Australia: Update On Negative Gearing Trusts

Last Updated: 22 January 2009
Article by Greg Cahill

There were a number of developments in relation to hybrid trusts in late 2008.

The ATO issued a number of alerts and TD 2008/16 outlining problems with claims for deductions for interest paid on loans to "hybrid" trusts.

The scenarios outlined in these publications are markedly different to those in which the Cooper Grace Ward Negative Gearing Trust (NGT) is used. In our view, the Alerts and Determination do not impact at all on the validity of the NGT arrangements.

However, the ATO did issue a private ruling to a client of Cooper Grace Ward (PBR 88113) in which they ruled that where the beneficiary borrows from an external lender and then advances the funds to a related NGT:

  • the interest is incurred to derive assessable income; but
  • the interest is not fully deductible; and
  • the loan is a "qualifying security".

Download a copy of the ruling

While the ruling was unfavourable, there are a number of factors that suggest the ATO is not confident in the opinion set out in the ruling.

The ATO took six months to issue the ruling. This is an unusually long delay which usually indicates the ATO is "dredging" up arguments to avoid giving an answer they do not like.

Because of the long time delay the client had decided not to proceed with the transaction and therefore was not interested in objecting to the private ruling.

The ATO argue that the beneficiary could "only achieve an unapportioned deduction under section 8-1 of the ITAA 1997 by establishing that he reasonably expects to receive all income from the trust. It is not enough for him to establish that he expects to receive some income, or that the total amount of income he expects to receive is likely to exceed the total amount of his interest expense. A loss or outgoing is not deductible where it is incurred in order to gain or produce assessable income of another entity."

If this is correct, it means that any taxpayer who borrows from an external lender and advances the borrowed funds to a related trust (even at commercial rates of interest) would not be entitled to a 100% deduction for the interest, because they will not be entitled to receive all of the income generated on the borrowed funds.

This is clearly inconsistent with the principles of interest deductibility and would have fundamental ramifications for all parties who lend money to related entities.

The ATO relied primarily on an old case authority (FCT v Munro (1926) 38 CLR 153) to support its position.

The facts in Munro were substantially different to those which apply to the NGT structure. It involved a situation where a father lent money interest free to a company in which he owned only 10% of the shares (with the remaining 90% being held by his children).

There was no priority arrangement which would ensure that the father would receive a commercial return on the funds advanced to the company over time.

The NGT structure requires that all income must be distributed to the lender until such time as all interest (plus any applicable margin) has been recovered.

More importantly, the ATO did not mention (much less endeavour to distinguish) the principles outlined in Fletcher v FCT (1992 ATC 4611) or Crawford v FCT (1993 ATC 5234) which clearly support the contention that the interest is deductible.

In our ruling request we argued the loan was not a qualifying security and referred the ATO to PBR No 25890 – (the facts of which were also addressed by the Commissioner in ID 2003/261).

In that PBR and ID the ATO acknowledged that, where the interest payable on the loan was contingent upon the borrower generating profits from a Forestry Project, the loan was not a qualifying security because the return on the investment was uncertain.

In the PBR 88113, the ATO argue that the NGT arrangements can be distinguished from ID 2003/261 because "the loan is certain as it is not based on the profitability of an object or event at a future date. The applicant will be entitled to both the repayment of principal amount plus the distribution amount (interest)".

That is, in seeking to distinguish ID 2003/261, the ATO have argued that it is certain the applicant would receive interest on the loan. That is sufficient to justify a claim for a deduction, based on the principles in Fletcher and is inconsistent with the position they have taken in the PBR in relation the deductibility of the interest..

The ATO argument also ignores the fact that the "distribution amount" is dependant upon the trust generating income from the investment which is uncertain at the date that the loan is entered into and therefore it is difficult to see how it can reasonably be distinguished from the facts in ID 2003/261.

While we consider there are substantial weaknesses in the ATO arguments, clients who have entered into NGT arrangements (or propose to do so) will need to be aware that the ATO is unlikely to accept that the interest is deductible (at least not in full) and that, to sustain the claim for the interest deduction, it may be necessary to lodge an objection and possibly to appeal an unfavourable decision.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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