In Australian taxation law there have been numerous cases that deal with the question of when interest, which is paid on borrowed money, is tax deductible. A recent case, decided by the Full Federal Court, also dealt with this question in the situation of a hybrid trust.
A hybrid trust is one where there is a mixture of a discretionary component and a fixed component. If a trust is a discretionary trust (only) then the trustee has the power to distribute the income and capital of the trust at the trustee’s sole discretion to the beneficiaries of the trust. A fixed trust (often a unit trust) is one where the income and capital flows, normally, to the unit holder beneficiaries in proportion to their unit holding. A hybrid trust is a mixture of the two.
The case of Forrest v Commissioner of Taxation dealt with the issue of a unit holder of the trust (Mr Forrest) borrowing $4.5 million to purchase units in the trust. Mr Forrest then sought to deduct the interest that he paid on this debt. This was just over $860,000 over the course of three years.
The Commissioner of Taxation argued that the interest was not deductible because the way in which the trustee of the trust was required to determine what is income attributable to the unit holders and what is income attributable to the discretionary beneficiaries, was something that did not create a “present entitlement” for the unit holders, of which Mr Forrest was one. The argument of the Commissioner was that the trust deed gave the trustee the power to determine what was capital and what was income for the purposes of the trust. Under the trust deed the capital gains (both realised and unrealised) were to be distributed to the discretionary beneficiaries and all other amounts were to be distributed to the unit holders. Because the trustee had to make a decision as to what amounts were capital and what amounts were income, the Commissioner argued that there was no clear connection between the incurring of the interest by Mr Forrest and the receipt of assessable income from the trust. This was because any income that Mr Forrest would receive was at the discretion of the trustee. So, for example, Mr Forrest may never receive any income if the trustee always determined that all of the amounts received by the trust were capital.
The taxpayer objected to the assessment and appealed to the Administrative Appeals Tribunal which agreed with the Commissioner’s view and stated that the trust was a discretionary trust. The taxpayer then appealed from that decision to the Full Federal Court. So, the matter was heard before three judges.
The Full Federal Court disagreed with both the Commissioner and the Administrative Appeals Tribunal. The Full Federal Court said that the power of the trustee to determine whether a receipt of the trust was either capital or income was not a power to unilaterally decide that an amount was capital or income without regard to the receipt’s true nature. That is, an amount that was clearly income could not be deemed by the trustee to be of a capital nature and directed away from the unit holders to the discretionary beneficiaries. This meant the power given to the trustee in the trust deed to determine whether a receipt was capital or income, was merely stating the power of the trustee to determine whether an amount was capital or income according to law and not an arbitrary power to say that a receipt was capital or income according to the opinion of the trustee.
This meant that, in the opinion of the Full Federal Court, any income receipts received by the trust were bound to be directed towards the unit holders in the trust. Therefore there was a clear expectation that Mr Forrest would receive income in respect of the units that he had purchased in the trust and, accordingly, the interest deductions were permitted.
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Wishing you easier business.
John M. Jeffreys