• Capital protected products and borrowings

    As an investor, you may use a capital protected product (also known as a capital protected borrowing). This typically involves an arrangement under which you use a limited recourse to fund the acquisition of shares, units in a unit trust (units) or stapled securities, either directly or indirectly.

    Common types of capital protected products include:

    • capital protected loans
    • instalment warrants

    Capital protected products also include arrangements where:

    • you use shares, units or stapled securities as security for borrowing money or obtaining credit
    • those shares, units or stapled securities are protected from a fall in their value.

    How investors use capital protected products

    Typically, capital protected loans involve the use of a limited recourse loan to directly acquire shares, units or stapled securities. Other capital protected products include 'put options' and instalment warrants.

    Limited recourse loan

    With a limited recourse loan, if, as the borrower, you default on the loan, the lender is limited in the action that it can take to recover the amount loaned. For a capital protected product, the lender's recourse is limited to the underlying shares, units or stapled securities.

    This means that you can return the shares, units or stapled securities to the lender in full satisfaction of your outstanding loan obligations, either:

    • directly, or
    • indirectly – by going into default, leaving the lender the ability to only recover the shares, units or stapled securities.

    Because of the capital protection feature in a limited recourse loan, the lender will usually charge you higher rates of interest or additional fees.

    Capital protected borrowings can also include full recourse loans used to acquire shares, units and stapled securities where a fall in the market value of the shares, units or stapled securities is protected. One way of providing this protection is through the use of a put option.

    Put option

    Another common method for capital protection is through the use of a 'put option', which is normally used in conjunction with either a full recourse loan or a limited recourse loan facility. In general terms, a put option gives you the right to 'put' or sell the underlying shares or securities back to the lender for the higher of market value or the amount outstanding under the loan.

    Instalment warrant

    An instalment warrant is a specific type of security that provides for the purchase of shares, units or stapled securities, through the payment of several instalments over the life of the warrant. The warrant itself is tradeable and can be listed on the Australian Securities Exchange.

    As the holder of the warrant, you are entitled to dividends or distributions paid in relation to the underlying instrument. You may also be entitled to exercise the voting rights attached to the underlying instrument.

    If an instalment warrant product is also capital protected, the instalment payments (apart from the first instalment) are usually financed by a limited recourse loan. There is also generally a put option incorporated under these arrangements.

    The put option (instead of the limited recourse facility) is effectively providing the capital protection to the investor if both of the following apply:

    • A capital protected product features both a put option and a limited recourse facility.
    • The exercise price of the put option is the amount outstanding under the loan.

    Claiming a deduction

    The interest incurred on loans associated with capital protected products (which did not separately identify or attach value to the loan's capital protection component) is fully deductible.

    Application date

    The options for calculating interest deductions for capital protected borrowings have changed and there are some retrospective options:

    • Before late 2002 – our view was that part of the 'interest' on the loan associated with a capital protected product was a non-deductible capital protection fee.
    • Late 2002 – the Full Federal Court held that interest incurred on loans associated with capital protected products (which did not separately identify or attach value to the loan's capital protection component) was fully deductible.
    • April 2003 – we introduced an interim methodology for a capital protected borrowing entered or extended at or after 9.30am, by legal time in the Australian Capital Territory, on 16 April 2003.
    • July 2007 – there is a methodology for calculating interest deductions for capital protected borrowings entered into on or after 1 July 2007.
    • May 2008 – the benchmark rate to be used for capital protected borrowings changed on 13 May 2008 to the Reserve Bank's standard housing rate.
    • June 2011 – the benchmark rate was changed to the Reserve Bank's standard housing rate plus 100 points, with transitional provisions allowing products entered into at or before 7.30pm (AEST) on 13 May 2008 to use the previous benchmark interest rate to the earlier of
      • 30 June 2013
      • the expiration of the product.
       

    You can also amend your tax returns for the purposes of the capital protected borrowing products up until 29 June 2013.

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      Last modified: 23 Aug 2016QC 17546