It is a bit of a trend lately for property owners to set up hybrid trusts in which to manage their properties. The question remains: What are the benefits in doing so? Michael Quinn explains.

A hybrid trust is a mix between a discretionary trust and a unit trust.
A discretionary trust is one in which there is no fixed entitlement or interest to beneficiaries, but rather the amount that the beneficiary receives is at the discretion of the trustee. Beneficiaries don’t have a proprietary interest in the property of the trust, but rather a ‘mere expectancy’ to gain a monetary benefit from the assets of the trust, the size of which is at the discretion of the trustee.
A unit trust is a trust in which the trust property is divided into a number of defined shares called units. The beneficiaries subscribe for the units in much the same way as shareholders in a company subscribe for shares. In an ordinary unit trust, a beneficiary (or unit holder) is entitled to the income and capital of the trust in proportion to the number of units held. Like a company, it is possible for a unit trust to have different types of units with different rights attached.
Unlike a beneficiary of a discretionary trust, who has no proprietary interest in the property of the discretionary trust, a unit holder in a unit trust may have a proprietary interest in that property, generally being a relevant proportion of all the property of the unit trust (although this will depend on the terms of the trust deed).
However, for CGT purposes, a unit is a CGT asset so that when a unit is sold it is the unit that is the relevant CGT asset, rather than any interest the unit holder might have in the underlying property of the unit trust.
How does a hybrid trust work?
A hybrid trust is set up by a lawyer who tries to combine the best elements of a unit trust with the best elements of a discretionary trust in the one entity, and has both unit holders and discretionary beneficiaries. The trustee has the discretion to distribute income to the discretionary beneficiaries, and the unit holders then have a right to receive income and capital that has not been distributed to a discretionary beneficiary. Alternatively, the unit holders may be entitled to all of the income of the trust, but may have a right to redeem their units for face value, at which point the trustee will have complete discretion when distributing income (and capital).
This type of structure is useful if you hold capital growth or income-generating assets. Some of the key attributes of a hybrid discretionary trust are:
  • asset protection – it helps protect from bankruptcy and insolvency
  • it allows you to distribute income to family members who are on low tax rates
  • there are no formal audit requirements
  • there is an absence of any formal legislative framework, such as the Corporations Law, to control the activities of the trustee
  • it allows you to ‘stream’ income: you can distribute one type of income to one person and another type of income to another person
  • unit holders can claim a deduction for the interest incurred on the cost of their units
  • it is comparatively easy for new owners to join and for old owners to leave the structure.
In a basic sense, the way it works is you borrow money in your own name to ‘buy’ units in the hybrid trust. The interest is deductible against the rental income distributed to you by the trust. The immediate benefit to the borrowers is that they can claim gearing benefits against the units that they have purchased in the trust. The lender regards this as third party security. It’s similar to borrowing money in your name and using someone else’s property as security.  
Asset protection
From an asset protection point of view the hybrid discretionary trust is one of the best ways to protect assets. The increase in value of the asset will be free from potential creditors.
In the case of bankruptcy, the units held are your assets and could be redeemed for their face value. This will generally pay out the loan and, as mentioned, any increase in the property’s value will remain within the trust. Therefore it is important that you don’t mix high risk assets with low risk assets. For example, if you had a low risk asset (shares) you wouldn’t contaminate them by also putting business assets in the same trust.
However, hybrid trusts do not have the same asset protection advantages for unit holders that discretionary trusts have for beneficiaries. This is because of the nature of the units. The unit is a piece of property that entitles the unit holder to a proportion of the Special Attributable Income of the trust, as determined by the trustee. However, the trustee can continue to exercise its discretion in favour of the classes of beneficiaries to the exclusion of the special unit holders.
Where the units in a hybrid trust are held by a bankrupt, the trustee in bankruptcy could temporarily take the position of the bankrupt beneficiary and take possession of the units in the hybrid trust.
Tax issues
Another added benefit of using a hybrid discretionary trust is that, generally speaking, the hybrid trust does not stand in the way of the 50% Capital Gains Tax discount. Unlike a company, where the net income of the trust (incorporating the discounted capital gain) is later distributed to a beneficiary, the beneficiary gets the additional ‘gross up’ amount in their assessable income. If the beneficiary would have qualified for the discount had the beneficiary derived the gain (and not the trust), then the beneficiary may reduce the gain once again in its own right. The beneficiary therefore preserves the benefit of the discount.
However, if the beneficiary would not have qualified for the discount, then the discount remains reversed, ie, the beneficiary does not have the benefit of the discount. Therefore, your hybrid discretionary trust doesn’t get in the way of the 50% CGT discount to those that qualify for the discount. It is as though the beneficiary held the asset directly.
Important consideration
As mentioned previously, a hybrid trust is set up by a lawyer; however, due to its complexity (we have only scratched the surface), it is strongly recommended that you seek the services of someone with a lot of experience in setting these up. So many have fallen into the trap of a not-very-well-set-up hybrid trust and the outcome has not been pretty.
Although it all seems easy enough and to be of benefit in theory; however, operating such a trust may restrict your financing abilities as some of the banks restrict trusts from accessing certain loan products. This is because during a time such as the one we have and still are experiencing – the global financial crisis – it becomes harder to access funds and the first credit policies to feel the pinch are the more complex style of funds such as the hybrid trusts.
The Australian Taxation Office (ATO) has been quite vocal in its issue with hybrid trusts. One of their concerns is where units are redeemed for their face value as the property becomes positively geared.
However, their main concern is the possibility of tax avoidance. They have been highlighting the fact that the un-commercial use of certain Trusts will provide a scenario in which the distribution of possible income/capital gains to beneficiaries of the trust who may have a lower tax rate in relation to the expenditure those lower tax payers laid out when purchasing those units.
The ATO isn’t ruling the use of hybrid trusts as unacceptable, however those trusts with no commerciality and which are set up to effectively give negative gearing to a high tax rate individual and push all profits to a lower tax paying individual may give rise to ATO scrutiny. Investors should understand that if their intention or dominant purpose for pursuing a certain strategy is for a tax benefit, then that is tax avoidance and they may have their deductions disallowed by the ATO.
Arguably, the most important issue to consider when thinking of setting up a hybrid trust is that it is generally for people who have high income levels and are involved in high risk activities such as with multiple properties, and require a level of asset protection while maximising tax benefits. It would most likely be beneficial for an investor with a portfolio of say five or more properties; however, it really would be considered overkill for an investor with one or two properties to put these in a hybrid trust.
It is important to remember thateach individual situation is different and has a range of influencing factors. When you consider making any kind of significant financial investment or transfer it is important that you seekthe professional advice of a lawyer and/or accountant in order to ensure that you make the best possible choices for your situation.