Introduction
The holy grail for tax and estate planners is to structure investment property purchases to have access to investment losses to reduce the taxpayer’s personal tax and yet to protect the investment property inside a discretionary trust.
In Australia, taxpayers are able to use investment losses to offset against income from other sources, and therefore reduce their income tax. The discretionary (family) trust provides asset protection against law suits or bankruptcy of the taxpayer.
In the decision of Lambert and Commissioner of Taxation [2013] AATA 442, the Administrative Appeals Tribunal of Australia, Taxation Appeals Division, (the AAT) denied the taxpayer (Lambert) access to investment losses from an investment property held inside a family discretionary trust that he controlled.
In this article, we look why the AAT found that the Lambert property investment structure was noteffective to provide the taxpayer access to these investment losses.
The Lambert property investment structure
Lambert’s tax planner would have had three considerations in mind when structuring the purchase of three residential investment properties, with bank loan finance:
- The first was to use a discretionary trust structure (the Lambert Family Trust) to buy the properties to provide asset protection.
- The second was to borrow the whole of the price. As the loan interest and the outgoings would exceed the rental income, and the properties would be negatively geared. Unless a strategy was devised, the negative gearing losses would be locked inside the trust, and not able to be accessed.
- The third was to enable Lambert to access the negative gearing losses to reduce his personal taxable income.
The Lambert property investment structure was:
- Lambert was appointed the sole trustee of the Lambert Family Trust. Therefore, the title to the properties, and the bank loans for the properties, were to be in Lambert’s name. Lambert needed to show that the bank loans were his own personal loans so that he could claim the loan interest as a personal tax deduction.
- Lambert used an off-the-shelf discretionary trust deed, which had the usual provision that the trust income be distributed at the trustee’s discretion to Lambert and his family. He needed to amend the trust deed to connect the loan expenses to the rental income because ATO taxation ruling IT 2385 had stated that a beneficiary cannot claim deductions against a trust distribution unless they have a present entitlement to the trust income. Therefore the Deed of Settlement was varied by way of a Deed of Variation of trust to provide that Lambert had a present entitlement (as a trust beneficiary) to all income from the trust ‘until further notice’. The property rents were paid into Lambert’s personal bank account.
As a result, Lambert accessed the negative gearing loss – the shortfall between the rents received and the loan interest paid out – and applied it against his personal income to reduce tax payable.
The AAT Decision
The AAT decided that the Lambert property investment structure was not effective for these reasons:
The property loans
When purchasing the rental properties, the Contracts for Sale described the purchaser as: Rodney John Lambert as trustee for the Lambert Family Trust. The rental properties were therefore trust assets.
But when borrowing the bank loans to fund the purchase, the plan was for Lambert to borrow personally, and then to on-loan the funds to the trust interest free to purchase the rental properties. And so, Lambert would be able to claim the loan interest as a tax loss personally.
But the plan failed. The AAT found that the borrower was described in the bank loan documents as the trustee for the trust. For tax purposes, a trust is a separate entity from the trustee (s. 960-100 (1) ITAA), and so the Lambert Family Trust could borrow the bank loans.
Therefore the bank loans were made to Lambert in his capacity as the sole trustee of the Lambert Family trust, not in his personal capacity. And so, the AAT denied Lambert’s deduction of interest expenses.
The property rentals
The AAT considered whether or not the Deed of Variation of trust was effective to change the treatment of the trust income (the property rentals) to become a present entitlement, rather than a mere expectancy, in accordance with the Deed of Settlement of trust.
The AAT found that by directing the distribution of the trust income solely to Lambert, the Deed of Variation represented an invalid exercise of the trustee’s discretionary power to distribute trust income and was in breach of a trustee’s fiduciary duty. It was legally invalid and ineffective because the power was not exercised bona fide for the benefit of beneficiaries as a whole.
The AAT concluded that Lambert “was not entitled to a deduction for interest expenditure in the 2009 and 2010 income tax years because there is insufficient nexus between the outgoings and the derivation of assessable income”. He was also ordered to pay a penalty of 25% of the tax.
Conclusion
Structuring an investment property purchase properly is an important task for legal and financial advisors of the purchaser. In most cases, the best structure depends on the purchaser’s financial status and objectives. A one-size-fits-all structure does not work.
In Lambert’s case, the structure failed to meet the taxpayer’s requirements. Perhaps more consideration should have been given to using a hybrid trust, or using a unit trust and a discretionary trust in tandem.
Tax and estate planners seeking to create a tax deduction for interest paid by a taxpayer on a loan used for property investment through a trust need to take into account the ATO’s views on - Uncommercial use of certain trusts – which are contained in Taxpayer Alert TA 2008/3 and Taxation Determination TD 2009/7.
This article was first published by Cordato Partners in Lexology which is an international innovative, web-based service that provides over 200,000 company law departments and law firms around the world with a depth of free practical know-how on specialist areas of law © Copyright 2013 Sydney