Many Australian business owners and property investors hear that a hybrid trust can offer “the best of both worlds”, combining the certainty of unit ownership with the flexibility of a discretionary trust. That can be attractive, particularly where several people are contributing funds but the group also wants some capacity to direct income or capital among beneficiaries.
The difficulty is that a hybrid trust is not a simple off-the-shelf solution. The tax outcome depends heavily on the wording of the trust deed, how the trust is funded, who holds interests, and how the trustee administers the trust each year. A poorly designed or poorly run structure can create unexpected tax, compliance and commercial issues.
What is a hybrid trust?
For Australian income tax reporting purposes, a hybrid trust is generally a trust that is not a fixed trust, but under which one or more people have fixed entitlements to income or capital during the income year. A fixed entitlement requires an interest that is both vested and indefeasible under the trust instrument.
In practical terms, a hybrid trust often combines two features:
- Fixed interests, commonly represented by units or another defined entitlement. These may give an investor a specified interest in income, capital, or both.
- Discretionary powers, allowing the trustee to decide how certain income or capital is distributed among a wider class of beneficiaries.
The balance between those features varies substantially from deed to deed. One hybrid trust may give unit holders priority rights to income, while another may give the trustee broad discretion after meeting particular unit-holder entitlements. The label “hybrid trust” tells you far less than the actual provisions in the deed.
That is why a hybrid trust should never be selected simply because it sounds more flexible than a unit trust or more tax-effective than a discretionary trust. The legal rights created by the deed need to match the commercial arrangement between the parties.
The trust deed is the foundation
A hybrid trust deed needs to do more than name unit holders and list discretionary beneficiaries. It should make clear how the trustee is to deal with income, capital, losses, additional contributions, redemptions, transfers of interests and the eventual winding up of the trust.
Key questions commonly include:
- Who can subscribe for units or other fixed interests?
- What rights attach to each class of interest?
- Is income allocated first to fixed-interest holders, or can the trustee distribute it differently?
- How are capital gains and sale proceeds dealt with?
- Can additional units be issued, and on what terms?
- Can interests be redeemed or transferred?
- Who has the power to appoint or remove the trustee?
- What happens if a unit holder dies, becomes bankrupt, separates from a spouse or wishes to exit?
- Does the deed permit the trustee to stream capital gains and franked distributions where tax law allows it?
These provisions are not merely administrative details. For tax purposes, the existence of broad trustee powers, amendment powers, issue powers or redemption powers can affect whether an interest is regarded as sufficiently fixed. The fact that a document calls an interest a “unit” does not automatically mean it will be treated as a fixed entitlement for every tax purpose.
Before signing a deed, it is sensible to have both legal and tax advice. A structure that works well for a small group of active business owners may be unsuitable for passive investors, family wealth planning or a property acquisition involving unrelated parties.
How income, capital gains and distributions are taxed
Trust taxation is often misunderstood because there is a difference between the trust’s accounting or deed-defined income and its taxable net income. The trustee must first apply the trust deed and trust law to determine who is entitled to income or capital. Tax law then determines which beneficiaries, or sometimes the trustee, are assessed on the trust’s taxable income.
Broadly, a beneficiary who is presently entitled to a share of trust income may be assessed on a corresponding share of the trust’s taxable net income. The entitlement is based on the beneficiary’s legal right to the income, rather than whether they have physically received cash by the end of the income year.
This is especially important in a hybrid trust because there may be both fixed and discretionary beneficiaries. The trustee needs to identify:
- income that must be allocated under fixed rights;
- income that remains available for discretionary distribution;
- capital amounts that must follow particular interests;
- beneficiaries entitled under default provisions if the trustee does not make a valid decision; and
- whether the trust deed permits particular categories of income to be treated separately.
Capital gains and franked distributions require particular care. Tax law can allow capital gains and franked distributions to be directed to specific beneficiaries where the trust deed allows it and the relevant entitlement requirements are met. If no beneficiary is specifically entitled, those amounts may instead be allocated under proportionate rules linked to present entitlements to trust income.
The trustee’s documentation is central. The ATO states that trustee resolutions are needed by the end of the income year to make discretionary beneficiaries presently entitled to trust income. Written records are also essential where the trustee wants to create specific entitlements to franked distributions or capital gains for tax purposes.
A hybrid trust therefore needs more than an annual accountant-prepared distribution minute created after the fact. The trustee should understand the deed, consider the trust’s expected results before EOFY, make valid decisions within the required timeframes, and retain clear supporting records.
Borrowing to invest through a hybrid trust
Hybrid trusts have sometimes been promoted in connection with geared property investments. A common arrangement involves an investor borrowing personally to subscribe for units or another interest in the trust, with the trust using those funds to acquire an income-producing asset.
Interest deductions in these arrangements are not automatic. Whether an investor can claim interest depends on the connection between the borrowing and the production of assessable income, considered on the actual facts and legal rights created by the arrangement.
The ATO has specifically raised concerns about arrangements where borrowed funds are used to acquire interests in a hybrid or hybrid discretionary trust, particularly where the investor’s economic return is limited, interests may be issued to associates for inadequate consideration, or ordinary income is directed to lower-taxed beneficiaries while the borrower bears interest costs. The ATO has identified potential issues involving interest deductions, capital gains tax, trust creation rules and the general anti-avoidance rules.
This does not mean every geared hybrid trust arrangement is inappropriate. It does mean the commercial purpose, funding arrangements, investor rights and expected income flows need to be genuine, supportable and properly documented.
If a trust is buying property, the structure should also be reviewed before contracts are signed. Finance approval, lender requirements, personal guarantees, land tax treatment, duty implications and ownership records can all affect the practical outcome. State and territory taxes differ significantly, so advice must be specific to the location of the property and the transaction being considered.
Family trust elections and related entities
A family trust election can be relevant where a trust wants to access certain tax concessions connected with trust losses, bad debts or franking credits. However, an election is not a routine step that every hybrid trust should make.
Once a valid election is in force, the trust is tied to the family group of the specified individual for relevant purposes. Distributions or conferrals outside that family group can have serious tax consequences. The election also has wider implications for companies, trusts and partnerships within the private group, particularly where interposed entity elections are being considered.
For a hybrid trust with unrelated investors, a family trust election may be impractical or inconsistent with the commercial purpose of the structure. For a family-owned trust with fixed and discretionary elements, it may be useful in the right circumstances, but only after the consequences have been considered across the broader group.
This is a good example of why a hybrid trust should be reviewed as part of the whole business or investment structure. Looking at one trust in isolation can miss important interactions with companies, other trusts, beneficiaries and future succession plans.
Governance matters as much as the original structure
A carefully drafted hybrid trust can still create problems if it is not administered consistently. Trustees should maintain records that show how decisions were made and how beneficiaries’ entitlements were dealt with.
Good governance commonly includes keeping:
- the signed trust deed and every valid amendment;
- unit registers or records of fixed interests;
- subscription, transfer, redemption and loan documents;
- trustee resolutions and beneficiary notifications;
- financial statements and tax returns;
- records showing how entitlements were paid, applied, retained or otherwise satisfied; and
- documents supporting the commercial purpose of major transactions.
The ATO considers contemporaneous records to be an important part of good trust governance. It has also made clear that documentation alone will not protect an arrangement that is contrived, artificial or primarily tax-driven.
Hybrid trust trustees should also be cautious about informal dealings with beneficiaries. For example, if income is appointed to a beneficiary but the funds remain in the trust for business or investment use, the accounting treatment and legal basis for retaining those funds need to be considered. Similar care is needed where beneficiaries include companies or other trusts.
A simple example of how a hybrid trust may work
Consider a small group establishing a trust to acquire a commercial investment. Two family members contribute funds and receive defined fixed interests intended to reflect their respective contributions. The deed also gives the trustee discretion over a separate class of income and permits a broader group of family beneficiaries to receive amounts where appropriate.
During the year, the trust earns rental income and later makes a capital gain on the sale of an asset. Before EOFY, the trustee needs to work through the deed to determine which amounts are required to go to the fixed-interest holders and which amounts, if any, remain discretionary. The trustee must then make properly timed and documented decisions that are consistent with both the deed and tax law.
If the arrangement instead allows one investor to claim borrowing costs while most ordinary income is diverted elsewhere without a sound commercial basis, the tax risk increases considerably. The detail matters.
Is a hybrid trust right for you?
A hybrid trust can be useful where there is a genuine need to combine investor certainty with carefully limited trustee flexibility. It may suit some family investment arrangements, joint ventures and business structures, but it is not automatically the most tax-effective or simplest choice.
Before establishing one, consider the commercial relationship between the parties, funding plans, exit arrangements, asset protection objectives, expected income and capital outcomes, and the annual administration the structure will require. The cost and discipline of ongoing compliance should be part of the decision from the start.
This article is general information only and is not personal financial or tax advice. Trust taxation and structuring depend on the deed, the parties and the facts of each arrangement. Speak with a registered tax agent or accountant, such as, before setting up, changing or using a hybrid trust.