Product Ruling

PR 2000/6

Income tax: deductibility of interest incurred on borrowings under the Macquarie Geared Equities Investment Facility

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FOI status:

may be releasedFOI number: I 1020984

Preamble

No guarantee of commercial success

The Australian Taxation Office (ATO) does not sanction or guarantee these products as investments. Further, we give no assurance that the products are commercially viable, that charges are reasonable, appropriate or represent industry norms, or that projected returns will be achieved or are reasonably based.

Potential investors must form their own view about the commercial and financial viability of the products. This will involve a consideration of important issues such as whether projected returns are realistic, the 'track record' of the management, the level of fees in comparison to similar products, how the investment fits an existing portfolio, etc. We recommend a financial (or other) adviser be consulted for such information.

This Product Ruling provides certainty for potential investors by confirming that the tax benefits set out below in the Ruling part of this document are available, provided that the arrangement is carried out in accordance with the information we have been given, and have described below in the Arrangement part of this document.

If the arrangements are not carried out as described below, investors lose the protection of this Product Ruling. Potential investors may wish to seek assurances from the promoter that the arrangements will be carried out as described in this Product Ruling.

Potential investors should be aware that the ATO will be undertaking review activities in future years to confirm the arrangements have been implemented as described below and to ensure that participants in the arrangements include in their income tax returns income derived in those future years.

Terms of use of this Product Ruling

This Product Ruling has been given on the basis that the person(s) who applied for the Ruling, and their associates, will abide by strict terms of use. Any failure to comply with the terms of use may lead to the withdrawal of this Ruling.

What this Product Ruling is about

1. This Ruling sets out the Commissioner's opinion on the way in which the 'tax laws' identified below apply to the defined class of person who takes part in the arrangement to which this Ruling relates. In this Ruling the arrangement is the borrowing of moneys from Macquarie Bank Limited ('the Bank') to fund investments in the Macquarie Geared Equities Investment which is referred to in this Ruling as 'the GEI'.

Tax law(s)

2. The tax laws dealt with in this Ruling are:

•

section 8-1 of the Income Tax Assessment Act 1997 ("the 1997 Act");

•

section 51AAA of the Income Tax Assessment Act 1936 ("the 1936 Act");

•

section 82KL of the 1936 Act;

•

Part IVA of the 1936 Act.

3. This Ruling does not deal with the consequences or effects of the Goods and Services Tax or any associated 'A New Tax System' legislative reforms, including the proposed changes announced as part of the New Business Tax System.

4. On 21 September 1999, the Government announced a number of changes to the tax system as part of the New Business Tax System. A number of those changes could affect the tax laws dealt with in this Ruling. On 11 November 1999 the government announced further changes, some of which could also affect the tax laws dealt with in this ruling. Some of those changes apply from the dates of announcement and others are proposed to apply from nominated dates in the future. This Ruling does not deal with those announced changes.

Class of persons

5. The class of persons to whom this Ruling applies is those who enter into the arrangement described below on or after the date this Ruling is made. They will have a purpose of deriving assessable income from their involvement as set out in the description of the arrangement. In this Ruling these persons are referred to as 'investors'.

Qualifications

6. Precise arrangement: the Commissioner rules on the precise arrangement identified in the Ruling.

7. If the arrangement described in the Ruling is materially different from the arrangement that is actually carried out:

•

the Ruling has no binding effect on the Commissioner, as the arrangement entered into is not the arrangement ruled upon; and

•

the Ruling will be withdrawn or modified.

8. A Product Ruling may only be reproduced in its entirety. Extracts may not be reproduced. As each Product Ruling is copyright, apart from any use as permitted under the Copyright Act 1968, no Product Ruling may be reproduced by any process without prior written permission from the Commonwealth. Requests and inquiries concerning reproduction and rights should be addressed to the Manager, Legislative Services, AusInfo, GPO Box 1920, Canberra ACT 2601.

Date of effect

9. This Ruling applies prospectively from 1 March 2000, the date this Ruling is made. However, the Ruling does not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Ruling (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).

10. If a taxpayer has a more favourable private ruling (which is legally binding), the taxpayer can rely on the private ruling if the income year to which the private ruling relates has ended, or has commenced but not yet ended. However, if the arrangement covered by the private ruling has not begun to be carried out, and the income year to which it relates has not yet commenced, this Product Ruling applies to the taxpayer to the extent of the inconsistency only (see Taxation Determination TD 93/34).

Withdrawal

11. This Product Ruling is withdrawn and ceases to have effect after 30 June 2003. The Ruling continues to apply, in respect of the tax laws ruled upon, to all persons within the specified class who enter into the specified arrangement during the term of the Ruling. Thus, the Ruling continues to apply to those persons, even following its withdrawal, who entered into the specified arrangement prior to withdrawal of the Ruling. This is subject to there being no material difference in the arrangement or in the persons' involvement in the arrangement.

Arrangement

12. The arrangement that is the subject of this Ruling is described below. This description incorporates the following documents:

•

Application for a Product Ruling dated 20 January 2000, received from Baker & McKenzie on behalf of Macquarie Bank Limited.

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Drafts of the Macquarie Geared Equities Investment Brochure, Application for Finance Form and Loan and Security Agreement.

13. The details of the aspects of the arrangement subject to this Ruling are summarised as follows:

a)

Under the GEI, the investor borrows funds from the Bank to finance the purchase of shares.

b)

The investors are required to select shares to the value of their investment from a list of publicly listed shares, which is provided with the GEI application form. The minimum loan amount is $50,000.

c)

The term of the loan is three or five years. Interest on an investment in the GEI with a variable rate is payable monthly in arrears. It is possible for investors choosing a fixed interest rate to pay the interest annually in advance, although the deductibility of such prepaid interest is not the subject of this Product Ruling Arrangements where interest are prepaid is not within the class of arrangements on which this Ruling is made.

d)

The rate of interest charged by the Bank to customers borrowing under the GEI facility varies according to the term of the loan, with the shorter the period of the loan and the more volatile the price of shares, the higher interest rate charged. Investors can choose from a fixed or variable interest rate. At present the interest rate can vary from around 15% p.a. for a five year term to around 17% p.a. for a three year term.

e)

A share brokerage fee of 1.0% and stamp duty of 0.15% will apply whenever the investor purchases or sells shares. Financial Institutions Duty (FID) is also payable on the loan repayment.

f)

There may also be costs associated with an early unwind of the facility.

g)

Clause 23 of the GEI Agreement provides for a limited recourse facility. As such, the Bank is only entitled to enforce its rights as mortgagee in relation to the principal of the loan against the shares held as security. If, when the loan matures, the price of the shares purchased with the loan proceeds is below the original cost of those shares, the investor may give notice that it will not repay the whole (or any part) of the loan, but will require the Bank to exercise its rights as mortgagee of the shares. As such, the investor is never required to repay the difference between the market value of the shares and the principal borrowed.

h)

Due to the limited recourse nature of the loan, the rates of interest payable on the loan tend to be high when compared to more traditional lending facilities.

i)

Upon maturity of the loan, investors may;

(i)

repay the loan in full using cleared funds;

(ii)

release particular parcels of the shares to the Bank in lieu of part payment of the loan and repay the balance with cleared funds;

(iii)

sell all or particular parcels of shares; or

(iv)

roll the loan over for another term.

j)

If the value of the shares at maturity of the loan is greater than the principal borrowed, the investor will after the payment of the facility fee make a profit.

k)

Any dividends paid in respect of the shares purchased under the product are paid to the investor.

l)

The investor receives the benefit of any rebates on credits attaching to any dividends received subject to the at-risk holding period rules applying generally to shares acquired after 1 July 1997.

m)

Any dividends paid during the period of the loan and reinvested as part of a Dividend Reinvestment Plan will be retained by the investor at the expiry of the loan.

n)

Bonus shares issued will be held by the Bank on the investor's behalf and will form part of the security for the facility. At the expiry of the loan, should the market value of the original shares and any bonus shares be below the cost of the original parcel of shares, both the original and bonus shares will be released to the Bank.

The Participants

14. The Bank is the provider of loans under the GEI to investors to fund the acquisition of a portfolio of approved shares.

15. The majority of investors will be individuals. There will also be investors using companies or trusts to make an investment in the GEI.

Ruling

16. Subject to the assumptions listed in paragraph 18 of this Ruling:

a)

Part of the 'interest' charged under the GEI is a capital protection fee and is not deductible under section 8-1 of the 1997 Act.

b)

The GEI interest charge allowable under section 8-1 is the amount that does not exceed the benchmark interest rates calculated as the average between the Reserve Bank Bulletin Indicator Lending Rates for Personal Unsecured Loans and Credit Cards. The ATO has released the benchmark interest rates that govern the amount of interest that an investor is permitted to claim in respect of capital protected equity products such as the GEI.

c)

Section 51AAA of the 1936 Act will not apply to deny the GEI interest charge allowable under section 8-1.

d)

Section 82KL, a specific anti-avoidance provision of the 1936 Act, will not apply to deny deductibility of the GEI interest charge allowable under section 8-1.

e)

The anti-avoidance provisions in Part IVA of the 1936 Act will not be applied to deny deductibility of the interest incurred by the investor in respect of borrowings used to fund the purchase of shares under the GEI.

Assumptions

17. This Ruling is made on the basis of the following necessary assumptions:

a)

All of the investors are Australian Residents;

b)

No part of the GEI interest charge will be prepaid by the investors.

c)

The investors are not traders in investments and would not be treated for taxation purposes as trading in the GEI;

d)

The investors may or will derive assessable distributions from the GEI being dividends and realised gains derived from the investments held under the GEI;

e)

The investors may derive capital gains on the appreciation of shares acquired under the GEI;

f)

The dominant purpose of an investor in entering the arrangement is to derive assessable income from their investment in the GEI; and

g)

The arrangement will be executed in the manner described section of this Ruling in the "Arrangement".

Explanations

Section 8-1

18. The ATO view expressed in media release Nat 99/26 is that part of the 'interest' charged under the GEI is a capital protection fee and is not deductible under section 8-1. The ATO considers that the purpose of this fee is to give the taxpayer capital protection in the event of a share price fall.

19. In the GEI the amount of 'interest' charged is above the normal personal loan rate. This is because the 'interest' charge involves two components: the cost for the use of the bank's money, and the capital protection fee.

20. The cost (or interest paid) for the use of the bank's money to acquire income producing assets such as shares is generally treated as deductible under section 8-1 where it is expected that dividends or other assessable income would be derived from the investment (see Taxation Ruling TR 95/33).

21. The capital protection fee ensures that the borrower is protected from liability to repay the principal if the market value of the shares falls below their original purchase price.

22. In effect, the agreement provides that the bank is required to take the shares as full satisfaction of the debt if they have fallen in value below the amount borrowed. The fee compensates the bank for limiting its right to the repayment of the borrowed money.

23. The ATO view is that the capital protection fee is not deductible because it is incurred for a purpose other than to service or maintain the borrowed funds. It loses its character as a deductible cost of producing the expected income. The balance of the interest remaining is fully deductible.

24. Investors should only claim deductions equal to the amount of interest determined by the benchmark interest rates (see paragraph 16(b) above).

Section 51AAA

25. Under the GEI it is contemplated that over a period of an investor's involvement there will be assessable income derived by way of dividend income, possibly interest income, as well as by way of capital gain. Accordingly, the interest would have been deductible under section 8-1 irrespective of whether the capital gain is included in assessable income, or, more precisely, a deduction would have been allowable irrespective of whether the capital gain has been included in assessable income. Accordingly, section 51AAA has no application to an investor in the GEI.

Section 82KL

26. Section 82KL of the 1936 Act will not have any application as this section applies to deny a deduction for a tax benefit in certain situations arising out of a tax avoidance agreement. The GEI is not a tax avoidance arrangement.

Part IVA

27. Provided that the arrangement is entered into and carried out as disclosed (see the Arrangement part of this ruling), it is accepted that the arrangement is a normal commercial transaction and Part IVA will not apply.

Detailed contents list

29. Below is a detailed table of contents list for this Ruling:

Commissioner of Taxation
1 March 2000

Not previously issued in draft form

References

ATO references:
NO 99/1646-0

Related Rulings/Determinations:

TR 92/1
TR 92/20
TR 95/33
TR 97/16
TD 93/34
PR 1999/95

Subject References:
Financial products
interest expenses
prepaid expenses
product rulings
public rulings
taxation administration
tax avoidance

Legislative References:
ITAA 1936 51AAA
ITAA 1936 82KZM
ITAA 1936 82KL
ITAA 1936 Pt IVA
ITAA 1997 8-1