Chadbourne and Commissioner of Taxation (Taxation)
[2020] AATA 2441
•10 July 2020
Chadbourne and Commissioner of Taxation (Taxation) [2020] AATA 2441 (10 July 2020)
Division:TAXATION AND COMMERCIAL DIVISION
File Number(s): 2019/1761
Re:David John Chadbourne
APPLICANT
AndCommissioner of Taxation
RESPONDENT
DECISION
Tribunal:Deputy President Britten-Jones
Date:10 July 2020
Place:Adelaide
The decision under review is affirmed.
.................[Sgnd].........................................
Deputy President Britten-Jones
CATCHWORDS
TAXATION — Income Tax — Discretionary Trust — where the applicant took out a personal loan and provided funds to the trust to purchase real estate and trade in shares - Claimed deductions for interest and expenditure on rental properties and shares — Rental properties and shares owned by the Trust — beneficiary not presently entitled to income of the trust – insufficient nexus between outgoings and assessable income – decision affirmed
LEGISLATIONS
Income Tax Assessment Act 1997
Income Tax Assessment Act 1936
CASES
Antonopoulos and FCT [2011] AATA 431
Case M36 (1980) 80 ATC 280
Chief Commissioner of Stamp Duties for New South Wales v Buckle (1998) 192 CLR 226
Federal Commissioner of Taxation v Munro (1926) 38 CLR 153
Commissioner of Taxation v Day (2008) 236 CLR 163
Commissioner of Taxation v Payne (2002) 202 CLR 93
Federal Commissioner of Taxation v Smith (1981) 147 CLR 578
Federal Commissioner of Taxation v Vegners (1989) 90 ALR 547
Fletcher v Federal Commissioner of Taxation (1991) 173 CLR
Forrest v Commissioner of Taxation [2010] FCAFC 6
Glenn v Federal Commissioner of Land Tax (1915) 20 CLR 490
Harmer v Federal Commissioner of Taxation (1991) 173 CLR 264
Karger v Paul [1984] VR 161
Lambert and the Commissioner of Taxation [2013] AATA 442
Lygon Nominees Pty Ltd v Commissioner of State Revenue (Vic) [2007] 23 VR 474
Partridge v The Equity Trustees Executors and Agency Co. Ltd. (1947) 75 CLR 149
Queensland Trustees Ltd v Commissioner of Stamp Duties (1952) 88 CLR 54
Taxpayer and Commissioner of Taxation [2008] AATA 325REASONS FOR DECISION
Deputy President Britten-Jones
10 July 2020
The applicant is seeking a tax deduction (primarily) for interest on money lent to him for investment properties and shares purchased by a discretionary trust. The nature of a discretionary trust is such that the applicant is unable to establish the necessary nexus between the expenses he incurred, and the assessable income derived from the trust. Consequently, the tax deductions sought will be disallowed and the respondent’s decision will be affirmed. I set out below my reasons for coming to this conclusion.
Background to the decision under review
In tax returns for the years ending 30 June 2016 and 30 June 2017, the applicant claimed deductions of $72,556 and $110,161 respectively.
On 12 September 2017 the respondent wrote to the applicant advising that generally you cannot claim deductions against discretionary trust distributions. The taxpayer assessments were then amended so as to disallow the deductions and the applicant objected to those notices of amended assessment. On 20 March 2019 the respondent decided to not allow the objection. The applicant has now applied to the Tribunal for review of that decision.
Issues
The first issue is whether the applicant is entitled to a deduction under s 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)[1] for interest expenses incurred by him on the funds borrowed by him and used to acquire real property owned by the discretionary trust.
[1] All references to legislation are to the ITAA 1997 unless otherwise stated
The second issue is whether the applicant is entitled to a deduction under s 8-1 for interest expenses incurred by him on funds borrowed by him and used to fund the acquisition of shares by the discretionary trust.
The third issue is whether the applicant is entitled to claim a deduction under s 8-1 for certain non-interest outgoings.
The fourth issue relates to the amount of losses and outgoings that the applicant would be entitled to deduct from his assessable income.
The 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.[2] 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.[3]
[2] Chief Commissioner of Stamp Duties for new South Wales v Buckle (1998) 192 CLR 226 at [8]
[3] Federal Commissioner of Taxation v Vegners (1989) 90 ALR 547 at 552
By Deed made on 10 October 2006, the D & M Chadbourne Family Trust (the Trust) was established (the Trust Deed). The Trust was properly described by both parties as a discretionary trust. The trustee was Boulevard City Apartments Pty Ltd (the Trustee) of which the applicant was the sole director and shareholder at relevant times. The applicant and his wife were the ‘Primary Beneficiaries’. Within the class of ‘General Beneficiaries’ were the Primary Beneficiaries and various relatives of the Primary Beneficiaries. The applicant is named as the appointor and the guardian in the Trust Deed.
The terms of the Trust Deed included:
Clause 3.2
The Trustee may at any time prior to the expiration of each Accounting Period (until the vesting day) determine with respect to all or any part or parts of the net income of the Trust Fund for such Accounting Period, to do all or any of the following:
3.2.1 to pay, apply or set aside the same for any one of the General Beneficiaries (including any Additional Income Beneficiary) living or in existence at the time of the determination;
3.2.2 to accumulate the same;
3.2.3 to pay, apply or set aside the same for such charitable purpose as the Trustee may think fit.
…
Clause 3.5
The Trustee shall hold so much of the net income of the Trust Fund for each Accounting Period as shall not be the subject of a determination effectively made at or prior to the end of such Accounting Period pursuant to Clause 3.2 upon the same trusts as are declared in Clause 4.1 in respect of the Trust Fund as though the last day of such Accounting Period were the Vesting Day.
…
Clause 4.1 and 4.1.1
As from the Vesting Day the Trustee shall stand possessed of the Trust Fund and the income thereof UPON TRUST for such of the General Beneficiaries for such interest and in such proportions and for one to the exclusion of the other or others as the Trustee may by instrument in writing before the Vesting Day appoint and in default of and subject to any such appointment UPON TRUST-
4.1.1 For such of the Primary Beneficiaries as shall be living on the Vesting Day and as shall have attained the age of eighteen years as tenants-in-common in equal shares absolutely PROVIDED ALWAYS that the children (if any) who shall be living on the Vesting Day of any Primary Beneficiary who dies before the Vesting Day (and the descendants of any of such children or the children of such children who die before the Vesting Day) shall take as tenants-in-common the share calculated per stirpes which such deceased Primary Beneficiary would have received had he or she survived to the Vesting Day;
…
Clause 6.1 and 6.1.1
Subject to any provision in this Trust Deed to the contrary; the Trustee may at any time or times and from time to time in the Trustee’s absolute discretion before the Vesting Day: -
6.1.1 by instrument in writing appoint any portion or portions of the capital of the Trust Fund (or any asset or assets in specie representing a portion or portions of the Trust Fund) to such of the General Beneficiaries and in such proportions and for one to the exclusion of the other or others as the Trustee in the Trustee’s absolute unfettered discretion and without being bound to assign any reason shall think fit and the Trustee shall thereafter stand possessed of the said portion or portions of the Trust Fund (or the said asset or assets in specie representing the same) for such of them the General Beneficiaries so appointed absolutely.
The Operations of the Discretionary Trust
I make mention at this stage of one contentious issue raised at the hearing with respect to a written funding agreement between the applicant and the Trustee dated 22 October 2006. The respondent contended that the agreement was prepared after these proceedings had commenced and that the suggestion of any loan was a recent invention by the applicant to assist him on this application. However, I am not required to make a finding on this document because during the applicant’s closing address he accepted that he did not lend money to the Trustee and said that any funding agreement ‘is ineffective and not valid’. In any event, the existence of the document is not determinative of any relevant issue. It is sufficient to note that both parties agreed that the applicant provided funds to the Trustee which were used by it to purchase the North Terrace apartments and the shares.
Subject to one insignificant date, the applicant agreed with the respondent’s written chronology. The extent of agreement was confirmed by the applicant’s written response to the respondent’s opening statement. The following facts are not contentious.
In December 2003 the applicant and his wife signed contracts to buy three apartments at North Terrace off the plan.
In November 2006 the North Terrace apartments settled.
On 24 November 2006 the Trustee made three declarations of trust in respect of the memoranda of transfer it had executed for the North Terrace apartments. The deeds of declaration of trust said:
The Trustee declares that the Trustee holds and will henceforth hold all the Trustee’s right, title, estate and interest in the Land upon trust for the Trust in accordance with the terms of the deed of trust constituting the Trust.
The applicant gave evidence that the North Terrace apartments were purchased with the intent to rent them out and to eventually sell one or two of them. Considerable thought was given to the method of holding the North Terrace apartments and it was decided that a trust with a corporate trustee would be established. Various types of trust were examined in the time leading up to settlement. After speaking to an accountant and a commercial lawyer, it was decided to establish the discretionary trust.
To fund the acquisition of the North Terrace apartments the applicant arranged loan finance in his name from the Commonwealth Bank for a total amount of $1,205,600. The Trustee and the applicant’s wife guaranteed the loans from the Commonwealth Bank.
The North Terrace apartments were rented out and generated rent which was used to pay the expenses associated with the apartments.
In December 2007 the applicant refinanced part of the Commonwealth Bank loans with ME Bank. On 23 May 2017 the applicant refinanced all the Commonwealth Bank loans and the ME Bank loan with the National Australia Bank.
In March 2008 the applicant and his wife borrowed money from the Commonwealth Bank through a Commonwealth Securities margin loan share trading facility. The margin loan provided capital for the Trustee to purchase shares for the Trust. Shares were bought and sold in the name of the Trustee and in 2012 the Trust incurred a significant share trading loss of $114,229.
The interest paid by the applicant on the property loans in 2016 and 2017 is part of the deductions being claimed by him. The amount of interest claimed for 2016 is $61,833. The amount claimed for 2017 is $96,593 which includes an alleged upfront payment of interest for the 2018 year.
The interest paid by the applicant on the loan for share trading capital claimed by the applicant is $6,383 for 2016 and $6,367 for 2017.
The Trust generated no net income for the relevant years of 2016 and 2017 due to the trading loss in 2012.
The Legislative Scheme and Case Law
Section 8-1 of the ITAA 1997 provides (relevantly):
(1) You can deduct from your assessable income any loss or outgoing to the extent that:
(a) it is incurred in gaining or producing your assessable income; …
This provision was considered by the High Court in Commissioner of Taxation v Day[4] where the majority said:
[21] The terms of s 8-1(1)(a) of the ITAA and its predecessors have not been regarded as materially different. They refer to a relationship between expenditure incurred and what is productive of assessable income, which is to say the connection necessary for deductibility. The words “incurred in gaining or producing … assessable income”, appearing in the section, have long been held to mean incurred “‘in the course of’ gaining or producing” income … The words “in the course of” therefore facilitate the application of s 8-1(1)(a). They do not require a direct connection between the expenditure in question and an activity itself productive of income.
[22] … the words require more than a causal connection between the expenditure and the derivation of income; something closer and more immediate. The expenditure must be incurred “in the course of” gaining or producing the assessable income. Their Honours' reference to the words “in the course of” should not be taken to suggest a closer or more direct connection between expenditure and that which is productive of assessable income than the words of the provision themselves convey. Rather the words draw attention to the connection made necessary by the provision, which the majority considered on the facts of that case to be too remote.
[4] (2008) 236 CLR 163 at 175 – 176
In the High Court decision of Commissioner of Taxation v Payne,[5] the majority said:
The connection which must be demonstrated between an outgoing and the assessable income… is that the outgoing is “incurred in gaining or producing” that income. The sub-section does not speak of outgoings incurred “in connection with” the derivation of assessable income or outgoings incurred “for the purpose of” deriving assessable income.
[5] (2002) 202 CLR 93
In Federal Commissioner of Taxation v Smith,[6] the plurality said:
The section does not require that the purpose of the expenditure shall be the gaining of the income of that year, so long as it was made in the given year and is incidental and relevant to the operations or activities regularly carried on for the production of income. What is incidental and relevant in the sense mentioned falls to be determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character, and generally to its connexion with the operations which more directly gain or produce the assessable income.
[6] (1981) 147 CLR 578 at 585 – 586
It follows from these authorities that in order to determine if the applicant is entitled to a deduction it is necessary to identify:
(a)the loss or outgoing;
(b)the activity that is productive of the assessable income;
(c)any connection between the two above.
Following that process of identification, a deduction will then be allowed if the loss or outgoing is incurred in the course of gaining or producing income. This requires there to be a sufficient connection or nexus between the loss or outgoing and the activity that is productive of the assessable income.
There is no issue with respect to the identification of the loss or outgoing which the parties agree is (for the most part) the interest expenses incurred by the applicant in relation to the loans for the property and shares.
Contentions of the Applicant
The applicant contends that the interest on the loan monies used by the Trust to purchase the North Terrace apartments is deductible because the interest was incurred in the gaining of the applicant’s assessable income. The same contention is made with respect to the loan used to trade shares and the other claimed expenses.
The applicant adopts the submission which was accepted by the Full Court of the Federal Court in Forrest v Commissioner of Taxation[7] as follows:
To be deductible under s 8-1, an expense must be incurred “in the course of” gaining or producing assessable income [FCT v Payne (2001) 202 CLR 93 at [14] per Gleeson CJ, Kirby and Hayne JJ, FCT v Day (2008) 83 ALJR 68 at [22] per Gummow, Hayne, Heydon and Kiefel JJ]. It is both sufficient and necessary that the occasion for the loss be found in whatever would be expected to produce income [Ronpibon Tin NL v FCT (1949) 78 CLR 47 at 57; Payne at [9]; Day at [30]]. The taxpayer’s motive or subjective intention is relevant [Fletcher v FCT (1991) 173 CLR 1 at 17; Day at [39]]. For expenditure to be deductible it is sufficient that the occasion for incurring the expenditure be a “genuine and not colourable relationship between the whole of the expenditure and the production of such income” [Fletcher at 17–18]. Interest expenses incurred for the purpose of furthering Mr Forrest’s present or future income producing activities are generally deductible [Steele v DCT (1999) 197 CLR 459 at [45] per Gleeson CJ, Gaudron and Gummow JJ approving FCT v Total Holdings (Australia) Pty Limited (1979) 43 FLR 217 at 224; also Ure v FCT (1981) 50 FLR 219]. Income need not in fact be produced [Steele at [43]].
[7] [2010] FCAFC 6
This submission was relied upon in a decision of the Social Services and Child Support Division of the Administrative Appeals Tribunal (the SSCSD Decision) involving the applicant’s wife. The applicant in turn relies upon the finding by the Member that:
Applying this statement of the law, it is not necessary, in the opinion of this Tribunal, in order for the interest expense incurred by Mr Chadbourne to be deductible, that he should be presently entitled, at the time of incurring the interest expense, to any part of the income to be derived from the trust. It is enough that the borrowed money be applied to a commercial purpose which is designed to produce income in which Mr Chadbourne may reasonably expect to share, even if, in a given year, no income ends up being produced. The purchase of a rental property, in the name of a trust, by a beneficiary of the trust is clearly intended to produce trust income in the form of rent, in which income the purchaser, as a beneficiary may reasonably expect to share when the distribution of net income, if any, is made towards the end of the financial year. That, in the opinion of the Tribunal, is enough to qualify the interest as deductible, because if the project proceeds, as anticipated, the purchaser may expect to derive income from the project which will be assessable income in his or her hands.
This finding of the Tribunal Member is not binding on me and I note that the SSCSD Decision is the subject of a second review which has been adjourned pending the outcome of this application.
The applicant contends that, as the loans were in his name, he personally incurred the loss or outgoings of the interest on those loans. There is no issue with this contention. The applicant says that any income derived from the Trust is included in his assessable income; it was always expected that the activities of the Trust would produce income; the motive for buying the North Terrace apartments, the shares and the solar plant was to produce income and generate profits; and all of the deductions claimed were loan interest and other expenses associated with the income producing activities of the Trust.
Further, the applicant contends that not only is he a beneficiary of the Trust, but he also has a defeasible half-interest in the income of the Trust by operation of clause 3.5 of the Trust Deed.
Contentions of the respondent
The respondent contends that there is no nexus between the interest expense and the assessable income derived from the North Terrace apartments and the shares. The respondent relies upon the Tribunal decision of Lambert and the Commissioner of Taxation:[8]
It appears now to be settled that a beneficiary under a discretionary trust is not a person who is presently entitled to income and therefore cannot establish a nexus between borrowing expenditure incurred and assessable income resulting from the use of the borrowed moneys.
[8] [2013] AATA 442
The respondent says that the applicant did not incur the interest outgoings in the course of gaining or producing his assessable income, because the terms of the discretionary trust gave the applicant no more than a right to be considered by the Trustee in relation to the appointment of the trust income. The applicant’s interest in the income of the Trust is a mere expectancy and was too uncertain or contingent to be a source of assessable income reasonably expected by the applicant.
The respondent referred to s 97 of the Income Tax Assessment Act 1936 (ITAA 1936) which operates to include an amount attributable to the Trust in a beneficiary’s assessable income. It provides (relevantly):
(1) … where a beneficiary of a trust estate … Is presently entitled to a share of the income of the trust estate:
(a) the assessable income of the beneficiary shall include so much of the share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident;
The respondent contends that the applicant was not ‘presently entitled’ to a share of the income of the Trust because unless and until the trustee of the discretionary trust exercises the discretion to appoint 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.
The respondent contends that the fact that the applicant controls the discretionary trust as a director of the Trustee, and ultimately as appointor, does not affect the scope of the Trustee’s discretion to appoint the income of the Trust.
With respect to the finding in the SSCSD Decision that the applicant had a defeasible half interest in the income of the Trust by virtue of the default provision, the respondent says that, while it is correct that a default beneficiary has a vested but defeasible interest[9], that interest is not one that is vested in possession.[10] Further, a default beneficiary does not have a present legal right to demand and receive payment. For these reasons, the respondent says that a default beneficiary is not, without more, presently entitled to income of the trust estate.
[9] Queensland Trustees Ltd v Commissioner of Stamp Duties (1952) 88 CLR 54 at 63
[10] Lygon Nominees Pty Ltd v Commissioner of State Revenue (Vic) (2007) 23 VR 474 at [64]
With respect to the non-interest outgoings claimed as a deduction, the respondent relies upon the same contentions as above.
With respect to whether the applicant has established the amount of the deductions claimed, the respondent contends that the evidence produced by the applicant fails to substantiate the alleged outgoings.
Consideration
The issue as to the deductibility of interest payments on loans obtained to acquire income producing property has been considered by this Tribunal in Lambert and Commissioner of Taxation[11] and I adopt what Senior Member Fice said:
[11] [2013] AATA 442
[17] Plainly, in order to be eligible to deduct interest expenses on borrowed money, that money must be used by the person claiming the deduction solely for the purpose of producing assessable income. The Full Court of the Federal Court (Jenkinson, Hill and O’Loughlin JJ) in Commissioner of Taxation v Roberts and Smith (1992) 37 FCR 246 dealt with the nexus required to be established between the outgoings and whether they were incurred in gaining or producing the assessable income. Hill J said, at 254–255:
The expenditure must have the necessary connection with the operations or activities which more directly gain or produce assessable income so as to meet the statutory criterion that the outgoing be incurred in gaining or producing assessable income or in carrying on a business: Charles Moore & Co (WA) Pty Ltd v Commissioner of Taxation (Cth) (1956) 95 CLR 344 at 351; Commissioner of Taxation (Cth) v Smith (1981) 147 CLR 578 at 586. That is to say it must be “incidental and relevant” to that end (Ronpibon Tin NL v Commissioner of Taxation (Cth) (1949) 78 CLR 47 at 56), although as Williams, Kitto and Taylor JJ observed in Lunney (at 497), expressions of the kind “incidental and relevant” are:
… not used in an attempt to formulate an exclusive or exhaustive test for ascertaining the extent of the operation of the section; the words were merely used in stating an attribute without which an item of expenditure cannot be regarded as deductible under the section. …
The mere act of borrowing money, burdened with an obligation to pay interest, does not of itself gain or produce assessable income. The amount borrowed is not assessable income. What operates to gain or produce assessable income is the manner in which those moneys are used, so that the necessary connection between the outgoing for interest and the activities which more directly gain or produce assessable income will be found, in the ordinary case, in the use to which the borrowed funds are put.
[18] Hill J also referred to the Full Court of the Federal Court (Brennan, Deane and Sheppard JJ) decision in Ure v Federal Commissioner of Taxation (1981) 50 FLR 219, a case in which the taxpayer borrowed moneys which he on-lent at 1% per annum to either his wife or a family company. The taxpayer claimed, unsuccessfully, that the money he borrowed or used to produce income and the whole of the interest on the borrowed funds was deductible. Hill J said, at 256:
Brennan J in that case (at 223–224) expressed the test of deductibility of interest in terms of the purposes for which the borrowed money was laid out; turning upon the objective circumstances rather than the subjective state of mind the taxpayer. It depended:
… Upon what the taxpayer in the circumstances of the case is ascertained to have done in using and arranging for the use of the borrowed moneys.
Deane and Shepherd JJ, on the other hand, recognised that in complex cases where there was no obvious commercial explanation it would be necessary, in the process of characterisation, to have regard to:
… the whole set of circumstances including direct and indirect objects and advantages which the taxpayer sought in making the outgoing … it is “a common sense appreciation of all the guiding features which must provide the ultimate answer”.
[19] Hill J also referred to the High Court decision in Fletcher v Commissioner of Taxation (1991) 173 CLR 1 which was a case dealing with money borrowed by a partnership and used for the purpose of funding an annuity. His Honour said, at 256:
As the court points out in a unanimous judgement of all seven justices, the process of characterisation involved in resolving an issue under s 51(1) will be commonly possible without reference to the taxpayer’s subjective thought processes. In other cases motive may be a relevant fact, at least where the outgoing has been voluntarily incurred.
[20] The Commissioner has also issued a Taxation Ruling (IT 2385) dealing with expenses incurred by beneficiaries of discretionary trusts. He referred to a Tribunal decision referred to as QT 85/1311. The Tribunal in that case held that the taxpayer, who was a beneficiary of a discretionary trust, was not entitled to any deduction. That was because the taxpayer had a mere expectancy of receiving income from the trust and was not presently entitled to income from the trust when the expenditure was incurred. Because the taxpayer had no right to demand a share of the trust fund, the Tribunal was not persuaded that a sufficient nexus had been shown between the outgoing and the derivation of the assessable income. That decision appears to have been followed consistently by this Tribunal.
[21] Mr T Morganti, who appeared on behalf of Mr Lambert, referred me to the Full Court of the Federal Court of Australia decision in Forest v Commissioner of Taxation (2010) 78 ATR 417 in which the court found that: … the rights expressly conferred on the unitholder by cl 4 of the trust deed demonstrate that the settlor’s and trustee’s objective intention was that income other than capital gains was to be held on a fixed trust for the unitholders, and capital gains were to be held on a discretionary trust. The Tribunal, whose decision was being appealed, held that because the appellant did not have a present entitlement to income received by the discretionary trust, the interest costs were not deductible. The court said, at 430:
The question of present entitlement relevantly has application only in the context of a beneficiary. For a share of the net income of a trust estate to be included in the assessable income of a beneficiary under s 97 of the ITAA 1936, the beneficiary must be presently entitled to that share of income.
[22] It appears now to be settled that a beneficiary under a discretionary trust is not a person who is presently entitled to income and therefore cannot establish a nexus between borrowing expenditure incurred and assessable income resulting from the use of the borrowed moneys.
The applicant chose to use a discretionary trust as the vehicle for investments in real estate and shares. He borrowed money which was then used by the Trustee of the discretionary trust to invest and trade in the real estate and share markets. The investments and trading were conducted in the name of the Trustee who acted in its capacity as trustee of the discretionary trust. This structure meant that it was not the applicant who owned the real estate or traded in the shares, but rather a separate legal entity, namely a corporate trustee. It is a fundamental aspect of a trust that the trustee holds the legal interest in the trust property. Consequently, it was the trustee of the trust which derived income from its investments and trading. This income was recorded in the tax returns lodged by the Trust. Those tax returns recorded the rent and expenses associated with the North Terrace apartments and the trades and profits or losses associated with the share trading.
The assessable income of the Trust must be distinguished from the assessable income of the applicant because the required nexus is between loss or outgoings and the assessable income of the applicant (not the Trust). This proposition was illustrated in Federal Commissioner of Taxation v Munro[12] where a taxpayer subscribed borrowed funds for shares in a company, most of which were issued to his son. The borrowed funds were clearly spent to benefit other people, and the taxpayer’s mortgage interest was not deductible.
[12] (1926) 38 CLR 153 at 170
However, this distinction is impacted by Part lll Division 6 of the ITAA 1936 which provides for tax on the net income of a trust to be paid by either the trustee or a beneficiary. It does this by ascribing to the assessable income of the beneficiary any share of the net income of the trust to which the beneficiary is presently entitled: s 97(1) of the ITAA 1936. This has the potential to work in the favour of the applicant if he could establish a present entitlement to trust income as a result of being a beneficiary.
In Harmer v Federal Commissioner of Taxation[13] it was agreed and accepted by the High Court that:
…a beneficiary is presently entitled to a share of the income of the trust estate if, and only if: (a) the beneficiary has an interest in the income which is both vested in interest and vested in possession; and (b) the beneficiary has a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment.
[13] (1991) 173 CLR 264 at 271
An estate is vested in interest where there is a present right of future enjoyment and is vested in possession where there exists a present right of enjoyment.[14]
[14] Glenn v Federal Commissioner of Land Tax (1915) 20 CLR 490 at 496
If the applicant can establish a present entitlement, the authorities have found that there is a sufficient nexus between the interest expenses incurred on borrowed funds and the assessable income of the borrower derived from a trust. For example, Forrest v Commissioner of Taxation[15] where the Full Court of the Federal Court said:
[45] The question of present entitlement relevantly has application only in the context of a beneficiary. For a share of the net income of a trust estate to be included in the assessable income of a beneficiary under s 97, the beneficiary must be presently entitled to that share of income.
[46] The income of the Minderoo Trust, other than realised and unrealised capital gains, was held on a fixed trust for the Unit Holders in the Trust. It follows that the interest payments claimed by the appellant are wholly deductible.
[15] [2010] FCAFC 6 at [45] – [46]
If there is no present entitlement, then s 97(1) does not operate in which case the applicant beneficiary would only derive assessable income from the Trust if the Trustee exercises a discretion to distribute a share of the net income to him. The respondent relies upon this additional required step as severing the nexus between the loss or outgoings and the applicant’s assessable income.
The applicant contends that any income derived from the Trust will be included in his assessable income because it has always been his intention that any net income of the Trust, including any profits on the sale of one or more of the North Terrace apartments, would be returned to him. Because of his control over the Trustee, the applicant considers that he has a reasonable expectation of sharing in these profits by way of distributions from the Trust.
I reject this contention of the applicant. 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.[16] There must be ‘the exercise of an active discretion’.[17] 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.
[16] Karger v Paul [1984] VR 161 at 164
[17] Partridge v The Equity Trustees Executors and Agency Co. Ltd. (1947) 75 CLR 149 at 164
A contention similar to the applicant’s was rejected by the Tribunal in Antonopoulos and FCT[18] where Senior Member Frost said:
That submission disregards the legality of the arrangements by which the company, and the trust of which it was the trustee, chose to conduct its affairs. It seeks to undermine the provisions of the Trust Deed which required the exercise of a discretion by the Trustee (Antbuilt Pty Ltd), not by Mr Antonopoulos in respect of the income of the Trust.
[18] [2011] AATA 431 at [33]
The statement of the Tribunal in Taxpayer and Commissioner of Taxation[19] is also apposite:
Trust income is taxed in accordance with the provisions in Div 6 Part III of Income Tax Assessment Act 1936 (Cth) (“ITAA 1936”). A beneficiary is assessable where presently entitled. A trustee is assessable on the net income of the trust to which no beneficiary is presently entitled. To derive assessable income a beneficiary must be presently entitled to a share of the income of the trust estate. A beneficiary will not be entitled to deduct interest expenses incurred in acquiring units in a Trust if he or she is not presently entitled to any part of the trust. This is because in such circumstances the beneficiary has at most a mere expectation of deriving income. That is insufficient to establish a connection between the outgoing and the gaining or producing of income. Cf Case M36 80 ATC 280.
It follows that neither the belief of the applicant nor of his accountant is sufficient of itself to establish and sustain the condition of present entitlement so as to support the applicant’s claim for deductibility. Unless the Trust Deed clearly provided for such entitlement as a matter of objective determination rather than subjective belief, the requisite condition of present entitlement may not be made out. It is therefore necessary to turn to consider the terms of the Trust Deed.
[19] [2008] AATA 325 at [32] and [33] – this was the decision of the Tribunal which was the subject of the appeal in Forrest v FCT [2010] FCSFC 6. The Full Court decision did not consider the alternative submission relating to the interest expenses where there was a discretionary trust (as opposed to a fixed trust)
I accept the applicant’s contention that any assessable income of the applicant derived from the Trust need not be derived in the same year as the interest expenses (the loss or outgoings) were incurred, but a subjective expectation of the applicant receiving a Trust distribution in the future is not enough to establish a present entitlement.[20]
[20] Fletcher v Federal Commissioner of Taxation (1991) 173 CLR 1 at 18 – 19
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.
In the circumstances where a separate decision is required from a party other than the applicant (namely the Trustee) before income arising from the expenditure on the interest can find its way to the applicant, there is an insufficient nexus between the expenditure and the applicant’s assessable income. This was the same conclusion as reached in Case M36,[21] a decision with which I agree.
[21] (1980) 80 ATC 280
My conclusion is not altered by the provision in the Trust Deed at clause 3.5 for the net income to be held on trust for the Primary Beneficiaries in default of appointment by the Trustee. A taker in default has no present entitlement to a share of the income of the trust estate during the income year.[22] Their interest is defeasible up until the end of the income year by the Trustee exercising the power of appointment. Further, the Trustee is also authorised under clause 4.1 to make an instrument in writing altering the default dispositions. The discretionary nature of the entitlement remains.
[22] Lygon Nominees Pty Ltd v Commissioner of State Revenue (Vic) [2007] 23 VR 474 at [64]
The conclusion I have reached applies to the loss or outgoings in the nature of interest, together with the range of expenses claimed by the applicant to have been incurred in gaining assessable income. Consequently, the applicant fails with respect to issues 1, 2 and 3. There is no need to consider issue 4 because of the negative determination of the other issues.
DECISION
The decision of the Tribunal is to affirm the decision under review.
I certify that the preceding sixty one [61] paragraphs are a true copy of the reasons for the decision herein of Deputy President Britten-Jones.
[Sgnd]
................................................Administrative Assistant Legal
Dated 10 July 2020
Dates of hearing: 11 and 12 June 2020
Applicant’s Representative: Mr D Chadbourne, self-represented
Respondent’s Representative: Mr Sam Ure of Counsel, instructed by the Australian Taxation Office
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