Hybrid Trust is a cross between a Discretionary and a Unit Trust. This type of structure is quite appealing because it includes the benefits of both and is an extremely useful structure. You can split the trust up into units while giving the trustee a degree of control over how the income and capital of the trust should be distributed to potential beneficiaries.
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 (the unit holders) to be respected, while still allowing flexible income and capital distributions between those parties and all related persons (e.g. spouses, children, related family trusts and so on). The trustee of Hybrid trust has the power to issue units that encompass various rights. Those units normally described as “income units “which give their holders an entitlement to certain proportions of the net income of the trust.
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. A ‘high risk’ professional or business operating in an environment where they are prone to litigation risk, and where asset protection is paramount often consider this Hybrid ownership structure.
Scenario
Lorry is a brain surgeon who borrowed $800,000 from the bank in his own name to buy units in a negative gearing hybrid trust. The trust then used these funds to buy a rental property. His family members are the beneficiaries. Few years after he purchased the rental property, the property is now worth a $1.5 million.
When Lorry becomes bankrupt as a result of a malpractice claim against him, the trustee-in-bankruptcy has an interest in Lorry’s unit in the Hybrid Trust. Accordingly, the trustee can redeem Lorry’s units for $800,000 (the amount of the initial investment to purchase the units and the amount any redemption of unit is limited to). However, the trustee in bankruptcy has no right to claim against the capital growth in the rental property, that is the $700,000. At this point, the bank may call in its security and force the sale, the trust may then pay Lorry $800K, which must then be paid to the bank (secured creditor). The balance of $700,000 remains within the Hybrid trust and is protected. The rental property is not owned by Lorry, and therefore not available to the trustee-in-bankruptcy.
Please note: it is important to have an appropriately worded clause in the trust deed to empower the trustee to deal with the proceed for the redemption/cancellation of the units directly by discharging the amount owed by Lorry. This structure may also raise concerns to the ATO of the application of Part IVA although it is quite clearly Lorry is far better position to establish his dominant purpose is to provide asset protection. However, there are other tax consequences that may need to be considered (e.g. interest deductibility on borrowing to acquire units, 45 days holding period rule had the hybrid trust invested in shares, trust losses in the Hybrid Trust, etc)
Disclaimer: The material and contents provided in this blog are general guide and informative in nature only. They are not intended to be seen as legal and tax advice. If expert assistance is required, you should seek your own advice for any legal, tax or investment issues raised in your affairs.