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Hybrid Trusts: The New Tax & Estate Planning Tool

Hybrid Trusts: The New Tax & Estate Planning Tool


by Andrew Skinner, Andrew Skinner & Associates

Released February 2008

ABOUT THIS PROGRAM

Hybrid trusts offer a flexible structure to allow at risk professionals and highly paid professionals to invest in appreciating assets in a way which provides asset protection and tax effective treatment of capital gains.

This program examines the key tax issues involved in using hybrid trusts in this way, including tax deductions for interest, value shifting, Part IVA, streaming of capital gains and availability of franking credits.  It then proceeds to consider some of the key issues in establishing a hybrid trust structure, including the beneficiaries clause and the income clause.   It concludes with a case study which illustrates the use of hybrid trusts in estate planning.

Introduction

The value of household wealth in Australia has been growing at a staggering rate.   The combination of house price inflation, the mining boom, and a rapidly rising share market has created a huge increase in wealth. 

In my experience, as a taxation specialist, dealing with superannuation and retirement I have seen an increase in the average wealth of retirees by a staggering amount. 

It is quiet common for household wealth to comprise:

  • A family home, often worth over, $800,000. 
  • Superannuation assets often in excess of $1,000,000.
  • Other assets, such as a holiday home, other investments such as shares, and property of a further $1,000,000.  

Accordingly, in practice it is not unusual to be dealing with clients who have assets of many millions of dollars.

Combined, with a diverse range of assets is a unique set of taxation problems for every client.  All solutions that we offer up or strategies adopted are essentially a compromise of competing objectives.

When considering options, should we:

  • Optimise current taxation benefits, and not future benefits.  For example, dividend imputation strategies, where the shares are held in the individuals names are often an example of a short term solution, as the capital gain liability will continue to increase into the future.
  • Optimise future taxation benefits, superannuation is the classic case as future savings in tax are the basis of the strategy. For example, the abolition of tax on end benefits (for those over 60 years of age) is a classic case of such a change. 
  • Preserve family wealth.  For example, the use of trusts and other structures.

Estate planning is a problematic exercise as we only know that one day, my clients will die.  Life is a terminal disease and we ALL will pass of this mortal coil.   Accordingly, it is a responsible thing to do to plan for such an event. 

In my practice, one of my greatest stresses is a client ringing and saying, “I have a terminal cancer, and, have only been given 12 months to live”. 

Thus we as advisors have a responsibility to ensure that our clients are as best prepared as we can make them.  In this Paper I will consider the complex world of Hybrid Trusts in the context of Estate Planning.

Simply, a hybrid trust is combination of a “discretionary trust” and some kind of “fixed trust”.  Examples include such things as a unit trust with discretionary powers. 

A trust is simply a set of rules, normally set out in a document, called a trust deed, that determines the way that the property, held by the trustee, will be dealt with for the benefit of the beneficiaries. 

In this paper we will examine the use of Hybrid Trusts for estate planning.  

Particularly, we will consider how we can use such trusts to allow continuity of assets, planning for capital gains, flexibility for income distribution and other related structuring.

A word of warning, a Hybrid Trust would normally NOT satisfy the relevant requirements of both the superannuation and taxation law in respect of an investment by a superannuation fund into a fixed (unit) trust.   Thus, my paper does not address any superannuation issues and no reader should consider

But firstly, just a little sage advice: 

DISCRETIONARY TRUSTS VS HYBRID TRUSTS

Discretionary Trust

Under a typical discretionary trust arrangement, a trustee is given an exclusive power to apply the trust income and capital according to their discretion to or for any specified beneficiaries.  A discretionary beneficiary has no entitlement to income or capital of the trust until the trustee exercises its discretion to distribute the income or capital in a particular year.

In other words, beneficiaries have a mere right to be considered for the distribution of income and capital.  They have no present entitlement to the income that would give taxing rights to the Tax Office in relation to a beneficiary until such time as the trustee exercise’s its discretion.

Therefore, a beneficiary is assessable to tax only if a distribution is made to the beneficiary.  Where the beneficiary is under a legal disability, the trustee would be assessable.  If there is no trust distribution because the trustee does not exercise its discretion and there is no default beneficiary clause in the trust deed, none of the beneficiaries is presently entitled to the income and the trustee would be assessed on the net income of the trust at the top marginal tax rate.

Hybrid Trust

Essentially, a hybrid trust combines some features of a fixed (or unit) trust with some features of a discretionary trust.  However, not all hybrid trusts are the same.  Indeed, there are myriad types of trusts which could fall under the banner of a “hybrid trust”.

Normally a hybrid trust deed is likely to include the feature of fixed entitlement to capital and discretionary entitlement to income, or vice versa.  However, the most common hybrid trust structure involves fixed income units and discretionary entitlements to capital.  However, the use of such a hybrid trust raises a number of important taxation issues that require consideration.

In the context of fixed income entitlements, the distribution of income is determined under the trust deed having regard to the number of fixed interests or units that a beneficiary holds.  The distribution of taxable net income to the income beneficiaries is then determined having regard to the distribution of trust income.

TAXATION CONSEQUENCES OF USING TRUST STRUCTURES

The use of trust arrangements raises a number of important taxation issues that require consideration as follows:

  • Ability of beneficiary to get claim tax deduction and potential negative gearing at the beneficiary level.
  • Distribution of capital gains.
  • Value shifting provisions.
  • Entitlement to franking credits.
  • Application of the general anti-avoidance provisions.

Deductibility of Expenses Incurred by the beneficiary

Here we consider the general deductibility rules under section 8-1 of the Income Tax Assessment Act 1997 (“the 1997 Tax Act”) and how expenses incurred by the beneficiary may be deductible for tax purposes.

Section 8-1 of the 1997 Tax Act provides:

“You can deduct from your assessable income any loss or outgoings to the extent that it is incurred in gaining or producing your assessable income or it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income”

However, a deduction is not permitted if the expenditure is of a capital, private or domestic nature.  Historically, in determining the deductibility of expenses under ordinary principles, both the Tax Office and the courts have tended to look at the actual facts surrounding the expenses and the connection between the expenses incurred and the income derived.

Having regard to the basic principles of a discretionary trust, it is not possible to find a link between expenses and income.  Therefore, in my view, expenses incurred by a discretionary beneficiary in relation to the receipt of a trust distribution would not be deductible.  In support of this view, Taxation Ruling IT 2385, provides as follows:

“[a beneficiary is] not entitled to any deduction as the expenditure [is] not incurred in gaining or producing the [beneficiary’s]  assessable income.  The taxpayer [has not been able to show] that there [is] a sufficient nexus between the expenditure incurred and the receipt of the income.

At its highest the taxpayer had a mere expectancy of receiving income from the trust.  The taxpayer was not presently entitled to the income of the trust when the expenditure was incurred.”

As a result, it is clear that under a traditional discretionary trust structure, deductions are not available to beneficiaries for expenses incurred by them in relation to the trust and, accordingly, negative gearing benefits would not be available at the beneficiary level because the discretionary beneficiaries do not have fixed entitlements to the income of the trust.

One of a hybrid trust structure is that they can potentially overcome this disadvantage of a traditional discretionary trust by providing income unit holders with the ability to obtain deductions for certain trust related expenditure and to negatively gear these deductions accordingly.

Funds borrowed to acquire income units

If for example, a unitholder has an outstanding loan on the acquisition of units in a unit trust of say $1,200,000 the unitholders are potentially eligible to deduct any interest incurred in relation to the acquisition of those units and effectively negatively gear the investment because acquisition of those income units provides a fixed income stream.  This is no difference to the situation where the taxpayer holds the asset directly (i.e. not through a trust structure).  This is supported by Taxation Ruling IT 2684, as follows:

“In this regard, a holder of units in a split property unit trust is, as a matter of principle, in no different a position from an owner of other kinds of income producing properties, eg property held for rental purposes or shares acquired for the purpose of producing assessable dividend income….In determining the essential character of an interest expense, regard is had to both the purpose of the borrowing and the application or use of the borrowed funds.”

Therefore, the question of interest deductibility largely depends on the relationship between the income derived from the income units and the interest costs incurred.  Provided the income expected to be received from the income units is greater than the expected interest deductions to be incurred over the total time the income units are expected to be held, all of the interest expenditure should be deductible.  That is, over the long term, the income units would be expected to generate positive taxable income (after deducting interest expenditure).

However, if over the long term, the income units would be expected to generate negative taxable income, and then the Tax Office would most likely take the view that the interest has been incurred with the partial purpose of obtaining a tax deduction.  Accordingly, in line with Fletcher’s case, the interest incurred would be deductible only up to the amount of assessable income received, i.e. no negative gearing benefit would be available.  For example, if the income units entitled the unitholder to a fixed return of 6%, but the interest rate on funds borrowed to acquire the income units was 8% and there was no prospect of the borrowed amount being reduced so as to allow for a future positive cash flow, then it is likely that the Tax Office would consider the excess of interest expenditure of 2% (8% less 6%) to be non-deductible.

As the level of income generated by the income units would be of key importance to ensuring the deductibility of any interest incurred, it would be beneficial for the income units to have a fixed entitlement to all trust income (although there are some hybrid trust structures which allow for part apportionment of income to discretionary beneficiaries having regard to increases in the value of underlying assets held by the trust).  In this regard, from a tax perspective, a hybrid trust structure can be better supported if there are no discretionary entitlements in relation to the distribution of trust income.

In my view, where funds are borrowed for the purpose of acquiring income units in a hybrid trust and the income units issued by the trust carry fixed entitlements to all of the income of the trust, the interest payable on those borrowed funds should be deductible.

In conclusion on this point, I am not aware of any action that the Tax Office has taken to disallow interest deductions in relation to income units held in a hybrid trust in this manner.

Distribution of Capital Gains

One clear advantage of having a hybrid trust with different income and capital beneficiaries is the ability to distribute capital gains to other family members, including those exposed to lower marginal tax rates.

However, where there is different income and capital beneficiaries, consideration must be given to the correct allocation of capital gains from a taxation viewpoint.  Specifically, where the trust deed does not contain a clause equating trust income with net income for the purposes of section 95 of the Income Tax Assessment Act 1936 (“the 1936 Tax Act”), distorted outcomes can arise.

For example, assume a hybrid trust has Simon as the fixed income beneficiary and Wilma, Child 1 and Child 2 as the capital beneficiaries. The hybrid trust makes a net income of $15,000 for tax purposes ($5,000 is a capital gain and $10,000 is net rental income).

In accordance with the “proportionate approach” to the taxation of the net income of a trust, the income beneficiaries (in this case, Simon would be presently entitled to all the trust income) would be treated for taxation purposes as being assessable on any net capital gains derived by the trustee of the trust in proportion to their interest in the trust income. That is, notwithstanding that there may be separate capital beneficiaries; it is the income beneficiaries that should technically include any capital gains made by the trustee of the trust in their assessable income as a trust distribution pursuant to section 97 of the 1936 Tax Act.

In Practice Statement PS LA 2004/3, the Tax Office has recognised the potential inequity that can arise in these circumstances, i.e. a capital beneficiary would receive the cash arising from the capital gain, but would not be taxable, while an income beneficiary would receive no cash from the capital gain, but would be taxable.  As a result, the Tax Office has determined that it will permit the net capital gains to be distributed to the capital beneficiaries for taxation purposes in accordance with the substance of the trust arrangement, rather than to the income beneficiaries under a technical interpretation of the operation of the trust provisions in Division 6 of Part III of the 1936 Tax Act.

However, we note that the Tax Office permits this concession only in circumstances where the income beneficiaries, the capital beneficiaries and the trustee agree in writing to apply it.  An agreement and any trustee resolution giving effect to the agreement must be made within two months of the close of the relevant income year.  While the agreement does not need to be provided to the Tax Office in the ordinary course, it should be available to be produced if requested by the Tax Office.

We note that, in a hybrid trust situation, it would not be appropriate for the trust deed to contain an income clause that equates trust law income with net income for the purposes of section 95 of the Income Tax Assessment Act 1936 (“the 1936 Tax Act”) because this would result in any net capital gains (as determined under the taxation laws) made by the trustee to be treated as income of the holders of the income units, i.e. this would be an outcome that would not be desirable from an asset protection perspective.

Value Shifting Provisions

On the basis that the hybrid trust uses the funds raised by the issuing of income units to purchase underlying trust assets, the ability of the trustee to distribute those assets (and any accompanying capital gains) to beneficiaries other than the income unit holders means that the income units may have a market value less than their face value.  In this instance, the value shifting provisions, which can result in an immediate capital gain in certain circumstances, need to be considered.

However, in order for the provisions to be triggered, there needs to be a decrease in market value of one or more trust interests (a “down interest”) and a corresponding increase in market value of another trust interest (an “up interest”).  In my view, while it may be argued that the face value of the income units have fallen in value (the “down interests”) because of the discretionary capital interests, the capital interests have not increased in value because there is no fixed capital interest to which an increase in value could attach.  That is, there is not a corresponding “up interest”. The capital interests in the hybrid trust are discretionary interests and, as such, would not have any relevant market value.

Accordingly, in my view, the value shifting provisions should have no application in relation to the separate income and capital interests.

Entitlement to Franking Credits

Where the hybrid trust invests in shares that generate franked dividends, consideration needs to be given to whether any franking credits are able to be utilised by the relevant beneficiaries who receive franked dividends.

Generally, to be entitled to a franking credit in relation to a dividend, a taxpayer must be a “qualified person” in relation to the dividend.  This, among other things, requires the taxpayer to satisfy the holding period rule.  Broadly, the holding period rule requires the taxpayer to be exposed to the risks in relation to the holding of the shares for a minimum period of 45 days.

Further conditions are required where the shareholder holds the relevant shares through a trust.  While these additional provisions are complex, their operation broadly requires that relevant beneficiaries have a sufficient interest in the corpus of the trust to expose them to at least 30% of the risks of loss and opportunities for gain in respect of the shares held by the trust.

In this instance, none of the beneficiaries or unitholders have a fixed entitlement to the underlying shares held by the trust (as all capital interests in the trust are discretionary).  Accordingly, none of the beneficiaries who receive a trust distribution comprising franked dividends would be deemed to hold that share at sufficient risk to allow entitlements to any franking credits arising from a dividend payable on that share.

However, franking credits may still be utilised by the relevant beneficiaries (i.e. the holders of the income units) where:

  • The recipient taxpayer (i.e. the unitholder) has total franking credits of less than $5,000 (including any franking credits arising from sources other than the hybrid trust); or
  • The hybrid trust makes a family trust election.

In general terms, making a family trust election defines (or restricts) which beneficiaries the trust can distribute to each year (being the test individual’s family).  The family of the test individual means:

  • Any parent, grandparent, brother, sister, nephew, niece, child or child of a child of the test individual or the test individual’s spouse; and
  • The spouse of the test individual and of anyone who is a member of the test individual’s family because of the first bullet point immediately above.

Once a family trust election has been made, distributions could only be made from the family (hybrid) trust to the above people, as well as to wholly owned family entities and entities which have made “interposed entity” elections.  If a distribution is made outside this defined group, family trust distribution tax (at 48.5%) would be payable by the trustee on the distribution.

This franking credit issue is only relevant where part of the investment strategy of the hybrid trust is to invest in shares, which would include the receipt of franked dividends from time to time.  If the investment strategy of the hybrid trust does not include investment in shares, eg because the trustee only invests in real property, then the franking credit issue would not arise.

Application of General Anti-Avoidance Provisions

While it cannot be guaranteed that the Tax Office would not form the view that the use of a hybrid trust would be contrary to the anti-avoidance rules in Part IVA of the 1936 Tax Act, my view is that such a conclusion could be dispelled on the basis that it is at least reasonably arguable that the dominant purpose of adopting a hybrid trust structure would not be the obtaining of a tax benefit.

In terms of the commercial objective of using such a structure, it may be argued that a hybrid trust offers genuine asset protection and flexibility of distribution of trust capital and any capital profits.  Specifically, the capital of the trust is not vulnerable in the event that the holder of the income units is made bankrupt (as the assets of the trust are held for the discretionary objects of the trust).

In other words, in the event that an income unitholder’s bankruptcy is on the horizon, the trustee could dispose of the assets of the trust and distribute the funds to the discretionary objects, thereby preventing the income unitholder’s creditors from benefiting from the potential income stream from the income units.  Put another way, the value of the income units is dependent upon the trustee’s ongoing utilisation of the capital assets of the trust.

In conclusion on this point, I am not aware of any action that the Tax Office has taken to disallow any purported tax benefits that may arise under hybrid trust arrangements on the basis that the general anti-avoidance provisions of Part IVA should be applied, eg the benefit of interest deductions arising from funds borrowed to acquire income units in a hybrid trust.

IMPLEMENTATION OF HYBRID TRUST

To establish a hybrid trust the following needs to be done:

  • Determination of who is to be trustee.
  • Determining who is to be settlor.
  • Identifying the appropriate type of Hybrid Trust, that is a trust with discretionary units, where those units have a fixed entitlement to income and capital, or a trust with a discretionary split of capital, with units that only rank for income distributions, or such other variations as may be considered to be appropriate. 
  • Instructing the drafting of the trust deed.
  • Transferring of assets to the trust. 
  • Pay the relevant stamp duty.
  • Apply for registration for ABN, TFN etc.

The following is an example of an outline of the rules governing a Hybrid Trust:

The Hybrid Trust structure

1 The term ‘Hybrid Trust’ does not refer to one particular type of structure. There are many types of Hybrid Trust. Indeed, ‘Hybrid Trust’ means different things to different people. Therefore, it is crucial that you understand the type of structure that is being established.

2 In this example the Hybrid Trust is established by the settler transferring the settled sum to the trustee in consideration for the issue of the initial units to the initial unit holders.

3 The Hybrid Trust under consideration allows for only fully paid units. (There can not be partly paid units.)

4  When the Hybrid Trust is set up, the unit holders receive units in consideration of the settlor paying the settled sum. So there is no unit price that applies to those units. If a unit holder later invests in the Hybrid Trust, then they can be issued units in consideration of their investment (and a price can be set then).

5 The trustee may make income distributions or capital distributions or both.

6 There are a number of beneficiary classes equal to the number of unit holders. Each class of beneficiaries is defined by reference to their relationship with the relevant unit holder.

7 In this example 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.)

8 In this example 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.

9 The trustee is not bound to make a distribution to any particular person. Instead, any distribution must be only to some person or persons who meet the definition of a beneficiary in the relevant class.

10 The trust deed provides for meetings of unit holders. Also, unit holders have the power to wind-up the trust (by a simple majority) or to remove the trustee (by a special majority).

The following are examples of some of the typical clauses of a Hybrid Trust Deed:

Beneficiaries

The beneficiaries of the trust are as follows:

  • A sole unit holder.
  • A joint unit holder who is the first-named of the joint unit holders in the Register.
  • Any charity.
  • Any person defined by this deed as a beneficiary by reason of a relationship with a sole unit holder or a first-named joint unit holder. A sole or first-named joint unit holder is called an ’effective unit holder’.

Extension of beneficiaries

A Hybrid Trust is a combination of a fixed (unit) trust and a discretionary trust, thus to capture the greatest number of potential beneficiaries the deed might say in respect of a unit holder who is an individual:

If an effective unit holder is an individual, then the beneficiaries by reason of a relationship with that unit holder are:

  • the unit holder’s parents, brothers, sisters, spouses, children and grandchildren
  • the spouses, children and grandchildren of those brothers, sisters, children and Grandchildren
  • the trustees (in that capacity) of any trust or settlement under which any of the beneficiaries mentioned above has any interest whatever — including an interest solely by expectancy
  • a corporation in which any of the beneficiaries mentioned above is a shareholder
  • another legal entity in which any of the beneficiaries mentioned above owns or holds a share, interest or expectancy
  • any person who holds a unit jointly with the effective unit holder.

One of the most important clauses of any Hybrid Trust deed is that relating to the distribution of income:

Distribution of income

Before the end of each financial year, the trustee must decide whether any and, if so, what amount or proportion of net income is to be distributed in respect of that financial year. The trustee may decide to make an interim distribution of net income in respect of a financial year at any time during that financial year. As soon as practicable after deciding that an amount or proportion of net income is to be distributed in respect of a financial year, the trustee must pay, apply or set aside that amount or proportion to, or for, any one or more of the beneficiaries who are alive or in existence at the time of the trustee’s decision.

Distribution of income to be in proportion to units held by effective unit holders

A distribution of net income must be made among the classes of beneficiaries in proportion to the number of units held by the effective unit holders. The only exception is that the trustee may make a distribution of net income that is not in proportion to the number of units held by the effective unit holders if no unit holder objects to a proposed distribution within 14 clear days after receiving a copy of the proposed distribution from the trustee. The copy must set out:

  • The fact that the proposed distribution is not to be made among the classes of beneficiaries in proportion to the number of units held by the effective unit holders.
  • The names and addresses of the beneficiaries who are to receive a distribution.
  • The amount of each distribution.
  • The income years to which the distribution is to apply.
  • A unit holder’s right to object to the proposed distribution within 14 clear days after receiving a copy of the proposal.
  • The fact that a single objection by a unit holder will prevent the distribution from being made — that is, any one unit holder or one member of a joint holding may veto the proposed distribution.

Trustee’s discretion to distribute within a class

The trustee has a discretion to distribute an amount within a class of beneficiaries. The trustee may exclude one or more beneficiaries from a distribution, and may distribute between beneficiaries in any proportion the trustee thinks fit. The trustee may pay, apply, set aside or divide part of the amount differently from another part of that amount.

And of relevance to our discussions the following clauses reflect the treatment of units on death:

Death of sole unit holder

The trustee must recognize the personal representative of a deceased sole unit holder as having title to the unit holder’s units. The trustee must register the personal representative as holder of the units and issue him or her with a new certificate if each of the following conditions is satisfied:

  • The trustee receives satisfactory proof of the unit holder’s death and any statutory certificate that is required to deal with the unit holder’s assets.
  • The trustee receives satisfactory proof that the person is the unit holder’s personal representative.
  • The last certificate of the deceased unit holder is delivered to the trustee.

If the personal representative requires it, then the trustee must register the person entitled to the units under the will or on the intestacy of the deceased unit holder as the new holder of the units. Before doing so, the trustee may require the personal representative to make a declaration of the person’s entitlement in a form specified by the trustee. The trustee may also require a request by the person to be registered, and the delivery of the unit holder’s last certificate. When the personal representative is registered as the holder of the units, the beneficiaries by relationship shall still be determined on the basis that the decreased unit holder is still alive.

Estate planning and Hybrid Trusts

A Hybrid Trust thus allows for the allocation of income and capital equally between “unit holders” and then within the category of unitholders there is discretion between all of the potential beneficiaries.

Let us consider a case study on the lifecycle of a Hybrid Trust.

Billy Blue is a high flyer.  Billy has a number of businesses that he owns. 

One of these is a 50/50 joint venture between Billy and Teddy Bare who have set up a Hybrid Trust to carry on the activities of the Long Cloud Mining Trust LCMT.   The LCMT has a mining lease in the back blocks of Queensland.  The ore deposit is estimated to be 2 million tonnes, of gold at an average grade of 5 grams a tonne.  (At current prices the resource is estimated to be $312,500,000).  The ore can be mined and processed for $50 per tonne, with estimated profits of $212,500,000.    The LCMT is mining the resource at the rate of $500,000 of profits per month. 

The trustee of the LCMT is the Long Cloud Mining Company Pty Ltd.    The company has 100 shares on issue.  50 are owned by Billy Blue’s private investment company, Eulb Pty Ltd.  Eulb is the trustee of a family discretionary trust, the Billy Blue Family Trust (BBFT).   Billy is a joint director of LCMC with Teddy Bare. 

Billy, is aged 55, he has been married twice, and is currently living with Rosalie Tixe.  Billy’s first wife Clarise, died of cancer at the age of 35, leaving Billy (then 37) with two children, William (the 3rd) now age 28 and Chantal now age 26. William is married with one child, Chantal is in a de-facto relationship with Joe, 15 years her senior.  Joe’s son, Patrick lives with them.  Chantal is currently expecting a child.  

Billy’s second wife Anna (now 48), produced 3 children, Fred, Katherine, and Richard.   All children are currently under 18.  Anna and Billy divorced when he was 52 and reached a property settlement. They have joint custody of the children.   

Tixe (30) has no children with Billy but often wishes to have them.

The executor of his will is Billy’s oldest son William (the 3rd) and his best friend Guss Dribble.

The LCMT has 100 units on issue.   There are 50 A class units held by Eulb Pty Ltd as trustee for the BBFT.  The beneficiaries eligible for distributions from the LCMT are:

  • Billy.
  • Any current spouse or de-facto.
  • Any former spouse.
  • Any grandparent of Billy, any parent of Billy. 
  • Any child of Billy.
  • Any grandchild of Billy.
  • Any company of which Billy (or another beneficiary) is a director of shareholder.
  • Any trust of which Billy (or another beneficiary) is a beneficiary or unitholder in.
  • Registered charities. 

The LCMT trust distributes the net income of $6,000,000 50% to Billy’s interest typically as follows:

  • $1,000,000 per year to Billy.
  • $250,000 to his former spouse.
  • $500,000 to his de-facto.
  • $250,000 each to his two adult children.
  • The balance to a “bucket company”, that pays tax at 30% on the income received.   This company, Goldbuck Pty Ltd is wholly owned by Eulb Pty Ltd as trustee for the BBFT.

A few years go by and Rosalie has a child of 1 year of age and Billy is a happy father of 57 years.   However, his fast living has caught up with him and he dies suddenly of a heart attack in the Gym. 

On Billy’s death is will provides that the shares in Eulb Pty Ltd pass to his oldest son. 

Billy’s will directs that the income of the BBFT and LCMT is to be paid in accordance with the prior distributions as made, with the exception, that 50% of the accumulated net income of Goldbuck is to paid as dividends, via the family trust, equally to all of his children, former spouses and current spouses with the balance to be left to accumulate in the company and 50% of the annual net income to be paid, via the family trust, equally to the same.

What are the other implications on death of the asset structure?

  • Eulb Pty Ltd – this company is only a trustee.  Control of the company passes to William the 3rd.   William is bound to operate the BBFT in accordance with the trust deed of the trust.  However, nothing in the deed provides that he must consider his other siblings or other mother-in-laws.
  • LCMT all of the units are held by Eulb as trustee for BBFT.  As there is continuity of entity there is no change on death.   

Essentially, the entire structure continues un-changed, other than for the transmission of the shares in Eulb, the trustee for the BBFT, that in turn owns all of the assets. 

Will, Billy’s will be effective?   Obviously, no, as the will does nothing to bind the trustee of the LCMT (which decides to distribute the income and capital gains of the Eulb unit holder as it pleases) and BBFT is now controlled by William the 3rd, nothing in the will of Billy controls him. 

Thus in order for the distributions to be made as Billy directs in his will the only way for such wishes to be followed is based on the goodwill of William the 3rd.   Although he is joint executor of the will of Billy, nothing in the will can bind the discretionary powers of the trustee of the Hybrid trust, LCMT.

How, could Billy’s wishes in his will have been satisfied? 

  • One option would have been for Billy to have entered into a family arrangement with William 3rd to ensure that he exercised his powers as director of the trustee entities to distribute in accordance with Billy’s will.
  • Another option would have been for Billy to have the shares in the trustee entities to pass to a new trust, being a “will trust”, that is one arising on the death of a person, with the terms of that will trust being such that the distributions would then be made in accordance with the will of Billy.  

The above case study of Billy Blue illustrates the following key points:

  • A Hybrid Trust allows for discretionary distributions between the various beneficiaries in a unit class. 
  • The control of the trustee of the Hybrid Trust rests with the Trustee.   The question of dealing with the passing of the control of the Hybrid Trust must be given serious consideration under the will.
  • A Hybrid Trust has in the first instance a requirement for the Trustee of the Hybrid Trust to distribute income to the unit holder. Thus the control of the units held must also be considered in the will.
  • Ultimately, it would appear that a further trust may be necessary to ensure that income is distributed in accordance with the will. 

Thus a Hybrid Trust allows for flexibility of distribution, and continuity of the ownership of assets, however, in my opinion they do not readily cater for the ability of a person to control the distribution of income from the trust after their death, simply, because there is a discretionary power to distribute income between a number of potential beneficiaries.  

A traditional unit trust, however, provides that income and capital is distributed by the trustee to the unitholder with no discretion as to the beneficiary.   Thus on death the unit is property of the deceased and can be passed on to a new trust arising out of the will of the deceased, and that trust, can include requirements for the distribution of income and capital as the deceased may have wished.   

Ultimately, our case study shows how a Hybrid Trust, like all structures, is a compromise between, the requirement for current flexibility when choosing beneficiaries and that of future “ruling from the grave” of fixed distributions.   When structures are changed at a later time there are often adverse tax, stamp duty and transaction costs which may not be acceptable.

About the author:

Andrew Skinner is an accountant and director of Andrew Skinner & Associates Pty Ltd practising in the areas of taxation and superannuation. He holds a Bachelor and Masters of Economics and is currently completing a Masters of Taxation. His work involves advice on the establishment, planning for, and administration of small superannuation funds, pension planning, income tax and superannuation structuring, advice on compliance with the law by trustees of superannuation funds, and income tax and business structuring.

He is an accountant, fellow of the Taxation Institute of Australia, and a member of Superannuation Australia and of the Taxpayers Association of Australia.

He is a seasoned presenter of seminars in the area of superannuation and taxation for various organisations, such as, TENS, the CLE Centre, the Taxpayers Association, Taxation Institute of Australia, the Institute of Chartered Accountants, and the Certified Practising Accountants.

Andrew has written and published many articles and papers for various professional bodies.

Disclaimer

While all efforts have been made to ensure that this paper is accurate and complete it should not be relied upon by any person in making any decisions in respect of their or another persons superannuation benefits. Neither the TENS nor Andrew Skinner & Associates Pty Limited nor the author gives any warranties in respect of the accuracy to any person. This paper should not be construed as being financial advice, nor does it seek to be relevant to you or your client’s circumstances. In all situations, advice specific to your circumstances should be sought and obtained from an appropriately qualified professional.  This paper should not be considered to be an offer to invest in any financial product, financial interest nor an endorsement of an investment and/or membership of a self-managed superannuation fund.

This work is copyright.  Apart from any use as permitted under the Copyright Act 1968, no part may be reproduced by any process without prior written permission from TENS, Andrew Skinner & Associates Pty Ltd or Andrew Skinner.  Requests and inquiries concerning reproduction and rights should be addressed to TENS or  Andrew Skinner.

Hybrid Trusts Case Study

Asset protection

Fred Fenton is a well known “private banker”. Fred’s company, FF Finance Pty Ltd provides loans and invests in real estate.   FF Finance also borrows money to make investments.  Unfortunately, FF Finance is caught up in the US sub-prime market and is insolvent.   Fred when borrowing the money had given a personal guarantee.  Fred goes bankrupt as well.

Fred and his wife Hilma both 100 units each in the FH Investment Trust (the Trust).  The Trust is a Hybrid Trust.   The units have a capital value of only $1 each.  Distributions by the trustee may be made to Fred, Hilma, their children, grandchildren, parents, companies and trusts of which they are directors or shareholders. 

Over the years the distributions have been made to a company, Dref Investments Pty Ltd (a bucket company) and to Hilma.

The trustee of Fred’s estate seeks to take the assets of the Trust, but because it is a “unit” trust, the only amount that the trustee is able to access is the redemption value.   The trustee of the Trust redeems the units of Fred for $50. 

Income splitting

Tony Grey is in business making portable building. When he started his business he was the sole owner.  However, his accountant suggested a hybrid trust as such a structure allows a great deal of flexibility for distributions, and beneficiaries. 

Tony set up the TG Building Company Pty Ltd as trustee for the TGB Trust.   Initially, all of the 100 A class units of only $1 each are held by Tony and his wife Thelma equally. 

Tony’s business expands rapidly.   He develops modular building methods.  The mining boom in Australia results in more work than he can cope with, and he is lacking equity.   Tony brings in a partner, Jeffrey Mace who buys 100 B  class units of $1 each in the TGB Trust.  Jeffrey also makes a loan to the business of $500,000 on commercial terms.  

Previously, distributions had been made to the beneficiaries related to Tony and Hilma.   With the introduction of the new partner distributions can now be made easily to any beneficiary able to be included in Jeffrey’s “family”.

The result of using the Hybrid Trust was that:

  • A new partner could be easily included.
  • There are no re-settlement issues on the introduction of a new party. 
  • There was no adverse tax issues included in the issue of new units or no disposal.
  • There is still a unit entitlement for both Tony and Jeffrey. 
  • There is flexibility of distributions of income between whatever parties are considered appropriate.

Estate Planning

Bill Fuggle is an art collector.   He is single, but has 3 brothers.   When building up his art collection he discussed with his advisors the best way to structure his affairs.  A hybrid trust was recommended.  

The Elgguf Investment Trust has 100 units on issue to Bill.  Bill dies suddenly in a light plane crash at 45.  His will provides that of the 100 units in Elgguf be distributed 30 to each brother and 10 to a trust arising from his estate where the income is to be applied to charitable works.  

Each brother inherits 30 units.  As Elgguf is a hybrid trust each of the brothers extended “group” of beneficiaries are now included.    Initially, there is no income to distribute but a few years later one of the paintings of Nolan is sold for $2,000,000, each of the brothers is able to determine how to distribute the gains to their chosen beneficiaries.

The use of a hybrid trust for estate planning:

  • Allowed the easy transmission of a “fixed” share in the estate to each brother.
  • Allowed the ability to include a large group of beneficiaries of each new unit holder.
  • Avoided CGT issues on death.
  • Avoided any re-settlement issues.
  • Allowed Bill to direct the units in the trust to his brothers and charitable trust.

STUDY POINTS

  1. What is the definition of a hybrid trust?
  2. On what basis might one argue that interest deductions will lie for borrowings to acquire income units in a hybrid trust?
  3. Do you agree that (a) the value shifting provisions and (b) Part IVA will generally not apply to the typical hybrid trust discussed in this program?  Give reasons for your answer.
  4. When would a hybrid trust need to make a family trust election?
  5. Why is it desirable that the income clause in a hybrid trust deed not equate trust income with net income of the trust estate under section 95?
  6. What are the main benefits of using a hybrid trust structure for (a) asset protection and (b) estate planning and (c) income splitting?