What we learned from the ATO about property and hybrid trusts
Over the last three years of negotiating with the ATO to achieve an ATO-approved product ruling for our Property Investor Trust ® (PIT®) we have learned a few things that we thought was interesting to share.
Firstly some background information:
The use of privately held trusts in Australia has had a long history dating back many decades. Over the years many taxpayers inadvertently began using trusts incorrectly and in some cases exceeded the boundaries beyond what was acceptable in the eyes of the ATO.
This national exposure led four years ago to the ATO reviewing their position with a specific focus on hybrid trusts. As a result in March 2009 a tax determination was issued TD 2009/17.
Unfortunately the 2009 determination TD 2009/17 created significant confusion and lack of certainty regarding eligible interest tax deductibility in the marketplace at a client, advisor and accounting professional level.
In short it stated that the uncommercial use of trusts could lead to the denial of full interest deductibility on borrowed funds.
Many well-meaning and respected commentators, including accountants, interpreted that to mean that all hybrid trusts were illegal, and many practitioners ceased using hybrid trusts. This was compounded by the fact that many banks also ceased lending to hybrid trusts.
Commerciality means that there must be a motive to make a profit. Some trust deeds were written where they would never make a profit and thus never need to pay tax.
For example, when the property went from negative gearing to positive gearing and tax was due to be paid, some trust deeds allowed an event to occur such that the positive rental was driven else where and no tax was ever payable.
While many hybrid trust deeds did not do this, the ATO took a blanket view and the tax determination in 2009 created sufficient confusion that most people ceased using hybrid trusts. This was a great way for the ATO to win the war without the battle.
While our legal advice, backed up by Queens Counsel was that a properly constructed hybrid trusts was fine and certainly our Property Investor Trust® fell into that category, the tax determination created sufficient confusion that many accountants and commentators argued among themselves. We were divided into two camps: Those for hybrid trusts and those vehemently against hybrid trusts.
In the meantime Andrew Forrest (Twiggy) of Fortesque fame took the ATO to court on a similar matter in respect to his hybrid trust.
Three High Court judges ruled in Forrest’s favour, ruling that interest was fully deductible for monies borrowed to buy income units in his hybrid yrust. However, the ATO argued that apportionment (which was not in its draft ruling issued at the time) was not considered in the Forrest case and retained its position in the final tax determination TD2009/17.
Apportionment is when interest deduction is not fully allowable and maybe restricted to the net rental received by the taxpayer where the unit holder was not entitled to both income and capital.
A tax determination is not law, and it’s simply the judges’ view.
Of all the thousands of cases that end up in court it’s been reported that the ATO only wins approximately 50%. That excludes the thousands of cases where the taxpayer had simply conceded without a fight even though they may have been legally correct but did not have the financial means to see it through the courts.
However the tax determination created enough confusion that those who were conservative in nature simply followed the tax determination and the ATO would have succeeded in stopping something that would have taken years to pass through Parliament.
Tax determinations, whether they are legally correct or not, is a cost-effective and practical tool for the ATO to achieve its means.
The ATO product ruling granted to the Chan & Naylor Property Investor Trust® brings certainty to the community and opens the way for others to pursue this course if they believe that holding a property in a trust is for them.
This will have also opened the door for many banks to once again begin lending to hybrid trusts. Certainly the banks are lending to our PIT®, with the evidence of an ATO approved product ruling behind it.
This will have huge positive ramifications for property investors in Australia.
Is a “product ruling” the same as a “private ruling?”
A “product ruling” is NOT the same as a “private ruling”. While some have been able to achieve a private ruling for themselves this is not automatically transferable to another taxpayer. Relying on someone else’s private ruling in the hope that the ATO will also see your situation in the same light and the same facts is not recommended.
A private ruling is specific to the individual taxpayer and may not be relied upon by another taxpayer.
A product ruling such as the Chan & Naylor product ruling on the Property Investor Trust® is an approval on the product itself and is applicable for all who own a Property Investor Trust Deed® as long as the ATO conditions are followed strictly.
Our negotiations with the ATO have reviewed some major points (among many smaller ones) they wanted to see in one’s trust deed:
- There needed to be a fixed entitlement to both income and capital. Many trust deeds were not clear and left open the ability for the trustee to distribute income and capital at their discretion.
- The income units needed to have some capital/market value attached to it
- The ATO would apportion the interest deduction if there was not a definitive fixed entitlement to both income and capital, meaning they would not allow interest deductions in full and maybe restrict it to the net rental income of the property.
- There must be commerciality in your dealings, meaning there must be an intent to make a profit, albeit it could be at a later date.
In summary, the ATO will apportion the interest deduction if someone other than the taxpayer can or will benefit from the transaction.
We hope this article helps you understand the background to the ATO’s challenge to hybrid trusts and in so doing assist you in structuring your affairs correctly.
Ed Chan is a founding partner of Chan and Naylor accountants and a leading property tax specialist. He has co-authored three best-selling books as a seasoned property investor who understands the relationship between property investment and tax.
