Edited version of private ruling

Authorisation Number: 1011466416163

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Ruling

Subject: Deductions - Interest deductions - Part IVA

Issue 1

Do you disregard any capital gain or capital loss you will make from the sale of property A?

No.

This ruling applies for the following period/s:

2009-10 income year

2010-11 income year

2011-12 income year

2012-13 income year

The scheme commences on:

1 July 2009

Issue 2

1. Will the interest expenses you incur on your new investment loan used to finance the purchase of property B be allowable as deductions under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes.

2. To the extent that the interest expenses you claim in relation to the arrangement described are allowable deductions pursuant to section 8-1 of the ITAA 1997, will Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to deny any part of the deduction?

No.

This ruling applies for the following period/s:

2009-10 income year

2010-11 income year

2011-12 income year

2012-13 income year

The scheme commences on:

1 July 2009

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You own a house on less than two hectares of land (property A), which is your principal place of residence. You bought this property as sole proprietor about six years ago and have provided an estimate of its market value. You have a principal and interest loan on this property.

You renovated this property when you bought it and also built an extension on to it. You stayed with your parents while the renovations were being completed and moved into it immediately once they were completed.

You will choose to treat the property as your main residence from the date of purchase until you moved into it.

Your spouse owns an apartment (property B), which is their principal place of residence. Your spouse bought this property as sole proprietor about three years ago and you have provided an estimate of its market value. Your spouse has an interest only loan and a principal and interest loan on the property. Your spouse is about to combine these loans into one principal and interest loan.

You live together between your residences on an ad hoc basis.

You will also choose to continue to treat property A as your main residence should it cease to be so as a result of your spouse becoming your domestic partner given the time you spend at their place.

Your spouse will choose to continue to treat property B as their main residence should it cease to be so as a result of them becoming your domestic partner given the time they spends at your place.

Your spouse and you wish to purchase a new house to become your principal place of residence. You have suggested locations for the house and that it would be a run down house that requires a renovation and extension.

Your spouse and you wish to maintain ownership of property A and property B as investment properties in order to build up a portfolio of rental properties that will eventually generate a positive income stream that will assist in funding your retirements.

You advise that the following transactions will occur:

· Your spouse will sell property B to you for its current market value. You will establish an investment loan for this amount with a major bank with interest payable at their standard commercial rate to fund your purchase. Your spouse will use the proceeds from the sale to pay out their loans and dedicate the remainder towards the purchase of the new home.

· You will sell property A to your spouse for its current market value. Your spouse will establish an investment loan for this amount with a major bank with interest payable at their standard commercial rate to fund their purchase. You will use the proceeds from the sale to pay out your loan and dedicate the remainder towards the purchase of the new home.

· Your spouse and you will combine your proceeds from the sales to each other (after repayment of your existing home loans), to jointly purchase a new property. As well, you will jointly take out a principal and interest loan with a major bank with interest payable at their standard commercial rate. Cash on hand will also be added to fund the purchase. This is sufficient to fund the total project including purchase, renovation, extension and costs.

Following the transactions as set out above, your spouse will immediately make property A available for rent. You will also make property B available for rent. Current market conditions dictate that property A will be negatively geared and property B will more likely be positively geared as it will be rented as a fully furnished apartment.

Assumptions

This ruling assumes that the valuations of property A and property B each as stated in the facts is a true market value at that time, each reflecting the price that you would otherwise receive from the sale of your respective property to an independent arm's length purchaser.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 118-110

Income Tax Assessment Act 1997 Section 118-145

Income Tax Assessment Act 1997 Section 118-150

Income Tax Assessment Act 1997 Section 118-170

Income Tax Assessment Act 1936 Section 177A

Income Tax Assessment Act 1936 Section 177C

Income Tax Assessment Act 1936 Section 177D

Income Tax Assessment Act 1936 Section 177F.

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Issue 1

Summary

You do not disregard any capital gain or capital loss you will make from the sale of property A as you are not entitled to a full main residence exemption on it. However, you are entitled to claim a partial main residence exemption.

Detailed reasoning

To be entitled to claim the full main residence exemption, the dwelling that you sell must be your main residence for the whole of your ownership period, less than two hectares in size and not have been used to earn assessable income while you lived there.

You have advised that property A is less than two hectares in size and it will not be used to earn assessable income while you own it.

The main residence exemption may apply to property A throughout the period that you own it where it satisfies the conditions for the exemption. The main residence exemption takes account of certain life situations when determining whether a full or part exemption is available. These may extend or limit the availability of the exemption.

There are three distinct components of your ownership period and each is handled separately.

Period 1 - From the date of purchase (settlement) until you moved in

A dwelling cannot become your main residence until you physically begin to reside there. However, the period before you physically move in may be included among your main residence days if certain conditions are met.

You can choose to treat a dwelling as your main residence if the delay in moving in is caused by renovations to the dwelling. The dwelling must become your main residence as soon as practicable after the renovations are completed for this choice to be available.

The effect of making this choice is that the dwelling is treated as your main residence for up to four years before it actually became your main residence. No other dwelling can be treated as your main residence during this period (except where a special rule about changing main residences applies).

You have made this choice and the period between purchase and moving in was less than four years, so the whole of this period is counted among your main residence days.

All of this period is included as main residence days for the purpose of calculating the main residence exemption.

Period 2 - From the date you moved in until your spouse became your domestic partner

Property A was your common law main residence during this period and you have not chosen to treat any other dwelling as your main residence instead.

All of this period is included as main residence days for the purpose of calculating the main residence exemption.

Period 3 - From the date your spouse became your domestic partner until sale (settlement)

Property A was either your common law main residence during this period or your main residence as a result of you choosing to continue to treat it as your main residence after it would have otherwise ceased to be so. However, property B is your spouse's main residence during this period.

A limitation applies where spouses have different main residences to ensure that they only receive one full main residence exemption between them. Therefore, 50% of this period is included as main residence days for the purpose of calculating the main residence exemption.

This limitation is the reason why you will not be entitled to claim a full main residence exemption when you sell property A to your spouse.

Note: Your spouse could choose to treat property A as their main residence, but this would affect their entitlement to a main residence exemption on property B.

Issue 2

Question 1

Summary

The interest expenses you incur on your new investment loan used to finance the purchase of property B will be allowable as a deduction under section 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature.

Whether interest on a loan has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. Where a borrowing is used to acquire an income producing asset or relates to an income producing activity, the interest on this borrowing is considered to be incurred in the course of producing assessable income. This will include arrangements where the parties are related, if the arrangement is consistent with normal commercial practices.

In your case, you will borrow funds in the amount that you will use to finance the purchase of property B. The loan is a standard investment loan from one of the major banks. You will pay interest on this loan at commercial interest rates. You will immediately make property B available for rent. You will derive income from the rental property once leased. Therefore the interest expense payable on the loan is deductible under section 8-1 of the ITAA 1997 to the extent that it is incurred in producing assessable income.

Interest expenses payable on the separate loan that you jointly obtain with your spouse (also financed by one of the major banks at commercial interest rates) in order to purchase a home together will not be deductible under section 8-1 of the ITAA 1997 as the loan is considered private in nature.

Question 2

Summary

To the extent that the interest expenses you claim in relation to the arrangement described are allowable deductions pursuant to section 8-1 of the ITAA 1997, Part IVA of the ITAA 1936 will not apply to deny your claim.

Detailed reasoning

Part IVA of the ITAA 1936 is a general anti-avoidance provision that can apply in certain circumstances if a tax benefit is obtained in connection with a scheme, and it can be concluded that the scheme, or any part of it, was entered into for the dominant purpose of enabling a tax benefit to be obtained.

The application of Part IVA of the ITAA 1936 depends on the facts of the particular case. In order for the Commissioner to exercise the discretion in subsection 177F(1) of the ITAA 1936, the requirements of Part IVA of the ITAA 1936 must be satisfied. These requirements are that:

· a 'tax benefit' as defined in section 177C of the ITAA 1936, was or would, but for subsection 177F(1) of the ITAA 1936 have been obtained

· the tax benefit was or would have been obtained in connection with a 'scheme' as defined in section 177A of the ITAA 1936, and

· having regard to section 177D of the ITAA 1936, it would be concluded that the main or dominant purpose of entering into the scheme was to obtain the tax benefit.

The definition of scheme in subsection 177A(1) of the ITAA 1936 is very broad and applies to any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and any scheme, plan, proposal, action, course of action or course of conduct.

In the present case, the following steps comprise the scheme:

· You establish an investment loan with a major bank at commercial interest rates.

· You use these funds to purchase property B from your domestic partner.

· Your spouse will use some of the proceeds from this sale to pay off the home loan that they had on property B.

· At the same time, you sell property A to your domestic partner for its market value.

· You use some of the proceeds from this sale to pay off your home loan which you had on property A.

· You combine the remainder of the proceeds from these sales in order to fund the purchase of a new property together. You fund the remainder of the cost of the new property using additional funds borrowed at a commercial rate from one of the major banks and cash on hand.

Alternatively, a narrow scheme comprises steps 1 to 5 as above, or steps 1, 2 and 4 as above.

Tax benefit is defined in subsection 177C(1) of the ITAA 1936. Paragraph 177C(1)(b) of the ITAA 1936 provides that a taxpayer may be found to have obtained a tax benefit if they entered into or carried out a scheme that generates an allowable deduction that would not have been allowable, or might reasonably be expected not to have been allowable to the taxpayer in relation to a year of income if the scheme had not been entered into or carried out.

An alternate postulate is what would have happened or might reasonably be expected to have happened if the particular scheme had not been entered into or carried out, that is, what the taxpayer would have done absent the scheme.

In identifying a reasonable alternate postulate, the following factors are taken into account:

· the most straightforward and usual way of achieving the commercial and practical outcome of the scheme

· commercial and social norms

· behaviour of relevant parties before and after the scheme, and

· the actual cash flow.

A tax benefit will not arise for a particular taxpayer in connection with a scheme if:

· there is a reasonable alternate postulate that shows how the taxpayer would have undertaken or might reasonably be expected to have undertaken a particular arrangement absent the scheme, and

· the alternate postulate would or might reasonably be expected to have resulted in an allowable deduction of the same kind as the deduction claimed by the taxpayer under the scheme.

In your case, the scheme results in an allowable deduction under section 8-1 of the ITAA 1997 for the interest paid to finance the investment loan that you will take out with a major bank at commercial interest rates to fund the purchase of the investment property. Had you not entered into or carried out this scheme, you have stated that you would have still sold your current home and obtained finance from a major bank at commercial interest rates to purchase a rental property. Under this alternate postulate, the interest on the loan to fund the purchase of the rental property would be deductible under section 8-1 of the ITAA 1997. In fact, the amount of the allowable deduction claimed under the alternate postulate would be the same as per the amount under the scheme if the loan taken out under the alternate postulate was in the amount of $X at the same interest rates.

The alternate postulate is a plausible alternate transaction which does not raise doubt as to what you would have done in the absence of the identified scheme. In your circumstances it is a comparable way of achieving the practical outcome, is considered to be within commercial and social norms and it is reasonable to conclude that the allowable deductions would have been obtained absent the scheme. The fact that you are dealing with a related party under the scheme does not of itself deny the deduction of the allowable deduction under section 8-1 of the ITAA 1997 or compel the application of Part IVA of the ITAA 1936 particularly where it is found that you are dealing with each other at arm's length. Whether you are dealing with each other at arm's length, as parties would normally do, so that the outcome of your dealings is a matter of real bargaining is a question of fact.

The Commissioner accepts that there are a number of ways of doing a transaction or organising your affairs. In this matter, the Commissioner accepts that there is no tax benefit as defined in section 177C of the ITAA 1936, having regard to the alternate postulate and the manner in which the scheme is implemented. Therefore, Part IVA of the ITAA 1936 will not apply to deny the deduction for the interest expense otherwise deductible under section 8-1 of the ITAA 1997 in the proposed arrangement the subject of this Ruling Application.

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