Edited version of private ruling

Authorisation Number: 1011737395784

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Ruling

Subject: Geared equities investment

Question 1

Is penalty interest payable on the early repayment of your loan deductible under section 8-1 of the ITAA 1997 where it is of a non-capital nature?

Answer

Yes

Question 2

Do the costs which are related to the discharge of a put option form the cost base of your shares.

Answer

Yes

This ruling applies for the following period

Year ended 30 June 2010

The scheme commenced on

1 July 2009

Relevant facts and circumstances

You borrowed funds from the Bank to finance the purchase of certain securities approved by the Bank.

The term of your loan was five years.

The Bank calculated a different rate of interest for each security you purchased.

Through an agreement you granted a mortgage to the Bank over your securities and their related rights.

The agreement provides a limited recourse facility through the grant of a Put Option by the Bank to you.

A portion of the interest you paid to the bank is allocated to the Put option.

The Put Option gave you the right to transfer to the Bank the securities you purchased plus the loan where the market value of the approved securities has fallen below the purchase price of the securities.

The amount payable by the Bank to you was the amount of the securities plus the plus the loan.

Upon early exit from the scheme, you were required to pay a penalty payment to the Bank.

Relevant legislative provisions

Income Tax Assessment Act 1997, Section 8-1

Income Tax Assessment Act 1997, Section 25-30

Income Tax Assessment Act 1997, Section 247-10

Income Tax Assessment Act 1997, Section 247-15

Reasons for decision

a portion of the interest payable under the Geared Equities Investment (GEI) plus loan and the Interest Prepayment loan (if applicable) is allocated to the Put Option premium. The Put Option premium is no less than the excess of the interest rate charged on the GEI plus loan above the applicable Reserve Bank Bulletin Indicator Lending Rates for Personal Unsecured Loans. The Put Option premium will be calculated as a percentage of the interest rate, and will vary depending on the term of the GEI plus loan

Where the Bank is unable to provide you with a termination quote, you will be able to determine the split between the capital and interest expenses by applying the above guidelines.

Subsection 25-30(1) of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for an amount incurred to discharge a mortgage that was given as security for the repayment of money used solely for the purpose of producing assessable income.

As a general rule, expenses incurred in discharging some liability which is associated with, or ancillary to, a mortgage will not be deductible.

In your circumstances, we are dealing with an investment in which you are required to pay a penalty for an early exit from the scheme. A proportion of the penalty payment is related to the put option, and not to the mortgage.

Is a 'put option' itself a mortgage?

In essence, there are three practical requirements of a mortgage:

(i) there must be a promise by A to B to repay money or to perform some obligation,

(ii) as security for repayment or performance, A must transfer or assign his interest in property to B, and

(iii) the transfer must be subject to the proviso that, if A repays or performs, then B will retransfer or reassign the property to A.

In simple terms a 'put option' is a contract that gives the buyer of the 'put' the right, but not the obligation, to sell something in the future at a pre-determined price. The seller of the 'put' is obligated to buy the thing in question if the buyer exercises the option. The buyer pays a fee or premium to the seller for the option contract.

Clearly, by ordinary definition, a put option is not a mortgage. Whilst the first requirement is arguably satisfied, that there is a promise to repay money or perform some obligation, the second two requirements are absent. There is no transfer or assignment of an interest in property as security for the promise. In the present case, there is no transfer of property as security from the Bank to the Investor. The promise is purchased by the promisee. It is simply a contractual obligation to perform in certain circumstances.

Therefore, unless the payment to terminate the put option is considered to be inherently connected with the mortgage, it will not be a payment incurred to discharge a mortgage for the purposes of section 25-30 of the ITAA 1997.

Analogy with penalty interest

An amount paid to terminate the put option in circumstances such as the present may be considered to be analogous with an amount paid by way of penalty interest.

Generally speaking, provided loan moneys were borrowed for the purpose of gaining or producing assessable income, penalty interest payable on early repayment of the loan will be deductible under sect 8-1 of the ITAA 1997, unless it is of a capital nature.

Taxation Ruling TR 93/7 deals with the deductibility of penalty interest payments. It indicates that penalty interest is not considered to be in the nature of interest. It is not paid for the use of the lenders money. It is paid in respect of a period when the borrower has repaid the loan and does not have the use of the money. It is incurred to release the payer from a contractual obligation to pay recurrent interest on the loan.

Division 247

Division 247 of the ITAA 1997 applies to borrowers under capital protected borrowings. Part of the borrowers expenditure in relation to the capital protected borrowing is treated as being incurred only for a put option granted under the arrangement.

In effect, part of the payment is treated as being revenue in nature (the part that is treated as properly being interest) and part of the payment is treated as being capital in nature (the part that is treated as properly being related to a put option).

It follows that, where a payment is made to gain a release from a recurrent obligation which is treated as being partly revenue and partly capital, then the release is also related to this dual purpose.

Taxation Ruling TR 93/7 proceeds on the basis that penalty interest is for release of the recurrent obligation to pay interest. Release from that recurrent obligation is considered in that Ruling to be sufficiently connected to a discharge of a mortgage appended to the instrument of loan to be a mortgage discharge expense.

However, where part of the penalty interest is for release of capital protection costs, it relates to the surrender of a right to dispose of assets acquired with the loan capital. This is a discrete contractual right to the loan agreement and appended security.

Surrender of this asset by the borrower could not be said to be connected to the security held over the loan by the lender.

Allowable Deduction

In circumstances where an amount of expenditure is incurred which relates in part to discharging a relevant mortgage and in part to some other purpose which would not be deductible under section 25-30 of the ITAA 1997 in its own right, the expenditure is deductible under section 25-30 of the ITAA 1997 only to the extent that it relates to the discharge of the relevant mortgage.

Conclusion

In your case, the loan capital was required to be used to purchase assessable income producing shares. To the extent that the discharge expenditure relates to a mortgage given as security for the repayment of the loan monies, the expenditure will therefore be deductible.

The termination costs are not deductible to the extent that the costs relate to the put option as the expense is of a capital nature.

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