This information has been taken from THE FEEST COMPANY SERVICES GUIDE TO HYBRID TRUSTS FEBRUARY 2002 Terry McMaster & Co Pty A.C.N. 093 279 835

144 Church Street Brighton Victoria 3186 Telephone 03 9533 1488

Facsimile 03 9533 1789 E-mail terry@madas.com.au

This memorandum helps explain the commercial advantages and disadvantages of conducting an investment or a business through a hybrid trust, particularly for unrelated third parties in business and property ventures. The various planning opportunities and pitfalls are considered and consideration is given to how trusts may be used to create and protect wealth. The roles played by the various parties are explained. The trustee’s duties are described, a sample trustee minutes are provided and the life cycle of a typical hybrid trust is explored, including the procedure for ending the trust.

In summary, the income tax, capital gains tax and asset protection attached to hybrid trusts means that they are often the preferred method of structuring a business or investment activity. This is particularly where more than one un-related party is involved: for example, two separate family groups who are buying a commercial property together.

You should refer any particular questions regarding hybrid trusts to your accountant.

Hybrid trusts take the best features of a discretionary trust and the best features of a unit trust and blend them in the one entity to create a flexible and powerful tax planning solution.

They allow the respective rights and entitlements of unrelated third parties to be respected, while still allowing flexible income and capital distributions between those parties, and once this is done, between those parties and all related persons (eg spouses, children, related family trusts and so on).

Different solicitors have different approaches. One approach is to allocate units to unit holders. As for most unit trusts the units entitle the unit holder to a fixed proportion of the net income of the trust as at 30 June each year and to a fixed proportion of any capital distributions. However, the income and capital distribution rules also allow the trustee to:

• by written resolution before 30 June allocate net income between the unit holders other than in proportion to each unit holder’s issued units as a percentage of total issued units;

• by written resolution before a capital distribution, whether on the vesting of the trust or beforehand, allocate capital amounts including net capital gains between the unit holders other than in proportion to each unit holder’s issued units as a percentage of total issued units;

• by written resolution before 30 June allocate net income allocated to a unit holder to persons included in a class of discretionary beneficiaries connected to that unit holder (typically family members and related companies and trusts); and

• by written resolution before a capital distribution, whether on the vesting of the trust or beforehand, allocate capital amounts including net capital gains allocated to a unit holder to persons included in a class of discretionary beneficiaries connected to that unit holder.

The attribution principle applies to hybrid trusts. This means specific taxation credits and rebates, and particular types of assessable income, including net capital gains, can be allocated between unit holders and, once so allocated, between individual discretionary beneficiaries connected to that unit holder.

The hybrid trust is a flexible commercial structure and is particularly suited to situations where two or more unrelated persons co-own a business or an investment and there is a potential to distribute income and capital gains and tax credits and rebates to related persons.

This may help lower the unit holders’ income tax bills.

Because there is only one entity, ie the hybrid trust (and a trustee company), hybrid trusts are simple and cheap to put in place. Hybrid trusts can achieve the same commercial results as a partnership of discretionary trusts, but with less legal costs and less accounting and administrative costs (although often the unit holder will be the trustee of a discretionary trust or other entity, and will not always be a natural person).

More particularly, the advantages of a hybrid trust are:

• unit holders can claim a deduction for the interest incurred on the cost of their units. A beneficiary of a discretionary trust is not able to do this. This has an intrinsic tax planning value, but also means it is less likely for a trust to have quarantined interest losses that are locked up and cannot be readily accessed by related persons. This can happen, for example, if a trust borrows money to buy an investment property or if a trading trust incurs business losses;

• it is comparatively easy for new owners to join and for old owners to leave the structure. Because the class of discretionary beneficiaries are defined by reference to their relationship with the unit holder, a transfer of a unit or an issue of a unit to a new unit holder automatically introduces a new class of beneficiaries without the need to amend documents or, for example, end one partnership and start a new one, with the attendant tax consequences and extra costs;

• the interests of each owner are protected, and are not subject to a discretionary power on the part of the trustee. The resolutions to distribute net income other than proportionately must be signed by each unit holder to be effective and this protects each unit holder from unfair treatment. This means the units’ capital value is preserved and the units have a market value and can be bought and sold. This compares to the position of a beneficiary of a discretionary trust who only has a mere expectancy that the trustee may exercise a discretion in its favor, and does not have a separate assets recognized at law; and

• the difficulties experienced with section 160ZM of the Income Tax Assessment Act 1936 ("the Act"), where non-assessable income received in connection with units effectively erodes indexed cost base or even triggers a deemed capital gain, can be avoided by allocating this income to a discretionary beneficiary. This means, for example, problems with (under-capitalized) unit trusts realizing tax exempt capital gains on the sale of business goodwill can be avoided.

All the other tax laws applying to trusts, including the loss trust rules and the restrictions on channeling franking credits apply.

Yes. It is possible to convert an ordinary unit trust to a hybrid trust. An amending deed is prepared to delete the old income and capital distribution clauses and introduce new flexible income and capital distribution clauses. This deed should be approved by the directors of the trustee company and by a meeting of unit holders, and should be sealed and stamped as required under the law.

The capital gains and stamp duty impact of a conversion should always be considered before adopting the amending deed. It is quite possible the conversion comprises a resettlement, and this can be problematic if the trust owns significant assets, particular land.

Practitioners should proceed with a conservative caution. Hybrid trusts are excellent structures and can achieve significant commercial and taxation benefits for clients. As always, the particular circumstances of each client should be carefully considered before putting a structure in place.

Because hybrid trusts are typically used by un-related parties to co-own assets it is possible that a unit holders’ agreement is also required. A unit holders’ agreement sets out the rights and obligations of each unit holder in respect of each other whereas the trust deed sets out the relationship between the unit holders and the trustee. This includes issues like what happens if someone wants to sell their unit, or someone wants to sell the underlying assets of the unit trust and wind the hybrid trust up.

A unit holders’ agreement is a form of co-ownership agreement and is like a partnership agreement.

Contact your accountant if you need more guidance on whether a unit holder’s agreement is appropriate to your circumstances. FEEST Company Services can prepare a unit holders’ agreement for you.

Draft legislation is before the Federal Parliament to tax certain trusts as if they are companies. These rules were intended to apply from 1 July 2001 but were postponed due to their complexity, the number of other significant tax changes and insufficient lead-time. It is not clear when or if the draft legislation will be passed in the foreseeable future. If it is, this will be generally good for trusts, because for the first time they will be able to retain net income, pay tax at the company rate, i.e. 30%, and then carry the net income forward to a future year to be distributed as a franked dividend to an appropriate beneficiary, possibly generating franking credit refunds as this happens.

The draft legislation applies to hybrid trusts, and your hybrid trust falls into the definition of a discretionary trust for these purposes.

Any questions regarding the taxation of hybrid trusts and discretionary trusts should be referred to your accountant.

The above comments are all well and good, but to a large extent they pre-suppose an understanding of the general nature of trusts, particularly unit trusts. The remaining part of this memorandum intended to explain these areas.

Trusts originated in England hundreds of years ago. Their original purpose was to avoid feudal dues payable on land transactions. A landowner would give a piece of land to a friend to "hold on trust" for his descendants thereafter. This arrangement avoided paying dues as the land passed from fathers to eldest sons, through the generations.

Modern trusts are far more evolved and sophisticated than these early primitive trusts.

A modern trust is a fiduciary relationship rather than a legal person. The relationship requires one person to legally own an asset for the benefit of another person or set of persons or, in some cases, a purpose (eg a charitable cause). The person who legally owns the asset is called the trustee, and the person or persons for whose benefit the asset is held is called a "beneficiary" or, collectively, and rather pompously but thankfully rarely, the "cestui que trust".

A trust is defined in Underhill's Law Relating to Trusts and Trustees as follows:

Another definition is found in Osborn’s Concise Legal Dictionary:

For a trust to exist four elements must be present. These are:

1. a trustee;
2. a beneficiary, (called in the case of a hybrid trust, a "unit holder");
3. trust property; and
4. an equitable obligation on the part of the trustee to hold the property for the benefit of the beneficiary.

Most Australian businesses are carried on in trusts. Trusts can be small, for example, a family trust may own a small home with a cost of less than $80,000, or they can be very large: some of the managed investment trusts have more than 20,000 unit holders or beneficiaries. A trust can be very short lived, as is the case, for example, when a deposit for a house is left with an estate agent; or a trust can be very long lived, as is the case, for example, for most family trusts which may last for up to eighty years.

Virtually all modern trusts are evidenced by a deed. This is a legal document prepared by a solicitor which sets out the purpose of the trust, the rights and obligations of the beneficiaries, the powers of the trustee, and the identity of the beneficiaries, the trustee and the appointor. A formal trust deed is, at least for practical purposes, necessary to create a workable hybrid trust.

A hybrid trust is a trust where the rights of the beneficiaries to income and capital are fixed. This is in the sense that they are not subject to any discretion on the part of a trustee, and are hybridized, in the sense that those rights are divided amongst the beneficiaries based on how many units have been issued to them.

The beneficiaries are therefore usually referred to as "unit holders". Each unit holder’s interest in the trust is fixed. Different unit holders or different classes of unit holders may have different rights to income and capital distributions and voting rights. These rights will be determined at the time the units are issued or as otherwise agreed by the unit holders and the trustee.

Unlike the beneficiaries of a discretionary trust, unit holders do have rights to the underlying assets of the trust (adjusted for liabilities). These rights are recognized at law as a form of property, can be bought and sold and do have a value. These rights have a value because the unit holder is entitled to future payments of income and capital, and this means other people are prepared to pay to acquire the unit from the unit holder. (How much they are prepared to pay raises complex valuation principles that are very much outside the context of this memorandum. If these principles are of interest or concern to you they should be discussed with your accountant.)

A unit is a piece of property that entitles the unit holder to a specified proportion of the income and capital of the trust. The nature of a unit was considered by the High Court in Charles v FCT where it was said:

"A unit held under this trust is fundamentally different from a share in a company. A share confers on the holder no legal or equitable interest in the assets of the company; it is a separate piece of property; and if a portion of the company’s assets is distributed amongst the shareholders the question of whether it comes to them as income or capital depends on whether the corpus of their property (ie the shares) remains intact despite the distribution. Units under the trust deed before us confer a proprietary interest in all the property which for the time being is subject to the trusts of a deed; Baker v Archer Shee [1927] AC 844; so that the question were the monies distributed to the unit holders under the trust form part of their income or their capital must be answered by considering the character of those monies in the hands of the trustees before the distribution is made."

In other words, a unit in a unit trust confers on the unit holder an equitable interest in both the underlying capital and the income of the trust. Where an amount is distributed to a unit holder under a trust deed its character as capital or income, and even as different types of capital or income, in the hands of the unit holders will depend on its character in the hands of the trustee. The character will, of course, be the same.

Generally speaking, no, they do not.

Hybrid trusts do not have the asset protection advantages for unit holders that discretionary trusts have for beneficiaries. This is because of the nature of the unit s, as explained above. However, asset protection can be achieved by arranging for your unit to be held by a discretionary trust or perhaps some other related person.

If this is a concern we suggest you discuss it with your accountant.

The trustee is normally a shelf company owned by the client and set up specifically to act as trustee of the trust. The shareholders and directors control the trustee. The trustee legally owns the trust property but does not beneficially own the trust property. Beneficial ownership of the trust property lies with the unit holders.

The trustee can also be any competent natural person over the age of 18 who is not bankrupt or under some other legal disability.

The advantages of using a company as a trustee are that:

2. the company may stay in existence virtually forever, and will not die or become unable to manage its own affairs. This means things are simpler and there is less bother with changing trustees and re-registering ownership with authorities such as the various state Titles Offices; and

 

3. the directors or other persons who control the company can exercise defacto control without being personally involved in the trust.

If unit are owned via family trusts the various income tax, asset protection and estate planning advantages connected to family trusts are also available to you. Speak to your accountant or obtain a copy of the FEEST Company Services Guide to Australian Family Trusts if you need more information about who should own the unit and the advantages of family trusts.

The disadvantages of using a company as trustee are largely the extra cost of setting up and running a company each year.

Where a hybrid trust owns real estate it can pay to transfer unit in the trust rather than the underlying real estate. This is because stamp duty will be based on marketable security rates, typically about 0.5% of the value of the property, rather than land rates, typically about 5% of the value of the property.

This is particularly the case if it is likely that the underlying property may be transferred to related persons or to persons who are known to you and enjoy a mutual good faith. It may not be practical in the case of a transfer to a stranger because the stranger may be concerned that the trust has borrowed money or incurred some other liability. This may not manifest itself until after the transfer is completed. This has obvious problems and you can understand why the stranger would be happier to pay full stamp duty and be assured of full and unencumbered title.

In some cases such a transfer can trigger the so-called "land rich entity" rules. Where this happens the transfer is treated as being a property transfer and stamp duty is assessed at land rates. The rules differ from state to state and therefore cannot be more than noted here.

You should speak to your accountant before transferring units in the trust whether or not it owns property. The procedure for transferring units is set out in the trust’s deed.

The unit holders as a group control the trust. This is because the trust deed gives them the power to direct the trustee and, if necessary, to terminate the trustee’s appointment as trustee and appoint another person to act as the trustee instead.

The deed specifies the percentage vote required for a resolution of a meeting of unit holders to be effective. Usually it is 50% unless decided otherwise as the trust deed is being prepared. If 50% is not appropriate this should be discussed with your accountant.

Hybrid trusts can be combined with private companies to get the benefit of the 30% tax rate currently applying to private companies. Arranging for the units to be held by the private company does this. This means that some or all of the trust’s net income is taxed in the hands of the company each year.

The main rule here is that the cash must be actually paid over to the corporate beneficiary, and then retained in the corporate unit holder. If this does not happen there is a risk that special anti-avoidance rules applying to private company loans may apply.

Specific advice should be sought from your accountant before deciding to distribute net income to a corporate unit holder.

The other advantages of hybrid trusts include:

The major disadvantage of a hybrid trust is that it cannot distribute capital or revenue losses to its unit holders. As a result, should a trust incur a net loss its beneficiaries will not be able to offset that loss against any other assessable income that they may derive.

Expert advice should be sought if it is expected that a trust may make a revenue loss or a capital loss for taxation purposes. For example, it may be wise to have debt held at the unit holder level, rather than the trust level, to avoid negative gearing type losses being locked up in the trust. Your accountant can advise further on this issue and related issues.

The taxation of trusts is discussed briefly below.

The trust is expressed to start on the Start Date, being the date specified in Annexure A in the trust’s deed.

More technically, the Trust starts on the date that the Trustee first acquires property. This will probably be in the form of a small cash payment from the first unit holders to the trustee in return for the trustee issuing the first units. Something like 10 $1.00 ordinary units is quite common, and it is probable that your accountant has decided to stipulate this nominal amount (or a similar nominal amount) as way of getting the ball rolling.

The $10.00 will usually be treated as being paid on the date specified as the Start Date in Annexure A. The Trustee will probably issue more units to the first unit holders and new unit holders as the trust gets up and running.

The Trust finishes in 80 years from the Start Date unless the unit holders determine a shorter period or a longer period. 80 years is a conventional period: there is an old rule of equity called the rule against perpetuities which in effect means it is not possible to set up a trust that runs forever. This reflects a policy desire that at some time property vest in a person who is capable of dealing with it absolutely, and that property is not controlled from the grave.

Most modern trust deeds specify 80 years as the life of the trust. It appears 80 years is chosen because it is usually longer than the initial unit holders (or the underlying individuals) expected life span. 80 years is also the period used in some related Acts of Parliament, for example, section 209 of the Queensland Property Law Act.

80 years is certainly a common period and we see no reason to depart from it here.

The trustee is the legal owner of the trust’s property. This means the trustee’s name should appear on all ownership documents, such as shares in private companies, units in private trusts, or title deeds for land ownership.

You may add the tag "… as trustee for the (name) hybrid trust" if you wish, and this has the advantage of reminding all concerned that the asset is held on trust and does not belong to the trustee personally. However, in some cases this will not be possible. For example, most Title Offices will only register a title in the name of the trustee, i.e. the legal owner, and will not allow the tag "… as trustee for the (name) family trust" to be used.

Speak to your accountant if information is needed about who should hold assets.

Hybrid trusts are efficient tax planning vehicles. Usually hybrid trusts do not pay tax themselves. Instead the net income flows through them and is attributed to the unit holders. The amount of tax paid by the unit holders depends on their individual tax profiles. For example, a unit holder with $100,000 of carried forward tax losses will not pay tax on a distribution of $10,000. This is because the unit holder’s taxable income will still be less than nil. Another unit holder may pay up to $4,700 tax, plus Medicare levy on a distribution of $10,000.

The trust deed is drafted so franking credits, dividend rebates, and different classes of income, capital gains and other tax amounts having particular tax consequences flow through the trust to the appropriate unit holders.

The taxation of trusts is a very complex area and it is not possible to cover the field in a few short paragraphs, or even pages. Books have been written on the topic, literally.

We recommend you contact your accountant immediately if you have any questions or concerns as to how your trust is taxed.

A draft minute of a meeting of the trustee of a hybrid trust to distribute net income to its unitholders or beneficiaries is set out in appendix 4.

This minute will need to be modified to suit the particular circumstances of the each hybrid trust each year.

The dominant duty of a trustee of a hybrid trust is to exercise the utmost good faith towards the unit holders and to observe the trust deed and all relevant laws at all times. This means the trustee must put the interests of the beneficiaries ahead of his or her or its interests at all times and generally act in a competent and responsible manner.

More particularly, the duties of a trustee include:

1. to be familiar with the terms of the trust. The best way to do this is to read the trust deed and to ask your accountant questions if the meanings of the various clauses are not clear;
2. to hold and manage the trust property. This includes making sure all relevant records show the trustee as the owner of the trust property;
3. to observe the trust deed. Any procedures or processes set down in the trust’s deed should be observed at all times;
4. to exercise reasonable care, in the sense of exercising the same care and skill that a reasonable man would take in respect of his own affairs. If there is any doubt as to what this standard is, it is safest to err on the side of caution and if necessary engage experts to help the trustee with the tasks at hand;
5. not to delegate the trustee’s duties except as permitted under the deed. But delegation does not mean abdication, and the trustee is still responsible for the delegated task being completed appropriately;
6. to invest the trust’s assets in accordance with the law of trusts and any special rules set out in the trust deed. Most trust deeds contain extensive investment powers, and permit a very wide range of investments to be made;
7. to act impartially between the unit holders and classes of unit holders, subject to the trust deed and any special terms or conditions attaching to the units;
8. to maintain proper and complete books of accounts including minutes of meetings of the trustees/directors of the trustee company. Minutes of meetings of the trustees/directors should be created and retained to record all major transactions entered into by the trustee. An example of a minute of a meeting to record a trustee’s decision to acquire a property is included as appendix 3;
9. to deal with the trust property properly and not for the trustee’s own benefit;
10. prepare and lodge a tax return for the trust each year, and generally comply with the income tax law and related laws;
11. to keep the trust’s assets separate from other assets owned by the trustee; and
12. insure the trust’s assets, where appropriate.

The above list may seem onerous but usually trustees have no problems meeting these standards. Problems are only rarely encountered. Nevertheless a wise trustee will act conservatively and will create sufficient documents to show why and how a particular task was completed, acting on the assumption that one day he or she may have to demonstrate how the above duties were satisfied.

Ask your accountant if you have any questions about the duties of a trustee.

John Jones representing the Jones Family

Mary Smith representing the Smith Family

Mary Smith was elected chairperson

The meeting related to the company’s capacity as trustee of the Blue Sky Hybrid Trust.

The minutes of the previous meeting were read and affirmed as correct.

The Chairperson reported that XYZ Real Estate Agents had approached her with an offer to acquire a property located at 10 Smith Street Smithsville for an amount of $500,000. She reported that she discussed the offer with a property valuer and the company’s accountant, who after considering the offer and alternative offers, advised that the property comprised an appropriate investment for the company.

It was resolved to accept the offer and the Chairperson was authorized to do all things necessary to give effect to this resolution including applying the company’s seal to all appropriate documents.

There being no further business the meeting closed.

Signed as a true and complete record of the meeting on the date stated above.

………………………… Chairperson

DRAFT Minutes of a trustee company distributing income of trust, setting out sample paragraphs to be adopted or modified as circumstances require

[Name of chairperson] (Chairperson)

[Names of other directors present]

The minutes of the previous meeting of directors were read and confirmed.

The chairperson noted that the resolutions to be passed at this meeting are pursuant to the powers and discretions conferred on the company as trustee at law and by the trust deed of the Trust.

It was resolved that the income of the Trust (as defined in the trust deed) for the financial year ending 30 June [year] ('financial year') be paid to, applied for the benefit of or set aside for Beneficiaries, as defined in the Trust’s deed, as follows:

(choose clause or draft a new clause as required)

The amount of $[amount] is distributed to [name of Unitholder], being Unitholder in the Trust as follows

Distribution of a fixed amount to a minor beneficiary

The amount of $[amount] is distributed to [name of beneficiary] being a minor in the following manner:

• by paying $[amount] to a parent or guardian of the beneficiary;
• by paying $[amount] for the benefit of the beneficiary by;
• by setting aside $[amount] to a separate account in the name of the beneficiary in the books of the trust,

so that the beneficiary has an immediate vested indefeasible interest in the income distributed so as to be presently entitled to such income.

The amounts or percentages of the net income of the trust shown below next to each of the below named minor beneficiaries are distributed to minor beneficiaries in the manner stated below so that each beneficiary has an immediate vested indefeasible interest in the income distributed so as to be presently entitled to such income.

Name of Amount or Manner of

beneficiary percentage distribution

of income

first beneficiary] amount or %

second beneficiary] amount or %

An amount equal to [percentage number] per centum of the net income of the Trust is distributed to [name of beneficiary] in the following manner:

• by paying $[amount] to a parent or guardian of the beneficiary;
• by paying $[amount] for the benefit of the beneficiary by;
• by setting aside $[amount] to an account in the beneficiary’s name in the Trust’s books,

so that the beneficiary has an immediate vested indefeasible interest in the income distributed so as to be presently entitled to such income.

The amount of [$amount] is distributed to [name of beneficiary], who is a beneficiary of the trust not under a legal disability, by paying the money to the beneficiary or to such person as the beneficiary may direct so that the beneficiary has an immediate vested indefeasible interest in the income distributed so as to be presently entitled to such income.

or

The amount of [$amount] is distributed to [name of beneficiary], who is a beneficiary of the trust not under a legal disability, by setting the amount aside to a separate account in the books of the trust in the name of the beneficiary so that the beneficiary has an immediate vested indefeasible interest in the income distributed so as to be presently entitled to such income.

An amount equal to [percentage number] per centum of the net income of the trust fund3 be distributed to [name of beneficiary], who is a beneficiary of the trust not under a legal disability, by setting the amount aside to a separate account in the books of the trust in the name of the beneficiary so that the beneficiary has an immediate vested indefeasible interest in the income distributed so as to be presently entitled to such income.

or

An amount equal to [percentage number] per centum of the net income of the trust fund be distributed to [name of beneficiary], who is a beneficiary of the trust not under a legal disability, by paying the money to the beneficiary or to such person as the beneficiary may direct so that the beneficiary has an immediate vested indefeasible interest in the income distributed so as to be presently entitled to such income.

The remainder of the income of the trust fund for the financial year is distributed to [name of beneficiary] being a minor by setting aside the amount to a separate account in the name of the beneficiary in the books of the trust so that the beneficiary has an immediate vested indefeasible interest in the income distributed so as to be presently entitled to such income.

The remainder of the income of the trust fund for the financial year is distributed to [name of beneficiary], being a beneficiary who is not under a legal disability, by setting aside the amount to a separate account in the name of the beneficiary in the books of the trust so that the beneficiary has an immediate vested indefeasible interest in the income distributed so as to be presently entitled to such income.

[Use the following resolution only if income is to be accumulated]

IT WAS RESOLVED that the whole [or amount or percentage] of the income of the trust (as defined in the trust deed) for the financial year ending 30 June [year] be accumulated so that such amount forms part of the capital of the trust fund and that any tax levied in respect of such accumulated income be paid out of the capital of the trust fund.

There being no further business the chairperson declared the meeting closed.

Signed as a correct record on the date stated above

…………………………….. Chairperson