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Hybrid Trusts — Is interest on an investment loan deductible?

In many circumstances, an investor's loan borrowing costs can be deducted against the investor's income in a given financial year.

However, a recent case has shown that an investment in a hybrid trust may not allow for the borrowing costs to be wholly deductible.

Cleardocs Hybrid Trust To preserve an investor's tax deductions, the trustee under a Cleardocs Hybrid Trust deed must honestly assess all receipts as on income or capital account.

Jeff Holowaychuk

Investment Implications

A recent decision of the Federal Court[1] highlights three considerations for investors setting up and investing in hybrid trusts:

  1. The borrowing costs associated with an investment loan are only tax deductible if the investor has a fixed entitlement to income.
  2. If the a hybrid trust's deed allows the trustee to classify receipts as on either income or capital account, then the trustee must exercise its discretion in an honest manner.
  3. Apportionment is a material consideration for all investors in hybrid trusts — even though in this case, the taxpayer, on technical legal grounds, avoided having to apportion his investment between the fixed and discretionary components of the hybrid trust.


The Full Federal Court in Forrest v Commissioner of Taxation considered the income tax implications of a taxpayer's investment in a hybrid trust and whether the borrowing costs associated with that investment were tax deductible.


The taxpayer (and his associates) established a hybrid trust known as the Minderoo Trust (Trust). The taxpayer borrowed $4.5 million to buy units, and therefore became both a unitholder and a discretionary beneficiary of the Trust.

The Trust was established for the primary purpose of purchasing shares in a mining company. The Trust's investment in the mining company dictated the manner in which the income and capital assets were distributed. So:

  • The amount of capital invested in the shares remained an entitlement of the Trust's unitholders, in proportion to their unitholding;
  • The amount of any capital gain on these shares could be distributed to the Trust's discretionary beneficiaries (in whatever proportion the trustee saw fit); and
  • The amount of any income (in the form of dividends) generated by those shares remained an entitlement of the Trust's unitholders in proportion to their unitholding.

Further, the Trust deed gave the trustee a discretion to:

  • determine the nature of any receipt, profit or loss, or gain or loss, as either being on income or capital account; and
  • make distributions to the Trust's unitholders and discretionary beneficiaries according to that determination.

The taxpayer claimed income tax deductions for the costs of borrowing to purchase his units.

The ATO's Determination

For the 2000, 2001 and 2002 financial years, the Commissioner denied the deductions on the basis that:

  • the Trust deed permitted the trustee to classify any receipt as a capital gain, regardless of the receipt's real character;
  • this enabled the trustee, if it chose, to direct all amounts to the Trust's discretionary objects (by classifying all amounts as a capital gain);
  • for the taxpayer to receive a distribution the trustee had to exercise its discretion to classify a dividend as on income account; and
  • accordingly, the proper classification of the Trust was as a discretionary trust.

Under the law, for the ATO to accept a claim for a deduction for borrowing costs on an investment in a trust, the taxpayer must be presently entitled to a fixed proportion of any income distributed from the trust.

The Taxpayer's Arguments

The taxpayer, argued that:

  • the terms of the Trust deed clearly allocated:
    • to the unitholders all capital assets purchased with sums subscribed by unitholders, and all income generated by these assets, and
    • to the discretionary objects all capital gains; and
  • the power to classify income and capital amounts did not operate to alter these essential terms of the Trust.

The Court's Decision

The Full Federal Court found, in favour of the taxpayer that the interest on the loan was wholly deductible. The Court based its decision on the fact that:

  • the trustee could not alter the rights of the beneficiaries by wrongly classifying a receipt. For example, the trustee could not — in order to make a distribution to a discretionary beneficiary — simply classify an income receipt as a capital gain, regardless of the receipt's real character; and
  • the trustee's power under the deed was to make an honest administrative decision when classifying the receipts.

The Commissioner had also argued in Court for the deductions to be apportioned on the basis that the Trust had both fixed and discretionary components. The Court refused the Commissioner's request on the basis that the argument had not been raised when the case was at the Administrative Appeals Tribunal before it was appealed to the Federal Court. The topic of apportionment is discussed separately in a previous ClearLaw article here.

Cleardocs Hybrid Trust

The Cleardocs Hybrid Trust deed contains a similar clause to the one considered by the Federal Court in Forrest v Commissioner of Taxation. As a result, trustees of a Cleardocs Hybrid Trust must take care to ensure that all receipts are correctly classified as on either income or capital account, or make an honest attempt to do so, before distributing to unitholders and beneficiaries.

An incorrect classification may have serious tax implications for the trust's investors.

More information from Maddocks

For more information, contact Maddocks on (03) 9288 0555 and ask for a member of the Maddocks Tax and Revenue Team.

More Cleardocs information on SMSFs (?)

Read about the Cleardocs Hybrid Trust

Download checklist

Download a checklist of the information you need to order a Hybrid Trust.

[1] [2010] FCAFC 6


Lawyer in Profile

Leigh Baring
Leigh Baring
+61 3 9258 3673

Qualifications: LLB (Hons), BEc (Hons), Monash University

Leigh is a Partner in Maddocks Tax and Structuring team. Leigh has extensive experience in advising Australian and multinational companies, high net worth individuals, accountants and financial advisers on all areas of taxation law.

Leigh regularly provides advice on:

  • structuring of businesses and transactions,
  • mergers and acquisitions,
  • corporate reorganisations and distributions,
  • sale of businesses,
  • demergers,
  • capital raisings,
  • joint ventures and property developments,
  • international tax (both inbound and outbound), and
  • succession planning and liquidations.

His advice covers both direct and indirect tax considerations.

Throughout his career, Leigh has been at the forefront in developing tax-effective corporate, trust and superannuation structures.

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