cleardocs deed provides for additional units to be issued to existing or new unitholders with unanimous or 75% approval of the unitholders. As the issue of units is not a CGT event, the proportionate entitlements of unitholders can be adjusted simply. This adjustment is not subject to proportional entitlements likely to constitute a resettlement of the trust.

No CGT Event E4 on distribution of tax-free income: CGT Event E4 occurs if a unitholder receives a non-assessable distribution from the trust (such as an in specie capital distribution) in respect of their unitholding or interest in the trust. The capital gain is the difference between the non-assessable amount and the unitholder's cost base for their units. Given eligible beneficiaries in the hybrid trust (aside from the unitholder) do not hold units or an interest in the trust, these persons may receive non-assessable distributions without the occurrence of CGT Event E4.

Things to be wary of...

Income on borrowings to finance acquisition of units NOT deductible: Interest on loans which are used to make investments (such as the purchase of units in a unit trust) is only deductible if that loan was used to generate income. As a unitholder in the hybrid trust has no more than an‚ expectancy' (and not a right) to receive income from the trust, it is most likely that interest on loans used to purchase hybrid trust units would not be deductible. However, the hybrid trust does not affect the ability of the trustee to deduct interest from assessable income which is paid on loans invested for generating income.

Income means taxable income, unless otherwise determined: The Cleardocs deed adopts the definition of income as set out in section 95(1) of ITAA36. However the trustee may choose to adopt a different definition of income in respect of a year before the end of that year.

On a winding-up, the acquisition price of units is payable to the unitholder: On winding-up the trust, the acquisition price of a unitholders' units (subscription or transfer funds) will be repayable to the unitholder. The remaining amounts available may be distributed among the eligible beneficiaries in the relevant proportions — but you should be aware of these repayment provisions because for instance, the right to repayment of capital may make the units more attractive to a trustee in bankruptcy.

Need another type of hybrid trust? More information

The Cleardocs hybrid trust is only one type. If it is not exactly what you're after, it is likely that Maddocks can adjust the standard deed to suit your specific circumstances for an additional fee.

Any queries in relation to hybrid trusts can be directed to Julian Smith of Maddocks on 03 9240 0864.

[1] Section 102 of the Income Tax Assessment Act 1936 concerning 'revocable trusts'