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Ruling

Subject: Hybrid Discretionary Trust

Question

Are you entitled to a full deduction for interest expenses incurred on borrowed money used to acquire Special Income Units in a Trust under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes. A full deduction is available for the interest expenses incurred in the circumstances described in this ruling.

Facts

The settlor and trustee will execute trust deed to establish the trust.

A copy of the unexecuted trust deed has been included with your private ruling application.

The trust will be established with a settled sum.

You are the sole director and sole shareholder of the corporate trustee.

An associate of yours will settle an amount on the trust by way of gift. No further amounts will be settled on the trust.

The terms of the trust deed provide the trustee with the power to create units in the trust fund, to determine the rights that attach to those units and issue them to any person, including a beneficiary.

You are named as the principal beneficiary of the trust.

The trust deed empowers the trustee to create units in the trust.

The trust deed provides that a special income unit holder's entitlement to income and capital gains is determined by reference to the application for special income units and the trustee's determination in accordance with that application.

You will borrow to acquire special income units in the trust. The loan will be on commercial terms.

You will apply for special income units by submitting to the trustee a signed written application for the special income units (in a form acceptable to the trustee).

A copy of the draft application for special income units and a draft certificate for special income units has been provided with your private ruling application. The clauses in the certificate for special income units replicate the clauses in the application for special income units.

Your application for special income units states:

The holders of Special Income Units at the end of the Financial year ('Special Income Unit Holders') shall be presently and absolutely entitled to the Special Income of the Trust Fund derived during the Financial year in the same proportion as the number of Special Income Unit held by each Special Income Unit Holder bears to the total number of such units on issue at that time.

Further your application for special income units states:

If the holders of Special Income Units redeems their units during the year they shall be presently and absolutely entitled to the Special Income of the Trust Fund derived up to the date of redemption in the same proportion as the number of Special Income Units held by each Special Income Unit Holder bears to the total number of such units on issue at that time.

Further, also, your application for special income units states:

In this clause Special Income of the Trust means that portion of the income of the Trust as is attributable to the investment by the Trustee of the moneys received by it from the issue of Special Income Units

Your application for special income units states that 'apart from their entitlement under the heading of redemption in this application, the holders of special income units shall not have entitlement to amounts that have been settled on the trust.'

No additional special income units will be issued other than the special income units issued to you.

Upon acquiring the special income units, you will be provided with a certificate of special income units.

The trustee will use the funds gifted by your associate (being 50% of total funds) and the funds obtained from your acquisition of special income units (being 50% of total funds) to acquire a residential property from an arm's length third party at market value.

The trustee will lease out the residential property to an arm's length third party who will pay market value rent.

There will be no relationship between the trustee and the tenant or you and the tenant.

The trustee may sell the property to an arm's length third party at market value some time in the future.

Apart from your entitlement to amounts received when your special income units are redeemed, you shall not have an entitlement to amounts that have been settled on the trust.

The trust deed provides that 'any Special Unit Holder during the continuance of the Trust may request the Trustee to redeem some or all of his Special Units.'

Reasons for Decision

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income. A loss or outgoing is not deductible to the extent that it is of a private or domestic nature.

An outgoing of interest may be deductible under section 8-1 of the ITAA 1997 when borrowed money is laid out for the purposes of gaining or producing assessable income (FC of T v Munro (1926) 38 CLR 153 (Munro's Case)). In Munro's Case, it was decided that a father who subscribed borrowed money to fund the issue of 90% of a company's shares to his sons did not enjoy an unapportioned interest deduction merely because he expected to recoup his interest expense from dividends on his 10% shareholding.

The deductibility of interest is typically determined by reference to the use of the borrowed funds. In Ure v FC of T (1981) 11 ATR 484 (Ure's Case) it was established that the purpose of a borrowing will be determined objectively having regard to such matters as how the taxpayer arranged the use of the funds and his subsequent actual use of the funds.

A deduction for interest in a loan taken to purchase units in a hybrid trust was allowed by the Full Federal Court in Forrest v FC of T (2010) 2010 ATC 20-163 (Forrest's Case). In Forrest's Case, the terms of the deed were found by the Court to demonstrate that the trust was a fixed trust of income other than capital gains. It was not, in that respect, a discretionary trust. It followed that as the taxpayer had a fixed interest to all of the income of trust, interest payments claimed by the taxpayer in relation to his interest would be deductible. The issue of apportionment was not considered by the Court in that case (refer to the discussion under the heading of 'Issues decided by the Court' within the Decision Impact Statement for Forrest's Case).

Taxation Determination TD 2009/17 expresses the Commissioner's view as to whether interest on a loan is fully deductible under section 8-1 of the ITAA 1997 when the borrowed moneys are settled by the borrower on trust to benefit both the borrower and others.

Taxation Ruling No IT 2385 deals with expenses incurred by beneficiaries of discretionary trusts, and it states that the Commissioner does not allow deductions to beneficiaries of trusts in relation to trust income unless it is established that the beneficiaries were presently entitled to the trust income when the expenditure was incurred.

In order to claim a deduction for the interest expenses incurred on the money borrowed to purchase the special income units in the trust, you must be presently entitled to a fixed share of the income of the trust at the time the borrowing took place.

To ascertain whether you are presently entitled to a fixed share of the income of the trust, we must consider the terms of the trust deed to ascertain the rights attached to the special income units that you will acquire from the trustee.

The trust deed provides the trustee with the power to accumulate the whole or part of the net income of the trust as the trustee in its absolute discretion thinks fit (subject to any prior determination made under provisions of the trust deed and to the entitlements of the special unit holders).

The trust deed provides the trustee with an absolute discretion, subject to certain determinations and to the entitlements of the special unit holders, to distribute the net income of the trust to one or more of the beneficiaries. It also provides that if the trustee does not exercise their discretion in a beneficiary's favour in respect of the whole of the net income of the trust, then you (as principal beneficiary) will be deemed to have received the net income.

The trust deed provides that your entitlement to income and capital gains in your capacity as special income unit holder is determined by reference to your application for special income units.

Given that you will hold all of the special income units on issue, in each year where you continue to hold special income units at the end of the financial year, your application for special income units entitles you to all of the special income of the trust derived during the financial year. Where your units were redeemed at some point during a financial year, your application for special income units entitles you, as holder of special income units, to all of the special income of the trust, for the period in which you held the units.

The meaning of special income is defined in your application for special income units. It provides that the special income derived by the unit holder will be the amount that is 'attributable to the investment by the Trustee of the moneys received by it from the issue of Special Income Units.'

You have advised that the trustee will make a determination in accordance with the application for special income units provided and will issue a certificate to you, as unit holder, reflecting the same rights. You will therefore be presently entitled to 50% of the income and capital gains of the trust fund, as derived in respect of your holding of the special income units.

The rights attached to the special income units that you will acquire provide you with a fixed entitlement to the net income of the trust under the deed, application for special income units and certificate of special income units.

In conclusion, an interest expense that you incur on borrowed money used to acquire special income units in the trust, as set out in your application and associated documents, will be deductible under section 8-1 of the ITAA 1997.