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

Strange they issued that. s8-1 already makes that evident.
I would have preferred a ruling that explains what a compliant related party loan may be. This merely (may) relate to a zero rate loan. What if its 0.01% ? What are the features of a "loan agreement" that make it compliant for onlending to a disc trust ?

 

Ok. So i read this
https://www.ato.gov.au/law/view/pdf/pbr/td2018-009.pdf
and all the previously mentioned ones and it seems like it is near impossible to borrow money and lend (at the same or higher rate) to my trust and have it as a tax deductible expense. Seems in part due to a trust does not guarantee any beneficiary a distribution. If thats wrong then please explain how exactly it is done. I could bull money out of a LOC loan and lend to my trust (at same or higher rate) and then us it in the trust to purchase LIC's and EFT's in the trusts name.

My other option is to drag money back from offset accounts on IP's and do an interest free loan to the trust to purchase the same Lic's. This means my IP loans go back up and are tax deductible (money was in offset so if fair game for anything). My concern is this seen as us lending money to ourselves?

I really cant see another way of getting funds into the trust which makes sense.

 

You can either gift or loan to a trust. Interest on money borrowed to gift is not deductible directly, but could be indirectly if you withdraw from investment offset accounts.

If you want to claim the interest on borrowing and lending to the trust, even interest free, you would have to amend the trust deed to make yourself presently entitled to the income and capital of the trust while the loan is in place as per the latest private ruling. That will have consequences other than tax.

 

The process for amending the respective trust deed would be important. YOU may not be able to amend the trust. However I believe thats not the issue.

TD 2018/9 does NOT address a trustee borrowing from a person (who may or may not be a beneficiary) where the trust is contractually bound to pay interest and actually pays the interest. The determination is limited to the ATO views in an interest free arrangement. This TD is about interest deductibility NOT about interest bearing loans.

I disagree with this view :

 

So in your view would there be anything to prevent:
1. Beneficiary A borrows $10K @ 5%
2. Beneficiary A lends $10K to Trust B @ say 1%, with an obligation on the trust to immediately start paying that interest to Beneficiary A. Trust B also contractually agrees to pay, say 50% of the investment return that it makes on the $10K to Beneficiary A.

Beneficiary A gets a deduction for the difference between the 5% interest it pays and the 1% interest plus 50% investment return it receives (assuming it's negative - if it's positive Beneficiary A would have a tax liability).

I know the TD deals specifically with zero interest loans - I'm putting the 1% requirement in there to create a present entitlement to income and nexus - although arguably that could be done just with an immediate requirement to share the investment return with Beneficiary A.

 

1. Probably not. 1% is not a commercial and logical basis to onlend when the taxpayer incurs 5%. I would argue that not less than 5% should be the onlent rate.
2. This could be indicators of a scheme (as may 1) and the ATO may cancel any tax benefit

I think rates like 1% when a person incurs 5% is asking for the ATO to consider it a sham / scheme and Part IVA concern. Most tax schemes work on the basis of creating a difference between one taxpayer income and deductions through loans and or timing differences.

This is not a factually correct statement : the 1% requirement in there to create a present entitlement to income. The key issue is whether the party that LENDS to the trustee can deduct the interest cost they incur v's the $0 or a higher amount (1%) of interest received. The loan interest expense could even leave the trust with $0 net income and I see no issue for absolute entitlement. The tax ruling concerns the lender position and interest, not trust income.
Net trust income is determined by a trustee AFTER interest has been incurred in any event. There is scope for this ruling to apply to a hybrid disc trust which pays a defined rate of return to a special unit holder however. If that return were not commercial in respect of the interest incurred when the unitholder borrows it has potential to apply..

The Commissioners position in these cases was demonstrated in the Hybrid Trust era (2005-2012). Borrower incurs 5% - earns 1%. Commissioner would typically scale back the deduction allowed. The taxpayer may be assessed on the 1% and allow the deduction to the extent of assessable income OR it would all be denied and argued over as a scheme with duplicated assessment, penalties etc. The mischief would often be that someone else (another person or entity under the discretionary elements) benefited from the scheme since less income was given for the borrowed funds than the originating cost. IT 2684 and other rulings which often looked back to s8-1. Even look at TA 2016/12 which is more recent. And TA 2008/3 which is most relevant.

 

Many thanks for your reply . . . and apologies, I should have been clearer. My suggestion was that both 1 AND 2 from my email would be payable by the trust. That is, the beneficiary would receive both a fixed return (the 1%) and variable upside (half the return the trust makes from its investment). The rationale is that this is what negative gearing of property allows ie a deductible short term loss from interest exceeding rent in the hope of a taxable long term capital gain. I agree just receiving 1% when you incur 5% looks a lot like a sham. Although I think this question is a little off-topic of the TR as it doesn't require the lender to be a beneficiary and as you say, it is not necessarily distributing the income of the trust.

So back to the TR . . . do you think the trustee could irrevocably contract with the beneficiary to distribute to the beneficiary a fixed distribution of $X per month plus Y% of the returns each quarter from the trust's investing activities? The beneficiary would then make an interest free loan to the trust to enable these payments. The beneficiary would receive a deduction for the interest it incurs to borrow the money that it on-lends, but would pay tax on the distributions it receives. To me, that would seem to give the beneficiary a present entitlement to the income of the trust, as well as providing a nexus between that income and the deductible expense (the interest). Many thanks for pointing out TA2008/3 . . . I guess the difference here is that the loan would be for the purpose of on-lending with a contractual entitlement to a return, as opposed to a loan to subscribe for units in the trust which is within the discretion of the trustee to provide no return.

 

A trustee cannot fetter their discretion. They could not contract with a beneficiary to distribute income like that.

 

So what is an example of the fact situation that the TD is intended to deal with, in terms of the beneficiary being "presently entitled to income of the trust estate"?

 

Sorry, I may have misunderstood. That sort of discretionary trust would be worded in such a way that the beneficiary would be presently entitled to all income and capital of the trust until the loan they have lend to the trust, interest free, is repaid.

 

Oh I see . . . so the entitlement would have to be enshrined in the trust deed itself - it couldn't be an entitlement that arises by way of contract separate to the operation of the trust deed?

 

Probably. There could be an entitlement to income in the form of being contractually bound, but this would not amount to being 'presently entitled'. However, some trust deeds such as SMSF allow the trustee to follow directions of beneficiaries such as in Binding Death Benefit Nominations. so a trustees's discretion can be fettered in some instances.

But the trustee would also need to worry about CGT and making a beneficiary absolustely entitleed to income would be a declaration of trust which would trigger CGT too

 

That makes sense. Many thanks Terry.

 

Get it wrong and you have a problem that involves the trustee taxed at the top marginal rate as the distribution is not accepted. The loan matter and interest is a trust outgoing impacting net income. Then the trustee considers distribution of net income and making a beneficiary entitled. A defect in either can invalidate the other for income tax purposes and requires consideration. ie a Bamford style concern.

 

Two Qs:

Trust setup, I'm sole trustee, I'm beneficiary along with other family members.
Loan was setup under the trust, it's now been repaid but have ~$190k available in redraw.
Thinking of using the redraw to enter the stock market.
Wife (beneficiary) is going on mat leave and of this FY.
Thinking good way to get income flowing through to her.
Assume there is no hurdle here I'm missing?

I've also got ~$100k cash which is in my personal name (currently in offset)
If all goes well as this buffer increases would look to move some of this into the market also.
Would be 'recycled through OO loan' and available in redraw
But reading this post need to ensure document the use of the funds
Can't simply redraw > trust > invest
Would need to ensure loan agreement in place
So borrow 4% ensure trust paying 4%+

 

Hi Brady. A trust is just a relationship and cannot borrow. It is the trustee who is the borrower. You by the sounds of it, but in your capacity as trustee. So you could redraw and invest in shares without a loan agreement.

The issue will be lending your cash to the trust as you cannot contract with yourself.

 

Thanks @Terry_w yes poorly worded as I rushed out the door. It’s setup as ‘Brady IFT family Trust’. First part I was pretty confident about.

2nd part looks to be the concern. How can I get money into the trust? If I’ve got cash in the offset, best to rinse. But if can’t the claim the interest...

 

Seek legal advice about specifics, perhaps your spouse could lend to you

 

Perhaps better to NOT use a trust too ? I can think of reasons why using the trust could be more complex and difficult than if your wife borrowed from you and invested herself.

 

Ahh yeah didn't even think to simplify it like that.

So could use the trust loan now, no problem.

If want to leverage further look into spouse borrowing from me.
Not sure why I didn't think of this as setup something previously when she had shortfall on her construction of IP.

Was blinded by the features of the trust, where the main outcome was to have the facilities under her name.