Tax Tip 89: Borrowing and onlending Interest Free to a Discretionary Trust

Borrowing and onlending Interest Free to a Discretionary Trust and Interest Deductibility

Interest will not be deductible where a person borrows money and then lends to a discretionary trust interest free. There is no connection between the expense incurred by the individual and any income of the individual. Discretionary trusts are discretionary and therefore there is no guarantee that the lender will ever get a return on their ‘investment’ from the trust.

The same applies where the funds are gifted to a trust. Any interest on monies borrowed and gifted to a trust will not be deductible because there is no association with any income production.

However, the interest may be deductible to the person where the trustee is a hybrid trust or a fixed trust. If the person is guaranteed income and capital of the trust then they may be entitled to claim the interest on any loans to fund the trust.

For an example
PBR Authorisation Number: 1012046889183
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Therefore if you are borrowing money and diverting it into a related discretionary trust it may be best to enter into an arms length loan agreement with the trustee of the trust. The bank will charge you interest, you will charge the trust interest. The trust will pay you income, in the form of interest, which it can deduct, and against this income you can deduct the expense of interest paid to the bank. Keep in mind the interest rate should be market rates for deductibility to be maintained.

 

Thanks Terry a good reminder

 

An example.

Kramer has a main residence securing a $100,000 LOC. He sets up a discretionary trust with a company as trustee with himself as sole director. The trust has assets of just $10.

He causes the trust to go out and buy a $500,000 property. He doesn't think about this properly and just pays $50k deposit from his LOC. Later at settlement he pays another $50k for the trust.

Kramer cannot claim the interest at all. It doesn't relate to his production of income. During an ATO audit he argues that he should be able to claim because he used it for the trust. The ATO say no as there is no guarantee he will get any income from the trust. He says he can easily make the trust give him income because he controls it. The ATO point out that the trust is a discretionary trust and that even if he controls the trust as trustee he is still not guaranteed an income from the trust. Who would invest in a trust where they were not guaranteed a return of income and/or capital?

George does something similar. But George borrows from ANZ at 5% and lends to the trust at 5%. George is charged $5000 in interest by ANZ, but he also charges the trust 5% interest so the trust pays George $5,000. George's income from this transaction is $0. He has $5000 in income and $5000 in expenses. The trust is left with a $5000 expense. So the trust is the one that wears the interest.

During the ATO audit the ask to see the loan agreement. George says there is none because it was an oral agreement. ATO say would you be able to borrow from a bank with no written document? Sounds like a non commercial agreement. They also ask what security George has for his loan. George has none. They then ask if George could borrow from a bank or other lender at 5% without security. Nope. All banks will won't first mortgages. So the ATO's argument is that this loan is not a commercial loan at arms length. There is no written agreement and there is no security given.

Elaine does the same thing, except she charges the trust a slightly higher interest rate and has a written agreement with the trust giving a mortgage over its property - which is not registered but could be registered at any stage.

There are also asset protection issues. Best to document things clearly because you are not the trust, you are merely a temporary controller of the trust.

 

Not only should the rate be maintained on arms length terms but so should the loan activity and settlement.

It is essential that the loan is settled so that the proceeds are banked to the trust. I have seen this simple issue by passed due to online banking limits or to save a few bucks in bank fees etc. Not smart.

These issues are encountered when dealing with tax concerns with hybrid trusts. The loan should be regularly paid and a diligent accounting maintained not unlike banks do with statements. The loan agreement is something that ATO would ask for as well as review of the loan account.

The issue of being settled correctly is important as there are numerous occasions I have seen where the trust has borrowed money and used it for mixed purposes. That issue may require tax advice.

And in the example Terry used the ATO may argue that the funds obtained by the trust is income and then taxable unless there is a loan agreement that supports it. Sounds harsh but they will take that position in the absence of any other evidence. Best to avoid the dispute.

 

Yes good point Paul. The parties must be meeting their obligations under the loan agreement. If the parties agree to pay monthly then they should be paying monthly, otherwise a breach of agreement will happen. This may be evidence of an uncommercial arrangement. A bank wouldn't let you pay interest whenever you got around to it.

 

Does the $5000 in income from the trust get taxed at George's marginal rate? What is the tax effect of this transaction for George? My understanding is that the $5000 in expenses is not deductible.

Good point about the commercial arms length loan agreement. I had never considered the point about security.

 

If the trust distributes income to George he would be taxed on this income. But the income might go to someone else.

The $5000 is deductible to the trust.

 

Why is tax so confusing?

 

This is actually very straight forward.

I think tax law is confusing because they legislate against something and then 'loop holes' are discovered and then they try to legislate against these, but more things to consider pop up. And it is never ending!

 

Hi @Terry_w

Actually my question was related to the $5000 in interest received by George from the trust. Is this $5000 taxed at George's marginal rate?

My understanding is also that the $5000 in interest paid by George back to the bank is not deductible.

Cheers

 

George would have $5,000 in income and $5,000 in deductions with a net result of $nil

 

When a trust claims a tax deduction from incurred interest, how is that deduction applied (assuming the trust distributes all net income)?

 

deducted against the income of the trust before it is distributed

 

Can you give us an example? I'm struggling to understand how that is good, given that distributed trust income is not taxed to the trust.

 

Trust earns $30,000 in rent
Trust pays $10,000 in deductible interest

Net income is $20,000

 

Who can claim the $10k deduction?

 

Only the trust. It is the one investing.

 

The trust interest issue is often best illustrated by comparing two different forms of trust.

1. A disc trust that borrows v's
2. A Unit trust that does not borrow BUT the unitholder has borrowed to buy their units in the trust.

Trust income (rent) is $18,000
Trust Expenses (exl interest and incl depn) are $6,000
The loan interest in each example is $10,000

1. Disc Trust Net Income is $18K - $6K - $10K. Net Income is $2K
2. Unit Trust Net Income is $18K - $6K = $12K. The Trust has Net Income of $12K distributed to Dave the sole unitholde. Dave then includes $12K at Item 13 of his return and claims a $10K interest deduction. His Net Trust Income for tax is $2K.

The key issue is that if the interest caused a loss the Disc Trust cant distribute it. Its stays in the trust. The unit trust doesn't suffer this same fate.

 

Ummm ...

If a fixed trust had two equal beneficiaries A and B and only one borrows to on-lend interest-free to the trust then only 50% of the interest may be deductible to the borrower. That is still provided that the trust actually applies the funds earning income for distribution.

 

But the trust doesn’t pay tax so what is being deducted?

As a comparison:

A: Bob has $80k rental income and pays 10k in interest for an IP loan. Bob claims the interest and now has $70k taxable income.

B: Bob Discretionary Trust has $80k rental income and pays 10k in interest for an IP loan. Trust distributes net income of $70k and beneficiaries add distributions to their respective taxable income.

Where is the deduction applied in example B?