In the recent Administrative Appeals Tribunal case Chadbourne and Commissioner of Taxation (Taxation) [2020] AATA 2441 (10 July 2020) the AAT confirmed the disallowance of tax deductions to Mr. D. Chadbourne (the Applicant).

The Applicant was a beneficiary of the D & M Chadbourne Family Trust (DMCFT) and the Applicant was denied deductions for:

• interest on money borrowed by the Applicant to fund the acquisition of real estate and shares by the DMCFT; and
• other expenses incurred by the Applicant expended;

so the DMCFT could earn income.

The discretionary trust

The DMCFT was a discretionary trust. In Chadbourne Deputy President Britten-Jones usefully described a discretionary trust:

I note that the meaning of the term ‘discretionary trust’ is disclosed by a consideration of usage rather than doctrine, and the usage is descriptive rather than normative. It is used to identify a species of express trust, one where the entitlement of beneficiaries to income, or to corpus, or both, is not immediately ascertainable; rather, the beneficiaries are selected from a nominated class by the trustee or some other person and this power (which may be a special or hybrid power) may be exercisable once or from time to time.

Chadbourne at paragraph 8

The mere expectancy of a beneficiary of a discretionary trust

Because the beneficiaries of a discretionary trust are not immediately ascertainable and are to be selected, a prospective beneficiary only has an expectancy of earning trust income unless and until the beneficiary is so selected by the trustee to take income:

Unless and until the Trustee of the discretionary trust exercises the discretion to distribute a share of the income of the trust estate to the applicant, the applicant’s interest in the income of the discretionary trust is a mere expectancy. It is neither vested in interest nor vested in possession, and the applicant has no right to demand and receive payment of it.

Chadbourne at paragraph 57

or in the case of a beneficiary who takes in default of exercise of discretion they have no more than a similar expectancy.

The Applicant was a beneficiary of the DMCFT with an expectancy interest.

The available tax deduction

The Applicant could not satisfy the first limb of the general deduction provision, now in the Income Tax Assessment Act (ITAA) 1997, which allows an income tax deduction for a loss or outgoing to the extent:

it is incurred in gaining or producing your assessable income 

paragraph 8-1(1)(a) of the ITAA 1997 (emphasis added)

In Chadbourne the Applicant’s expenditure was incurred to gain or produce income for the trustee of the DMCFT, a separate legal entity. Applying authority including Federal Commissioner of Taxation v Munro (1926) 38 CLR 153, Antonopoulos and FCT [2011] AATA 431; 84 ATR 311, Case M36 (1980) 80 ATC 280,  Commissioner of Taxation v Roberts and Smith (1992) 37 FCR 246, where Hill J. referred to Ure v Federal Commissioner of Taxation (1981) 50 FLR 219, Fletcher v Commissioner of Taxation (1991) 173 CLR 1 and other cases, the AAT required a nexus between loss or outgoings of the Applicant and the assessable income of the Applicant; not the DMCFT. Although the Applicant stood to earn income indirectly as the likely beneficiary of the DMCFT the AAT found:

The Trust is a discretionary trust the terms of which require the Trustee to exercise a discretion as to whom a distribution of net income is to be made.  It is an inherent requirement of the exercise of that discretion that it be given real and genuine consideration. There must be ‘the exercise of an active discretion’. There were numerous beneficiaries in the Trust.  There was no certainty provided by the terms of the Trust that the Trustee would exercise its discretionary power of appointment in favour of the applicant.

Chadbourne at paragraph 53

and the Applicant thus had not incurred the expenditure in gaining or producing the assessable income of the Applicant.

Why did the Applicant run the AAT appeal?

The Applicant in Chadbourne was self-represented. With the benefit of professional advice or assistance the Applicant may have:

• more readily foreseen the outcome of his appeal to the AAT which, in the light of the authority applied by Deputy President Britten-Jones, could be seen as inevitable; or
• moreover, arranged the loan to achieve the required section 8-1 nexus between the outgoings and the assessable income of a taxpayer.

Safer alternative 1 – trustee loan

The most obvious alternative would have been for the trustee of the trust to have been the borrower and to have directly incurred the relevant expenses though those actions would have been different commercial arrangements to those that were done.

These actions may have been more complicated and expensive to arrange: not the least because the financier may have required the Applicant to personally guarantee repayment of the loan by the trustee of the trust which was a corporate trustee with limited liability. Nonetheless these precautions would have ensured section 8-1 deductions were available to the trustee of the trust.

(Somewhat) safer alternative 2 – on-loan to the trustee

The other and perhaps commercially easier alternative would have been an on-loan of the borrowed funds by the Applicant to the trust.

The Applicant in Chadbourne may have belatedly considered an on-loan solution. At paragraph 11 of the AAT decision it was observed that the Applicant had abandoned a contention that there was a “written funding agreement” between the Applicant and the trustee of the DMCFT which the Commissioner had suggested was an invention to assist the Applicant in the appeal.

In the event of a genuine on-loan the trustee of the trust would hold the borrowed funds as loan funds with a clarity as to whom interest and principal is to be repaid rather than as a capital contribution or gift to the trust without that clarity.

On-loan – interest free

Clearly the on-loan by the Applicant to the trustee of the trust should not be interest free as the Applicant then faces the Chadbourne problem of having no assessable income with which to justify a section 8-1 deduction. In the words of Taxation Determination TD 2018/9 Income tax: deductibility of interest expenses incurred by a beneficiary of a discretionary trust on borrowings on-lent interest-free to the trustee:

A beneficiary of a discretionary trust who borrows money, and on-lends all or part of that money to the trustee of the discretionary trust interest-free, is usually not entitled to a deduction for any interest expenditure incurred by the beneficiary in relation to the borrowed money on-lent to the trustee under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)…  

TD 2018/9 – paragraph 1

On-loan – at low interest

An on-loan at low interest was arranged in Ure v. Federal Commissioner of Taxation (1981) 11 ATR 484. In Ure the borrower borrowed funds at up to 12.5% p.a. interest and on-lent the funds to his wife and his discretionary trust at 1% p.a. The Full Federal Court found that the deduction Mr. Ure could claim under the first limb of the general deduction provision, sub-section 51(1) of the ITAA 1936, was limited to the 1% p.a. by which the interest income earned by Mr. Ure from his on-loan was confined.

On loan – at equivalent interest

It thus follows from TD 2018/9, Ure and Chadbourne that, to achieve deductibility in full for interest on funds borrowed and on-lent to a related discretionary trust, the interest earned by the beneficiary/on-lender on the on-loan should be the interest payable by the on-lender on the loan from the financier. This should leave the beneficiary/borrower in a tax neutral position on his or her loan on-loaned with assessable interest earned under the on-loan equalling deductible interest paid on the loan.

Related loan issues

As the on-loan is a related loan there are further considerations which will attract the scrutiny of the Commissioner:

A related on-loan should ideally be carefully documented and it should be clarified that the beneficiary/on-lender has an indefeasible right to the interest even though the on-lender is a related party of the borrower. It is also important that commitments in the on-loan agreement are met and generally interest due to the beneficiary/on-lender shouldn’t be capitalised and, especially, shouldn’t be aggregated with unpaid present entitlements due to the beneficiary.

The Commissioner could take these positions:

• that the on-loan with interest is inadequately documented and can’t be proved so accounting entries capitalising interest shouldn’t be considered conclusive; or
• the on-loan may be documented but it is a sham and the failure of the trust to pay interest when due shows this.

See my blog post at this site “Only a loan? Impugnable loans, proving them for tax and shams” https://wp.me/p6T4vg-8a which shows the fallibility of related party loans when these questions are contested with the Commissioner.

Woes with hybrid trusts

A hybrid trust, also a descriptive rather than a normative structure, can also fit the Deputy President Britten-Jones formulation of a discretionary trust where the entitlement of beneficiaries of the hybrid trust to income is not immediately ascertainable and is subject to the exercise of a discretion. It has been recognised,  including in the Commissioner’s Taxpayer Alert TA 2008/3 Uncommercial use of certain trusts that the considerations of the AAT in Chadbourne can similarly apply to deny a section 8-1 deduction to the holder of an interest in a hybrid trust who incurs expenditure to earn income through a hybrid trust structure.

In passing I note my wariness of hybrid trusts which are typically aggressive and sometimes tax abusive arrangements. The Commissioner’s Tax Alerts are particularly directed against tax aggressive activity.

That said, the trust in the case of Forrest v Commissioner of Taxation [2010] FCAFC 6, which was referred to in a citation (sic.) in Chadbourne, appears to have been an instance of a hybrid trust where entitlement of unit holders to ordinary income was ascertainable and not subject to a discretion. On appeal to the Full Federal Court, the unit holders in Forrest could establish a nexus between borrowing expenditure incurred and assessable income.