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Ruling

Subject: the deductibility of interest and the application of Part IVA of the Income Tax Assessment Act 1936 against this deduction

Questions

1. Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in respect of the interest incurred on the XYZ Investment Property Loan (IPL) in each of the 2010, 2011, 2012, 2013 and 2014 income years (Relevant Income Years)?

Answer:

Yes, you are entitled to a deduction under section 8-1 of the ITAA 1997 in respect of the interest incurred on the IPL in each of the Relevant Income Years.

2. Subject to the application of Part IVA of the ITAA 1936 (see (3) below), are you entitled to a deduction under section 8-1 of the ITAA 1997 in respect of all the interest incurred on the XYZ Line of Credit Facility (LOC) in each of the Relevant Income Years?

Answer:

2010 income year

No. Subject to the application of Part IVA, you are only entitled to a deduction under section 8-1 of the ITAA 1997 in respect of that part of the interest incurred on the LOC in the 2010 income year that has accrued on the portion of the outstanding daily LOC balance attributable to:

(a) the repayment of the portion of the Existing Loan (as defined below) balance that was attributable to the purchase of Rental Property 1;

(b) the payment of Deductible Rental Property Expenses (as defined below); and

(c) the payment of interest on the IPL.

No deduction is allowable for that part of the interest that has accrued on the portion of the outstanding daily LOC balance attributable to the repayment of the private portion of the Existing Loan (i.e. that portion of the Loan balance attributable to the purchase of the motor vehicle on a specific date in 2008).

2011 - 2014 income years

Yes. Subject to the application of Part IVA, you are entitled to a deduction under section 8-1 of the ITAA 1997 in respect of all the interest incurred on the LOC in each of the 2011, 2012, 2013 and 2014 income years.

3. Have you obtained a tax benefit in connection with a scheme to which Part IVA of the ITAA 1936 (Part IVA) applies?

Answer:

Yes. You have obtained a tax benefit in connection with a scheme to which Part IVA applies. The Commissioner is entitled to make a determination under paragraph 177F(1)(b) of the ITAA 1936 that the whole of the deduction for the interest incurred on the LOC shall not be allowable to you in each of the Relevant Income Years.

This ruling applies for the following periods:

Income year ended 30 June 2010

Income year ended 30 June 2011

Income year ended 30 June 2012

Income year ended 30 June 2013

Income year ended 30 June 2014

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.

Residential Property

· You and your former partner jointly acquired the residential property on a specific date in 2000 (settlement date). The purchase of the property was funded with a home loan taken out jointly by you and your former partner (Previous Joint Loan).

· The property was used as your private residence between sometime in 2000 and sometime in 2003.

· The property (hereafter Rental Property 1) was first rented on a specific date 2003 and has been rented ever since. Rental Property 1 will be rented, or available for rent, for the entire period between now and the end of the 2014 income year.

· Rental Property 1 is currently 'positively geared'.

· On a specific date in 2005 you acquired your former partner's interest in Rental Property 1 pursuant to Orders made under the Family Law Act 1975 .

· Later in 2005 you refinanced Rental Property 1 by obtaining a home loan (in your own name) from XYZ Bank (Existing Loan). All of the funds from the initial draw down of the Existing Loan were used to repay the Previous Joint Loan.

· On a specific date in 2008 you drew an amount from the Existing Loan to acquire a motor vehicle (for your private use). No further funds were drawn from the Existing Loan.

XYZ Investment Property Loan

· You acquired another residential property (Rental Property 2) on a specific date in 2007 (settlement date).

· The purchase of Rental Property 2 was funded with an investment property loan from XYZ Bank (IPL). The key terms of the IPL include the following:

o variable interest rate equal to the XYZ Bank Index Rate less X%

o repayments: on a specific date in 2010 the loan was changed from principal and interest minimum repayments to 'interest only' minimum repayments for X years with principal and interest minimum repayments thereafter

o term: X years

o security: Rental Property 1 and Rental Property 2

· Rental Property 2 was first rented during 2007 and has been rented ever since. Rental Property 2 will be rented, or available for rent, for the entire period between now and the end of the 2014 income year.

· Rental Property 2 is currently 'negatively geared'.

· On a specific date in 2010 you drew an amount from the IPL to partially repay the outstanding balance on the XYZ Line of Credit Facility (see below).

· You will not draw further funds from the IPL during the Relevant Income Years.

XYZ Line of Credit Facility

· On a specific date in 2010 you obtained an XYZ Line of Credit Facility from XYZ Bank (LOC). The key terms of the LOC include the following:

o approved credit limit: $X

o variable interest rate equal to the XYZ Line of Credit Rate less X%

o repayments: no repayments required provided the account balance remains below the credit limit

o no term specified

o security: Rental Property 1 and Rental Property 2

· Your first drawing of funds from the LOC occurred on a specific date in 2010 when an amount was used to repay the outstanding balance of the Existing Loan.

· Between a specific period in 2010 you only used the LOC to pay expenses relating to Rental Property 1 or Rental Property 2 (e.g. rates, repairs, plumbing expenses etc.) that are deductible under section 8-1 of the Income Tax Assessment Act 1997 (Deductible Rental Property Expenses) and to pay the interest debited to the IPL each month.

· On a specific date in 2010 you repaid the outstanding balance on the LOC with $Y from your XYZ transaction account and $X drawn from the IPL. You calculated the portion of the outstanding balance of the LOC attributable to an income producing purpose to be $X. You calculated the portion of the outstanding balance of the LOC attributable to a private purpose to be $Y.

· Since a specific date in 2010 you have only used the LOC to pay Deductible Rental Property Expenses and to pay the interest debited to the IPL each month. You will continue to only use the LOC in this manner between now and the end of the 2014 income year.

XYZ Home Loan

· You acquired the residential property on a specific date in 2010. The property (Home) is used as your residence.

· The purchase of the Home was funded with a home loan from XYZ Bank (Home Loan). The key terms of the Home Loan include the following:

o variable interest rate equal to the XYZ Home Loan Index Rate less X% \repayments: 'interest only' minimum repayments for X years with principal and interest minimum repayments thereafter

o term: X years

o security: Home, Rental Property 1 and Rental Property 2

Operation of loans / other information

· You will deposit all your income (including rent) into your XYZ Bank approved offset account (Offset Account), the balance of which will reduce the Home Loan balance for the purposes of calculating interest on the Home Loan.

· You will withdraw funds from the Offset Account to pay for private expenses and to make repayments on the Home Loan (i.e. minimum repayments each month plus additional repayments of at least $X per week).

· The balance of the Offset Account at a specific date in 2010 was approximately $X.

· You estimate that the net increase in the Offset Account balance will be approximately $X per month.

· You will only use the LOC to pay the interest debited to the IPL each month and Deductible Rental Property Expenses. In your view, the purpose of the LOC is to pay all your rental property expenses so as to enable the rents to pay off the Home Loan.

· You will not make any repayments on the LOC while the balance remains below its approved credit limit. As a result, interest on the LOC will be capitalised and compounded.

· Once the approved credit limit is reached you will begin making interest and principal repayments on the LOC (with no reduction in your home loan repayments). You will not apply for an increase to the LOC's approved credit limit.

· You estimate the LOC will reach its credit limit in X years.

· You estimate the Home Loan will be repaid within X years (based on your forecast of making additional repayments of at least $X per week). Thereafter, all your surplus funds will be directed towards repaying the IPL and the LOC.

· Prior to the establishment of the LOC you were making repayments on the IPL and paying Deductible Rental Property Expenses out of your personal savings account (i.e. out of the net cash flow from your salary and rental income).

· You will not dispose of Rental Property 1 or Rental Property 2 during the Relevant Income Years.

· You wish to repay the Home Loan as quickly as possible. You believe operating the IPL, LOC, Home Loan and the Offset Account in the manner described above (the arrangement) will enable you to 'pay off your home sooner'. You claim that even if you were not entitled to interest deductions you would still enter into the arrangement because it will 'pay off the home sooner'.

· You obtained the idea for the arrangement from a magazine article. The article described the arrangement and referred to the amount of tax savings involved.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1936 Section 177D.

Income Tax Assessment Act 1936 Section 177A.

Income Tax Assessment Act 1936 Section 177C.

Income Tax Assessment Act 1936 Section 177F.

Reasons for decision

Section 8-1 of the ITAA 1997

A deduction is allowed under section 8-1 of the ITAA 1997 for any loss or outgoing that is incurred in gaining or producing assessable income to the extent that it is not of a private, capital or domestic nature.

The deductibility of interest is typically determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put (Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613, FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52, and Steele v. FC of T 99 ATC 4242; (1999) 41 ATR 139).

Accordingly, a deduction is generally allowed for ordinary interest incurred on funds borrowed that are used to acquire an assessable income producing asset.

Interest on a new loan will be deductible if the new loan is used to repay an existing loan which, at the time of the second borrowing, was being used in an assessable income producing activity (FC of T v. Roberts; FC of T v. Smith 92 ATC 4380 at 4388; (1992) 23 ATR 494 at 504).

The principles governing the deductibility of compound interest are the same as those governing the deductibility of ordinary interest (Hart v. Federal Commissioner of Taxation [2002] FCAFC 222, 2002 ATC 4608, (2002) 50 ATR 369).

Interest incurred on the IPL

Funds from the IPL were used to acquire Rental Property 2 on a specific date in 2007 and to repay the income producing portion of the LOC balance (attributable to the repayment of the portion of the Existing Loan balance attributable to the purchase of Rental Property 1) on a specific date in 2010. Rental Property 2 and Rental Property 1 will be rented, or available for rent, throughout the Relevant Income Years. No further draw downs are to be made from the IPL. It follows that funds from the IPL were used by you wholly for the purpose of producing assessable income. Accordingly, you are entitled to a deduction under section 8-1 of the ITAA 1997 in respect of the interest incurred on the IPL in each of the Relevant Income Years.

The above conclusion is premised on you having correctly calculated the income producing and private portions of the outstanding LOC balance on a specific date in 2010 as being $X and $Y respectively. In calculating the portion of the LOC balance attributable to an income producing purpose, any repayment of principal should be applied proportionately against the balance of amounts applied to income producing and non-income producing purposes respectively, at the time the repayment is made (see Taxation Ruling TR 2000/2 at paragraph 16).

If the income producing portion of the outstanding LOC balance on a specific date in 2010 is in fact less than $X then the interest you have incurred on the IPL would not be wholly deductible in each of the Relevant Income Years. You would not be able to rely on this private ruling in such circumstances.

Interest incurred on the LOC: 2010 income year

During the 2010 income year, you used funds from the LOC to repay the outstanding balance of the Existing Loan on a specific date in 2010, pay Deductible Rental Property Expenses and to pay the interest on the IPL.

The outstanding balance of the Existing Loan on a specific date in 2010 was $. You used funds from the Existing Loan to refinance Rental Property 1 (a specific date in 2005) and to purchase a motor vehicle for private use (a specific date in 2008). As noted above, any repayments of principal on the Existing Loan should be applied proportionately between the income producing and private portions of the outstanding loan balance. Therefore, the balance of the Existing Loan on a specific date in 2010 included a portion attributable to your purchase of the motor vehicle on a specific date in 2008.

To the extent that funds from the LOC were used to repay the private portion of the balance of the Existing Loan, the LOC was not used for the purpose of producing assessable income. Therefore, no deduction is allowable for that part of the interest that has accrued on the portion of the outstanding daily LOC balance attributable to the repayment of the private portion of the Existing Loan (i.e. that portion of the Existing Loan balance attributable to the purchase of the motor vehicle on a specific date in 2008).

The funds from the LOC that were used to pay Deductible Rental Property Expenses, pay the interest on the IPL and to repay the portion of the Existing Loan balance attributable to the purchase of Rental Property 1 were used for the purpose of producing assessable income.

Accordingly, subject to the application of Part IVA, you are entitled to a deduction under section 8-1 of the ITAA 1997 in respect of that part of the interest incurred on the LOC in the 2010 income year that has accrued on the portion of the outstanding daily LOC balance attributable to:

· the repayment of the portion of the Existing Loan balance that was attributable to the purchase of Rental Property 1

· the payment of Deductible Rental Property Expenses, and

· the payment of interest on the IPL.

Interest incurred on the LOC: 2011 - 2014 income years

You repaid the outstanding balance of the LOC in full on a specific date in 2010. Since then you have only used the LOC to pay Deductible Rental Property Expenses and to pay the interest debited to the IPL each month. You will continue to use the LOC in this manner until the end of the 2014 income year. It follows that in each of the 2011 to 2014 income years all the funds from the LOC were used, or will be used, by you wholly for the purpose of producing assessable income.

Subject to the application of Part IVA, you are entitled to a deduction under section 8-1 of the ITAA 1997 in respect of all the interest incurred on the LOC in each of the 2011, 2012, 2013 and 2014 income years.

Part IVA

Part IVA is a general anti-avoidance rule. Part IVA gives the Commissioner the discretion to cancel a 'tax benefit' (or part of a 'tax benefit') that has been obtained, or would, but for section 177F, be obtained, by a taxpayer in connection with a scheme to which Part IVA applies.

In broad terms, Part IVA will apply where the following requirements are satisfied:

· there is a scheme (see section 177A of the ITAA 1936)

· a taxpayer has obtained, or would but for section 177F of the ITAA 1936 obtain, a tax benefit in connection with the scheme (see section 177C of the ITAA 1936), and

· the dominant purpose of a person who entered into or carried out the scheme, or any part of the scheme, was to enable the relevant taxpayer to obtain a tax benefit in connection with the scheme, or to enable the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit in connection with the scheme (paragraph 177D(b) of the ITAA 1936).

The application of Part IVA depends on a careful weighing of all the relevant facts and surrounding circumstances of each case.

Each of the requirements of Part IVA is discussed below in relation to the arrangement.

Scheme

There is a 'scheme' under subsection 177A(1) of the ITAA 1936 comprising the following course of action:

· the establishment of the LOC according to its terms and conditions

· your use of the LOC to pay the interest on the IPL and Deductible Rental Property Expenses

· the depositing of all your cash in-flows into the Offset Account, and

· your decision not to make any repayments (including the payment of interest) on the LOC while its balance remains below its approved credit limit.

The scheme was entered into or carried out by you and XYZ Bank.

Counterfactual

The formulation of what might reasonably be expected to have happened if the scheme had not been entered into or carried out (or 'counterfactual') is relevant in terms of identifying the tax benefit under section 177C of the ITAA 1936 and considering 'purpose' under paragraph 177D(b) of the ITAA 1936.

Having regard to the facts, the Commissioner considers it might reasonably be expected that if the scheme had not been entered into or carried out, the following would have happened:

· You would have met the interest payments on the IPL and the Deductible Rental Property Expenses out of your own cash flow rather than use the LOC (the counterfactual).

The counterfactual is less complicated than the scheme and satisfies the key commercial requirements of the arrangement. The Commissioner also notes that the counterfactual is consistent with your course of action prior to entering into the scheme.

Tax benefit

Under paragraph 177C(1)(b) of the ITAA 1936, a tax benefit is obtained in connection with a scheme if a deduction is allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out.

Under the counterfactual, you would not have incurred any interest on the LOC and so would not have been entitled to any deductions in respect of that. Accordingly, the relevant tax benefit obtained by you in connection with the scheme under paragraph 177C(1)(b) of the ITAA 1936 is the allowable deduction for the interest incurred on the LOC in each of the Relevant Income Years.

Weighing each of the eight factors in applying the purpose test in paragraph 177D(b)

Paragraph 177D(b) of the ITAA 1936 requires the drawing of a conclusion about purpose from the eight objective matters identified in that provision. The conclusion to be reached is the conclusion of a reasonable person (FC of T v. Spotless Services Ltd & Anor (1996) 186 CLR 404 at 421; 96 ATC 5201 at 5210). The provision does not require, or even permit, any inquiry into the subjective purpose or motive of the relevant taxpayer or others who entered into or carried out the scheme (FC of T v. Hart & Anor [2004] HCA 26 at [65]; 2004 ATC 4599 at [65]).

An objective purpose of the taxpayer of 'paying their home loan off sooner' does not prevent Part IVA from applying to the arrangement in question. As was noted in the joint judgment of the High Court in Spotless ((1996) 186 CLR 404 at 416; 96 ATC 5201 at 5206):

A particular course of action may be...both 'tax driven' and bear the character of a rational commercial decision. The presence of the latter characteristic does not determine the answer to the question whether, within the meaning of Part IVA, a person entered into or carried out a 'scheme' for the 'dominant purpose' of enabling the taxpayer to obtain a 'tax benefit.

Further, Gleeson CJ and McHugh J of the High Court noted in Hart ([2004] HCA 26 at [16]; 2004 ATC 4599 at [16]) that:

...a transaction may take such a form that there is a particular scheme in respect of which a conclusion of the kind described in s 177D is required, even though the particular scheme also advances a wider commercial objective.

Callinan J in Hart ([2004] HCA 26 at [96]; 2004 ATC 4599 at [96]) similarly distinguished between objectives that are 'entirely irreproachable and proper' and the 'means adopted to achieve these results'.

Therefore, the means by which you achieve your objective of 'paying off your home loan off sooner' may enliven Part IVA.

The purpose test in paragraph 177D(b) of the ITAA 1936 is applied below in respect of the tax benefit obtained by you in connection with the scheme. You are the 'relevant taxpayer' under section 177D of the ITAA 1936.

177D(b)(i) - manner in which the scheme is entered into or carried out

You entered into the scheme after reading a magazine article in which the scheme was described. The article referred to the amount of tax savings involved in the arrangement.

The scheme involves you using the LOC to pay the interest on the IPL and Deductible Rental Property Expenses whilst depositing all your cash in-flows (including rent) into the Offset Account. Further, you will not make any repayments on the LOC while its balance remains below its approved credit limit. Interest on the LOC will thereby be capitalised and compounded.

The manner in which the scheme is entered into or carried out is explicable only by the taxation consequences. For instance, apart from the purported availability of additional tax deductions for the interest on the LOC, it makes little (if any) financial sense for you to, in effect, fund repayments on the Home Loan (or deposits into the Offset Account) using the LOC, which has a higher interest rate than the Home Loan (based on specific dates).

This factor points toward you having entered into or carried out the scheme for the dominant purpose of enabling you to obtain a tax benefit in connection with the scheme.

177D(b)(ii) - form and substance of scheme

A key feature of the scheme is your use of the LOC to pay the interest on the IPL. This results in interest on the IPL, in effect, being capitalised and thus its payment deferred in order to enable you to repay an equivalent amount on the Home Loan (or deposit an equivalent amount into the Offset Account). Therefore, the real effect and substance of the scheme is to purportedly make the payment of interest on the capital sum paid in reduction of the Home Loan tax deductible.

The substance of the scheme points toward you having entered into or carried out the scheme for the dominant purpose of enabling you to obtain a tax benefit in connection with the scheme.

177D(b)(iii) - time scheme was entered into and the period during which the scheme was carried out

You obtained the LOC on a specific date in 2010 and commenced using it to pay interest on the IPL and to pay Deductible Rental Property Expenses from a specific date in 2010.

You propose to carry out the scheme throughout the Relevant Income Years until the LOC's approved credit limit is reached.

This factor is neutral in indicating whether you entered into or carried out the scheme, or any part of it, for the dominant purpose of enabling you to obtain a tax benefit in connection with the scheme.

177D(b)(iv) - income tax result achieved by scheme

The income tax result achieved by the scheme (but for Part IVA) when compared with the counterfactual is the availability of additional tax deductions for you in each of the Relevant Income Years equal to the interest incurred on the LOC. Under the counterfactual, interest deductions are only available in respect of the interest incurred on the IPL.

The availability of these additional tax deductions for interest under the scheme significantly reduces the income tax payable by you in each of the Relevant Income Years.

This factor strongly points toward you having entered into or carried out the scheme for the dominant purpose of enabling you to obtain a tax benefit in connection with the scheme.

177D(b)(v) - change in financial position of the taxpayer resulting from the scheme

The effect of the scheme is that you are borrowing funds (via the LOC) to pay interest on the IPL and the Deductible Rental Property Expenses in order to deposit an equivalent amount of your cash-flow into the Offset Account (or repay an equivalent amount on the Home Loan). That is, the increase in the LOC balance is matched by an equal reduction in the balance (or effective balance) of your Home Loan.

Your overall debt remains the same. Your financial position (but for the tax saved) is no better than under the counterfactual. Indeed, as you are paying a higher interest rate on the LOC than on the Home Loan your financial position under the scheme (but for the tax saved) is worse than under the counterfactual.

This factor strongly points toward you having entered into or carried out the scheme for the dominant purpose of enabling you to obtain a tax benefit in connection with the scheme.

177D(b)(vi) - change in financial position of any connected person resulting from the scheme

XYZ Bank's financial position is marginally better under the scheme when compared with the counterfactual. Under the scheme, XYZ Bank's total lending exposure is the same as under the counterfactual but it derives slightly more interest income across the three loan products. This is because the interest rate on the LOC is X% higher than the Home Loan.

On balance, this factor is neutral in indicating whether you entered into or carried out the scheme for the dominant purpose of enabling you to obtain a tax benefit in connection with the scheme.

177D(b)(vii) - any other consequences of the scheme for the taxpayer or any connected person

There are no other consequences for you or any connected person of the scheme being entered into or carried out.

This factor is neutral in indicating whether you entered into or carried out the scheme, or any part of it, for the dominant purpose of enabling you to obtain a tax benefit in connection with the scheme.

177D(b)(viii) - nature of the connection between the taxpayer and persons affected by the scheme

You have a borrower/lender relationship with XYZ Bank.

This factor is neutral in indicating whether you entered into or carried out the scheme, or any part of it, for the dominant purpose of enabling you to obtain a tax benefit in connection with the scheme.

Conclusion as to purpose after considering the eight factors

While three factors are neutral, the others (in particular, the manner in which the scheme was entered into or carried out, the change in your financial position and the income tax result achieved by the scheme) clearly point toward the conclusion that you entered into or carried out the scheme for the dominant purpose of enabling you to obtain a tax benefit in connection with the scheme.

Accordingly, consideration of all the eight factors together leads to the conclusion that you entered into or carried out the scheme for the dominant purpose of enabling you to obtain a tax benefit in connection with the scheme.

Conclusion on the application of Part IVA

You have obtained a tax benefit in connection with a scheme to which Part IVA applies. The Commissioner is entitled to make a determination under paragraph 177F(1)(b) of the ITAA 1936 that the whole of the deduction for the interest incurred on the LOC shall not be allowable to you in each of the Relevant Income Years.

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