Converting loan to trust to income units in the trust

I currently have a discretionary trust set up which holds some shares and managed funds. I borrowed money in my personal name (against my PPOR) and on-lent that money to the trust. This allows me to effectively tax-deduct the interest inside the trust. That's fine if the trust makes a profit, but recently it's been making big losses (with the GFC and all).

I'd like to change this to a hybrid trust arrangement, so that I can tax-deduct the full amount of the interest in my personal name, even if it's greater than the income I receive (negatively gear). My trust deed already allows for issuing units, but what do I do when I'm not purchasing new assets with the borrowed money? Can I actually "convert" the loan (from myself to the trust) to income units - ie. effectively repay it with units instead of money? Are there any issues I need to watch out for with this or with hybrid trusts in general? Finally, can you recommend someone in Melbourne who can give me professional advice on this (preferably in the CBD, though I'm vary of the prices )?

 

The ATO loves hybrid trusts.

The deductibility of interest is determined by the purpose or use of the underlying funds.

From what you have said, there is a loan between yourself and the trust - so you should have a loan agreement. The trust should be paying interest to you which you declare as taxable income, and then you claim the deduction for the interest you pay on the loan in your own name - making your tax position neutral but the trust still claiming the deduction for the interest paid to you. This is not an ideal structure and needs to be cleaned up.

You cannot claim a deduction for monies borrowed and invested in a discretionary / family trust - which I assume is why you want to go down the hybrid path and issue some units (what I have described in the previous paragraph you are claiming a interest deduction against interest income - not your income from your contribution / investment in your discretionary trust).

If you are looking to make debt which is currently non-deductible deductible, then simply changing your loan to being units issued by the trust will not work - as the underlying use of the borrowed funds will not have changed. You could however issue units in place of the loan - but still only the interest on the amount borrowed for investment purposes (not private) will be deductible.

If you own 100% of the units, you really need to be distributing 100% of any income or capital gains to yourself - otherwise the deductibility of the interest will be lost. You effectively loose the discretionary ability of the trust as far as it relates to income generated from the invested funded by the borrowed monies.

Confused? I am.

I would talk to your bank and change your loans around to have one in your own name for your PPOR and a second facility (still secured against your PPOR) in the name of the trust. If your bank won't do it shop around or find someone at the bank who actually knows what they are talking about.

It may cost you a little more in fees - but it makes it a lot cleaning and will keep you accountant and the ATO happy. You can then look at strategies to pay down the non-deductible debt while maximising tax deductions on the deductible debt.

I really need to do some reading on hybrid trusts - because if set up the correct way they can be useful. A recent ATO Determination can be found here. It is not specifically about hybrid trusts - but rather the bigger picture on the deductibility of interest - hopefully it doesn't contradict anything I have said.

Not sure about any Melbourne accountants - but ask me after Xmas and I may be able to point you in the right direction.

 

Thanks for your reply, Superman.

Yes, that's how it's set up.

Yes, I know that any money borrowed and gifted to the trust isn't deductible, so I haven't done that. All the money I've borrowed has been lent to the trust, so all of it is deductible (but neturally geared).

I'm not looking to change any non-deductible debt into deductible. It's already deductible, but currently the tax deductions are (effectively) inside the trust, which is of no use to me when the trust makes a loss. I want to be able to deduct the interest in my personal name instaed.

Yes, well, that's the tricky part - not all of the money that's in the trust was borrowed. Some of it was gifted. That would mean that some part of the income remains discretionary, doesn't it? Calculating which part is non-trivial and that's one of the things I'd like to get professional advice on.

I'm not really sure what that would achieve. The interest deductions would still be in the name of the trust in that set-up.

Interesting - thanks. That pretty much confirms my understanding that the investment in trust units needs to be on an "arms length" basis, ie. the trust needs to pay me (as a unitholder) as much in income and unit redemption proceeds as I'd expect to get if I was completely independent of it. If I do that then the interest to puchase units seems to be deductible.

Thanks, I will.

 

You wish to swap debt for equity.

A simple concept that can be complicated in practice, especially between related parties.

The trust has existing assets over which it would like to issue units, you have an existing unsecured loan (I presume).

Issue of units at a different value compared to the loan or the underlying market value of the securities could be a debt forgiveness, possibly a capital gain/loss and perhaps compromise deductibility of interest.

Don't forget Part IVA could apply if there is a scheme to get a tax advantage.

I presume your trust deed is robust enough to avoid a resettlement on issuing units secured against existing assets which are already held on a discretionary basis.

Time for some competent and comprehensive professional advice. This will be expensive, but better to avoid pitfalls.

Cheers,

Rob

 

Converting Loan to Trust to Income Units in a Trust

I concur with Rob G. You need a good accountant to help you with this. My readings on Hybrid Trusts indicate interest on borrowings to acquire units may not be deductible. Also they are not appropriate where revenue losses are involved and also not appropriate if franked dividends will be received. As you can see there are some issues to be covered.

Possibly the simpliest way out is to wait for the market to improve make a gain on your investments sell the asset, off set the gain against the losses of the trust and ultimately reduce your CGT liability.

Alternatively, do you need the trust ? If you now want the personal tax deductions close the Trust.

I don't live in Melbourne so I can't help with an Accountant, sorry.

 

How about looking at streaming some of your personal taxable income into the trust to eat up the losses.

Tricky if you only really have wages / salary in your own name - but not impossible.

 

Oh? Why would it not be deductible? Could you share a link? There wouldn't be revenue losses (from a business, presumably), but there are some franked dividends. Can't those franking credits be passed onto the unit holders same as they are from managed funds?

Yeah, I only have salary in my personal name, so I don't know how that could legitimately be streamed into the trust.

 

G'day Superman,

It would be great to get your thoughts on where you were going with "streaming some of your personal taxable income into the trust to eat up the losses. Tricky if you only really have wages / salary in your own name - but not impossible".

As a manager in a SME, I am a salary earner in the 39.5c tax bracket. In April of this year, I will be paid an annual, contracted bonus of approximately $25,000. I have a discretionary trust with carried forward trading losses of $73,000. It would of course be extremely advantageous if I could divert the bonus into the trust to soak up those losses. In future, once the losses have been utilised, the trust income could be distributed to my wife who is at home with young children. Note, we have a large, non-deductible mortgage for our PPR and a mortgage for a rental property.

Perhaps I could look at doing something with more than just the bonus?

Note that while I have no ownership in my employer, they are reasonably flexible and could be open to assisting me in reducing my personal tax position.

If anyone has some comments or leads for further research, they would be greatly appreciated. Happy New Year!

 

OK - so the thread has gone a little off topic....

What I alluded to in my previous post was sometimes a person who is an employee may have the flexibility to change to being a contractor running their own legitimate business with the former employer becoming a client.

The major issue is a little thing called Personal Services Income which prevents you from simply getting your employer to contract your services through your family trust to enable you split the income in a tax effective way.

I have attached an ATO ruling that explains it in more detail and also gives some examples.

If you have further questions please start a new topic / post.

SM