Edited version of your private ruling

Authorisation Number: 1011985118779

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Ruling

Subject: interest expenses and the application of Part IVA

Questions

1. Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for all interest that accrues on the line of credit facility (LOC1) you hold jointly with your spouse and use as described in the relevant facts and circumstances below?

Answer:

No, subject to the application of Part IVA of Income Tax Assessment Act 1936 (ITAA 1936), you are only entitled to a deduction for your share (50%) of the interest that accrues on LOC1.

2. Would the Commissioner make a determination under paragraph 177F(1)(b) of ITAA 1936 to deny you a deduction for interest on the LOC1 because you have obtained a tax benefit in connection with a scheme to which Part IVA of ITAA 1936 applies?

Answer:

Yes. The Commissioner would make a determination under paragraph 177F(1)(b) to deny you a deduction for interest on the LOC1 because you have obtained a tax benefit in connection with a scheme to which Part IVA applies.

3. Are you entitled to a deduction under section 8-1 of ITAA 1997 for all interest that accrues on the line of credit facility (LOC2) you hold jointly with your spouse and use as described in the relevant facts and circumstances below?

Answer:

No, you are not entitled to a deduction under section 8-1 of ITAA 1997 for any amount of interest that accrues on the LOC2.

4. Would the Commissioner make a determination under paragraph 177F(1)(b) of ITAA 1936 to deny you a deduction for interest on the LOC2 because you have obtained a tax benefit in connection with a scheme to which Part IVA of ITAA 1936 applies?

Answer:

The Commissioner will not rule on this issue. As you are not entitled to a deduction for interest on the LOC2, Part IVA cannot apply.

The Commissioner notes that if you were entitled to a deduction for any amount of interest that accrues on the LOC2, the Commissioner would make a determination to cancel that deduction because you would have obtained a tax benefit in connection with a scheme to which Part IVA applies.

This ruling applies for the following periods

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commences on

1 July 2008

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 are the sole director of Company A. Company A("the Trustee") is the trustee of The Family Trust ("the Trust").

The Trust is a discretionary trust settled by a Deed of Settlement of Discretionary Trust.

You and your spouse are listed as general beneficiaries of the Trust.

Details of the relevant properties

You and your spouse jointly own your main residence ("your home") that has a security value of $X.

In your personal capacity and the capacity of the director of the Trustee, you control the following rental properties ("all rental properties"):

· the rental property with a security value of $X you solely own ("your rental property"), and

· the rental properties that the Trustee owns ("the Trust rental properties") being:

o the properties with a security value of $X each ("the initial Trust rental properties"):

§ rental property A

§ rental property B

§ rental property C

§ rental property D

o the rental property with a security value of $X ("rental property E").

The rental property E was purchased during 2011. The Trustee is the sole legal owner of the rental property E. You said that the Trustee acquired the rental property E to improve your cash flow position. You paid the deposit for the property with the funds drawn down under the line of credit that you took out jointly with your spouse ("LOC2"). The Trustee funded the remainder of the purchase price with the rental loan E.

Details of the relevant accounts and loans

In your personal capacity and in the capacity of the director of the Trustee, you control the following accounts:

· your personal savings account with your bank ("your savings account"),

· your personal VISA account ("your VISA card"),

· the joint home loan account in your and your spouse's name ("your home loan") used to refinance the loan funding the purchase cost of your home ("your old home loan") on the following terms:

· the rental loans funding all rental properties ("all rental loans") being:

o the loans funding the purchase cost of your rental property that are in your name only ("your rental loans"), and are:

§ rental loan 1

§ rental loan 2

o the loans funding the Trust rental properties ("the Trust rental loans") that are in the name of the Trustee for the Trust, and are:

§ the loans funding the initial Trust rental properties ("the initial Trust rental loans") being:

· the loan funding the purchase cost of the rental property A("rental loan A")

· the loan funding the purchase cost of the rental property B ("rental loan B")

· the loan funding the purchase cost of rental property C ("rental loan C")

· the loan funding the purchase cost of rental property D ("rental loan D")

§ the loan funding the purchase cost of rental property E (less the deposit), ("rental loan E")

o two line of credit accounts ("the LOCs") that you hold jointly with your spouse:

§ the line of credit ("LOC1")

§ the line of credit ("LOC2"):

Current loan and expense payment arrangement

During 2010, you refinanced your old home loan, being a home loan account in your and your spouse's name with your home loan.

Later in 2010, you took out the LOCs with your spouse and commenced a new loan and expense payment arrangement ("new loan repayment arrangement").

Under this arrangement:

· All income you and the Trustee receive is deposited into your savings account;

· You use drawings on your savings account as follows:

o to pay for your personal expenses,

o to make repayments on your home loan on a principal and interest basis,

o to make payments on your VISA card to 'reverse' the amounts charged on the card for your personal expenses,

o the balance of any income deposited into your savings account and not used as described above is used to make additional repayments on your home loan;

· You use your VISA card to pay for:

o your personal expenses,

o your rental expenses, and

o the deductible expenses of the Trust rental properties ("the Trust rental expenses");

· You always pay of the outstanding amounts on your VISA card in full on or before the due date for payment. You are never liable for interest on expenses you charge to your VISA card.

In this document, your rental expenses and the Trust rental expenses are together referred to as "all rental expenses".

· You now make drawings on LOC1 to pay interest on your rental loans and repay a portion of the monthly balance outstanding on your VISA card equal to the monthly total of amounts charged on the card for your rental expenses;

· You now make drawings on LOC2 to pay interest on the Trust rental loans and repay a portion of the monthly balance outstanding on your VISA card equal to the monthly total of the amounts charged on the card for the Trust rental expenses;

· You will not make any repayments on the LOCs provided that their balance remains below the credit limits. As a result, the interest and other charges on the LOCs will be allowed to capitalise and compound. You expect that you will not reach the credit limit of the LOCs until your home loan is paid off in approximately 20XX. You have stated that the credit limits on the LOCs were calculated so that they will reach their approval limit at the same time your home loan is paid off.

· Once you have paid off your home loan in approximately 20XX, you:

o will start making principal and interest repayments on the LOCs and all rental property loans out of your and the Trust's income; and

o expect to have fully repaid all these loans by 1 June 20XX.

In this document the period between 2010 and the day on which you make the last repayment on the LOCs is referred to as the "relevant period".

Other relevant information

· During 2010, the Trustee passed a resolution to distribute the Trust net income. The Trustee distributed $X of the Trust net income to a beneficiary and balance of $X to you. The Trustee resolved that it holds the income so distributed on behalf each of the beneficiaries, with an option to reinvest the money as an interest free loan by the beneficiaries to the Trust payable on demand.

· There are no agreements between you and the Trust in respect of the payment of the interest on the Trust rental loans and the Trust rental expenses.

· You calculated the LOCs credit limits by reference to the average interest rate on all rental loans, historical monthly VISA card payments, and the time it would take you to pay off your home loan with the funds that the LOCs will replace.

· You and your spouse were not provided with any promotional material in relation to any of the rental loans or the LOCs. You have not paid anyone to advise you on the new loan repayment arrangement or to set it up for you.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 Division 393

Income Tax Assessment Act 1997 Division 36

Income Tax Assessment Act 1936 Section 95(1)

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 Section 177A(1)

Income Tax Assessment Act 1936 Section 177C(1)(b)

Income Tax Assessment Act 1936 Section 177D(b)(i)

Income Tax Assessment Act 1936 Section 177D(b)(ii)

Income Tax Assessment Act 1936 Section 177D(b)(iii)

Income Tax Assessment Act 1936 Section 177D(b)(iv)

Income Tax Assessment Act 1936 Section 177D(b)(v)

Income Tax Assessment Act 1936 Section 177D(b)(vi)

Income Tax Assessment Act 1936 Section 177D(b)(vii)

Income Tax Assessment Act 1936 Section 177D(b)(viii)

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.

Section 8-1

An interest expense will be an allowable deduction under section 8-1 of ITAA 1997 if it can be characterised as an outgoing the taxpayer incurs in gaining or producing the taxpayer's assessable income or an outgoing the taxpayer necessarily incurs in carrying on a business for the purpose of gaining or producing the taxpayer's assessable income, and is not capital, or of a capital, private or domestic nature: Taxation Ruling TR 95/25.

The character of interest is determined by the purpose of the borrowing, generally established by the use to which the borrowed funds have been put. Strict tracing of the borrowed funds is not required. Rather, the character of interest is ascertained by reference to the advantages sought from the use of the borrowed funds: Taxation Ruling TR 95/25.

Where a borrowing is used to acquire a rental property and that property is rented or available for rent, the interest on this borrowing is considered to be incurred in the course of producing assessable income: Taxation Ruling TR 2000/2.

The taxpayer's interest expense can only be deducted to the extent to which the taxpayer has used the borrowed moneys to gain or produce assessable income of the taxpayer. The interest will not be deductible to the extent that the taxpayer has used the borrowed moneys for the purpose of benefiting persons other than the taxpayer: Taxation Determination TD 2009/17.

The Commissioner considers that at it highest, the taxpayer beneficiary of the discretionary trust has a mere expectancy of receiving income from the trust: paragraphs 6 of IT 2385. Unless it is established that the beneficiary is presently entitled to the trust income when they incur an expense, the Commissioner will disallow deductions under section 8-1 for expenses they incur in relation to that trust income: Taxation Ruling IT 2385.

The taxpayers that borrowed jointly only incur their share of the interest due and payable on the joint borrowing, notwithstanding that one of them may actually pay all of it: Taxation Ruling TR 97/7; Case U169 87 ATC 967; Federal Commissioner of Taxation v Reed 88 ATC 5014.

The same principles apply to determine the deductibility of both ordinary interest and compound interest as both are simply the cost of borrowed funds. The deductibility of compound interest is usually but not necessarily determined by the use to which the original loan funds were put: Taxation Determination TD 2008/27.

Interest on the LOC1

You took out the LOC1 jointly with your spouse. You use it to pay interest on your rental loans and a portion of balance outstanding on your VISA card attributable to your rental expenses.

The interest payable on your rental loans has a character of an expense incurred in gaining or producing your assessable income because you used these loans to purchase your rental property from which you derive assessable income. Provided that no interest is payable on your VISA card, a portion of balance outstanding on your VISA card attributable to your rental expenses also has a character of such an expense.

Seeing that you use the LOC1 to pay the expenses you incur in gaining or producing your assessable income, all interest (including compound interest) on the LOC1 takes the character of these expenses. However, because you incur all interest on the LOC1 jointly with your spouse, only your share (50%) of this interest will be deductible to you.

Subject to the application of Part IVA, you are entitled to a deduction for 50% of the interest that accrues on the LOC1.

Interest on the LOC2

While you are the sole director of the Trustee, you took out the LOC2 jointly with your spouse in your personal capacity.

You used the funds drawn down under the LOC2 to pay the deposit for the rental property E and you continue to draw down funds to pay interest on the Trust rental loans and the portion of balance outstanding on your VISA card attributable to the Trust rental expenses.

There are no agreements between you and the Trustee in respect of the LOC2. Until the Trustee exercises its discretion in your favour, you are not presently entitled to a share of the Trust income. When you incur interest on the LOC2, you merely have an expectation that the Trustee will exercise its discretion in your favour. It follows that rather than being used in gaining or producing your assessable income, the LOC2 is used to benefit the Trust. Accordingly, you are not entitled to a deduction for any amount of interest on the LOC2.

The Commissioner notes that if you were to show that you are entitled to deduction for any amount of interest on the LOC2, the Commissioner would be entitled to make a determination to cancel that deduction because you have obtained a tax benefit in connection with a scheme to which Part IVA applies.

Part IVA

* All legislative references in this section are to the ITAA 1936 unless otherwise stated.

Part IVA is a general anti-avoidance rule. Part IVA gives to 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,

§ a taxpayer has, or would obtain, but for section 177F, a tax benefit in connection with the scheme,

§ the dominant purpose of any person entering into or carrying out the scheme, or any part of the scheme, was to enable the relevant taxpayer and/or another taxpayer to obtain a tax benefit in connection with the scheme.

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 scheme.

The 'scheme'

A scheme is defined under subsection 177A(1) as 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.

Based on the limited facts stated in the ruling application, the scheme under subsection 177A(1) comprises the following course of action:

§ You taking out the LOCs jointly with your spouse according to all their terms and conditions,

§ You directing all income flows (including the rent from the Trust rental properties) into your savings account and using them to pay for:

o your private expenses,

o a portion of balance outstanding on your VISA card attributable to your private expenses, and

o to pay off your home loan,

§ You using the funds drawn down under the LOCs to pay for interest on all rental loans and a portion of balance outstanding on your VISA card attributable to your rental expenses and the Trust rental expenses,

§ You not making any repayments on the LOCs until you pay off your home loan.

The 'tax benefit'

The identification of a tax benefit in respect of this scheme requires a consideration of what would have happened or might reasonably be expected to have happened if this scheme had not been entered into or carried out. This reasonable expectation forms the background against which the objective ascertainment of the dominant purpose occurs.

Considering the facts, particularly your objective of paying of your home loan sooner, it might reasonably be expected that had you not entered into the scheme, you would have continued using the income flows available to you in your personal capacity and in the capacity of the director of the Trustee to pay off your home loan and then pay interest on all rental loans and the portion of balance outstanding on your VISA card from the redraw component of your home loan, rather than use the LOCs to pay for these expenses.

This is less complicated than the scheme and satisfies the key commercial requirements of the arrangement. The Commissioner also notes that what you might reasonably be expected to have done had you not entered the scheme is consistent with your old loan repayment arrangement.

Under paragraph 177C(1)(b), 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.

It might reasonably be expected that had you not entered into the scheme, you would not have incurred any interest on the LOCs and so would not have been entitled to a deduction for your share of the interest on the LOC1. Therefore, the tax benefit that you obtain in connection with the scheme for purposes of paragraph 177C(1)(b) is a deduction for your share of the interest that accrues on the LOC1 during the relevant period.

Should you show that you are otherwise entitled to a deduction for any amount of interest that accrues on the LOC2, such deduction would also represent the tax benefit you obtain in connection with the scheme for purposes of paragraph 177C(1)(b).

The 'dominant purpose'

A key question, for Part IVA purposes, is whether you entered into or carried out the scheme with the dominant purpose of obtaining a tax benefit in connection with the scheme. This requires the drawing of a conclusion about the objective purpose of undertaking the scheme by reference to the eight objective factors identified in paragraph 177D(b). The conclusion to be reached is the conclusion of a reasonable person.

An objective purpose of a taxpayer of 'paying their home loan off sooner' or similar, does not prevent Part IVA from applying to this type of arrangement. As was noted in the joint judgment of the High Court in FC of T v. Spotless Services Ltd & Anor (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 FC of T v. Hart [2006] 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 FC of T v. Hart [2006] 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 your home loan off sooner' may attract the operation of Part IVA.

In the context of applying the eight factors in paragraph 177D(b) to this scheme, the following observations are made:

§ The scheme involves you using the LOCs to pay interest on all rental loans and portion of balance outstanding on your VISA card attributable to the rental property expenses, whilst depositing all rental income (including the Trust rental income) into your home loan. Further, you will not make any repayments on the LOCs until your home loan is paid off. Interest on the LOCs will thereby be capitalised and compounded. The effect is the deferral of the payment of interest on all rental loans in order to enable the repayment of an equivalent amount on your home loan.

§ The manner in which the scheme in question is entered into or carried out is explicable only by the taxation consequences. For instance, apart from the purported availability of additional tax deductions, it makes no financial sense to, in effect, fund repayments on a borrowing for the home using the LOCs and at a higher rate of interest.

§ The effect and substance of the scheme is that the borrowings under the LOCs are financing additional repayments on the home loan, on which interest is not deductible, that you would otherwise not be able to make.

§ The scheme will only last for the period during which the balance on your home loan on which interest is not deductible is outstanding. Once you repay your home loan, you will revert to making the payments on all rental loans and balance outstanding on your VISA card out of the income flows available to you.

§ Apart from the purportedly availability of additional tax deductions, your financial position under the scheme is no better, and possibly worse given the higher rate of interest on the LOCs, than it would be compared with what you would reasonably be expected to have done if you had not carried out the scheme.

§ The total interest deductions available to you under the scheme are greater than the deductions you might reasonably be expected to be entitled to if you hadn't entered into the scheme. That is, if you hadn't entered into the scheme, you would reasonably be expected to be entitled only to interest deductions on your rental loans.

§ The availability of these additional tax deductions for interest under the scheme could significantly reduce the income tax payable by you in each of the income years of the relevant period.

Accordingly, it is open for a reasonable person to conclude (and the Commissioner is satisfied) that you entered into or carried out the scheme, or part of 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, and would, make a determination under paragraph 177F(1)(b) that the whole of the deduction for your share (50%) of interest that accrues on the LOC1 shall not be allowable to you in each of the relevant income years of the relevant period.

Should you show that you are otherwise entitled to a deduction for any amount of interest on the LOC2, the Commissioner would also be entitled to, and would, make a determination under paragraph 177F(1)(b) that the whole of that deduction shall not be allowable to you in each of the relevant income years of the relevant period.

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