Tax planning for families - discretionary trusts

The traditional discretionary style of trust has long been used by families as a sensible structure in which:

  • to hold family assets together for current and future generations;
  • to protect family assets;
  • to achieve legitimate tax planning benefits to assist the family’s financial position.

As the name suggests, a discretionary trust is a trust in which a trustee holds assets for the benefit of a defined group of persons, called beneficiaries, but with none of those beneficiaries having any entitlement to any of the income or any of the trust capital unless the trustee exercises a discretion in their favour.

One of the few tax disadvantages of discretionary trusts relate to geared investments and in more recent years the traditional discretionary trust has evolved in an attempt to overcome these tax disadvantages. The creature that this trust has evolved into is known in the tax world as the "hybrid trust" and is designed to offer the benefits of negative gearing at a personal level while protecting the capital of the asset in the trust.

A hybrid trust is simply a trust that has features of both a discretionary trust and a fixed trust. That is, the beneficiaries of a "hybrid trust" have some entitlements to benefit (generally as to income) that are fixed in their favour by the terms of the trust deed while other benefits (generally as to capital) will only come their way if the trustee of the trust exercises a discretion in their favour.

There are a myriad of hybrid trusts available in the market place. They all work differently and, consequently, all have different tax implications. The Taxation Office ("ATO") has long been very concerned about the use of "hybrid trusts" and have issued a number of Rulings and Determinations in relation to them.

A particular style of "hybrid trust" was recently considered by the Full Federal Court in the case of Forrest v Commissioner of Taxation.

Forrest v Commissioner of Taxation

On 30 June 1999 Mr Forrest borrowed $4.5 million and used $4,293,000 of that money to acquire Ordinary Units in the Minderoo Trust. The Minderoo Trust used that money to purchase shares in Anaconda Nickel Limited ("Anaconda").

The Minderoo Trust had the following features:

  • the holders of Ordinary Units were entitled to share equally in the "Fixed Income Component" of the trust (which included all income derived by the trust other than realised and unrealised capital gains);
  • realised and unrealised capital gains (defined to be the "Discretionary Component") could be distributed to the broad class of defined "Discretionary Beneficiaries", at the discretion of the trustee;
  • the trustee had a power to determine whether any amounts derived by the trust were on income or capital account.

During the income years ended 30 June 2000 to 30 June 2002 Mr Forrest incurred an aggregate interest expense of $858,061 on the loan for which he claimed tax deductions, arguing that there was a direct nexus between the interest expense he incurred and the derivation of the Fixed Income Component he derived from the trust and therefore the tax deduction was denied by the ATO on the basis that the Minderoo Trust was a discretionary trust. That is, the ATO position was that the interest expense on the loan was not incurred by Mr Forrest "in the course of" gaining or producing assessable income because the trustee of the Minderoo Trust had an overriding discretion to characterise a receipt by the trust as income or capital, ie. as a Fixed Income Component or as a Discretionary Component. In this way, the ATO argued, any income Mr Forrest derived from the trust would always be as a consequence of the trustee exercising a discretion in his favour. As such, the ATO argued that there was insufficient nexus between the interest expense incurred and the deriving of the Fixed Income Component.

The Full Federal Court found in favour of Mr Forrest.

The Full Federal Court characterised the Minderoo Trust as a "hybrid trust" not a discretionary trust. The trustee’s power to classify income as capital and vice versa was not unrestricted but could only be exercised in accordance with long standing principles of trust law which meant that "income" of the trust (as is ordinarily understood by that term) could not be reclassified as capital.

After characterising the Minderoo Trust as a "hybrid trust", the Court was then able to find that the interest expense in question was indeed incurred by Mr Forrest "in the course of" gaining or producing assessable income (being the Fixed Income Component as defined under the trust deed).


Does this decision in favour of the taxpayer mean a "green light" for tax planning with "hybrid trusts"?

We suggest ….."no"….. at least not for the time being.

In our view there is still a level of caution that must be adopted with any proposed use of "hybrid trust" because:

  • each "hybrid trust" model is different and the terms of each "hybrid trust" must be understood because different trust terms will be interpreted differently by the Courts and will give rise to different tax implications;
  • the ATO does not like "hybrid trusts" which means there is always a risk of legislative change to outlaw their use;
  • the issue of "apportionment" of the interest expense was not argued by the ATO and, consequently, was not considered by the Court – in our view this is an important issue that remains unaddressed and unclear and was a significant weakness in the way the ATO litigated the matter;
  • the matter will likely be appealed to the High Court.

If you require any assistance with tax planning or understanding the many ways that trusts can be used effectively please contact Andrew Frankland or Chris Tsovolos at Bartier Perry.

Author: Andrew Frankland