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Ruling

Subject: NRAS Structure

Question 1

Is the interest payable on an Investment Loan allowable as an income tax deduction to the Taxpayer?

Answer

Yes

Question 2

Is the Loan Establishment Fee payable on an Investment Loan allowable as an income tax deduction to the Taxpayer?

Answer

Yes

This ruling applies for the following periods:

Year ending 30 June 2012

Year ending 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

Year ending 30 June 2017

The scheme commences on:

1 May 2012

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.

1. The National Rental Affordability Scheme was established to encourage investment in affordable housing stock by offering a National Rental Incentive (Incentive) to providers of new rental dwellings.¹ The objectives of the NRAS include encouraging large-scale investment in and innovative delivery of affordable housing.

2. The Incentive comprises a Federal Government contribution in the form of a refundable tax offset for each dwelling provided and a State or Territory Government contribution in the form of a cash payment per dwelling. The entitlement to the Federal tax offset is the subject of Division 380 of the Income Tax Assessment Act 1997 (ITAA 1997). The State/Territory payment is non-assessable non-exempt income of the entity deriving the payment: section 380-35 of the ITAA 1997.

3. A pre-condition of entitlement to Incentive is the issue of a certificate by the Federal Housing Secretary to an NRAS Approved Participant, which is the entity primarily responsible for ensuring compliance with the provision of dwellings under the NRAS and the other NRAS statutory requirements (such as reporting and record-keeping). However, Division 380 provides that the entitlement to the tax offset may pass to other entities, including investors in consortiums established for the purpose of participating in the NRAS or who otherwise derive the rental amounts from NRAS dwellings indirectly through trusts or partnerships.

4. The transaction will be undertaken:

a. the Investor will acquire Units in a Trust, funded by a limited recourse loan (Investment Loan) made available by the Lender

b. the Investor must pay to the Lender interest on the loan (in advance) and a Loan Establishment Fee

c. Investors on the register of the Trust at the end of the income year will be presently entitled to all of the net income of the Trust. A distribution of the income of the Trust will be made at the end of the income year

d. on or around 30 June, the Investor will redeem their Units and apply the funds from the redemption of the Units to repay their Loan.

5. As a consequence of their investment in the Trust the Investors will also become entitled to the Federal tax offsets.

6. Based on figures and worked examples supplied, the aggregate of the interest expense and Loan Establishment Fee will exceed the aggregate of the distribution on the Units and the Federal tax offset.

Assumptions

The ruling is made on the basis of the following assumptions:

(a) the taxpayer is not a trader in investments and is not treated for taxation purposes as trading in interests in the Trust, carrying on a business of investing in the Trust, or holding their interests in the Trust as trading stock or as a revenue asset;

(b) all dealings between the taxpayer the Lender will be at arm's length;

(c) the Investment Loan will not extend beyond its original maturity date;

(d) the taxpayer will not repay the Investment Loan prior to their maturity or terminate the scheme early; and

(e) that taxpayer will be presently entitled to, and will have a vested and indefeasible interest in, the income of the Trust.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997

Section 25-25 of the Income Tax Assessment Act 1997

Division 247 of the Income Tax Assessment Act 1997

Subdivision H of Division 3 of Part III of the Income Tax Assessment Act 1936

Reasons for decision

Question 1

Is the interest payable on an Investment Loan allowable as an income tax deduction to the Taxpayer?

Summary

Yes, the interest on the Investment Loan is deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), subject to the application of Division 247 of the ITAA 1997.

Detailed reasoning

Section 8-1

1. Section 8-1 of the ITAA 1997 governs the deductibility of the interest expense on the Loan. The interest expense is incurred by the Investor in gaining or producing assessable income, being the distribution on the Units for the purposes of subsection 8-1(1) of the ITAA 1997.

2. Fletcher & Ors v FCT 91 ATC 4950 and Taxation Ruling TR 95/33 state that where there is a disproportion between interest expense and income produced an apportionment of outgoings may be appropriate, depending upon the extent to which the expenditure is devoted to the gaining or producing of assessable income.

3. Under the NRAS Structure, the Investor's share of the income of the Trust (disregarding tax offsets that arise under Division 380 of the ITAA 1997) is expected to be less than the interest expense on the Loan. However, the share of income plus tax offsets should be greater than the interest expense.

Taxation Determination TD 1999/33

4. In Taxation Determination TD 1999/33 in relation to tax offsets under the Land Transport Facilities rules in Division 396 of the ITAA 1997, the Commissioner stated that a deduction for funding costs would be allowed in full where the taxpayer was in a cash positive position "inclusive of the amount of the tax offset."

5. The transaction described in TD 1999/33 and the general operation of Division 396 of the ITAA 1997 is different in some respects to the present Loan and Division 380 of the ITAA 1997. However, similar to Division 380 of the ITAA 1997 (and unlike Division 207 of the ITAA 1997 in relation to franking credits), the operative provisions of Division 396 of the ITAA 1997 create an entitlement in a taxpayer to tax offsets without a provision expressly "grossing up" the assessable income of the taxpayer. A similar approach should be taken in the present circumstances. That is, the Division 380 of the ITAA 1997 tax offsets should be taken into account in considering whether the Investor is in a "cash positive" position.

Division 247

6. Section 247-10 of the ITAA 1997 describes when a borrowing under an arrangement satisfies the requirements as a capital protected borrowing. Subsection 247-10(1) of the ITAA 1997 states:

An *arrangement under which a *borrowing is made, or credits is provided, is a capital protected borrowing if the borrower is wholly or partly protected against a fall in the *market value of thing (the protected thing) to the extent that:

(a) the borrower uses the amount borrowed or credit provided to acquire the protected thing; or

(b) the borrower uses the protected thing as security for the borrowing or provision of credit.

Subsection 247-10(2) of the ITAA 1997 states:

That protection is called capital protection.

7. Division 247 applies to the Loan as:

(a) the investor uses the Loan from the Lender to acquire Units; and

(b) the investor is protected against the fall in the market value of those Units.

8. Under the scheme, the amount reasonably attributable to the cost of capital protection afforded by the limited recourse loan is worked out according to the method statement in subsection 247-20(3) of the ITAA 1997. This amount is treated as the cost of the Investor's Put Options under subsection 247-20(6) of the ITAA 1997.

9. Under subsection 247-20(3), the amount reasonably attributable to the cost of capital protection in an income year is the amount by which the interest charge under the Loan exceeds:

· where interest is charged on the Loan from the Lender at a fixed rate for all or part of the term of the Loan and that fixed rate is applicable to the Loan for all or part of the income year, the amount of the Loan multiplied by the sum of the Reserve Bank of Australia's Indicator Lending Rate for Standard Variable Housing Loans and 100 basis points (the 'adjusted loan rate') at the time when the interest charge is first incurred during the term of the Loan, or the relevant part of the term (subsections 247-20(4) and (5)); and

· where interest is charged on the Loan from the Lender at a variable rate for all or part of the term of the Loan and a variable rate is applicable to the Loan for all or part of the income year, the amount of the Loan multiplied by the average of the adjusted loan rates applicable during those parts of the income year when the Loan is at a variable rate (subsections 247-20(5) and (5A)).

10. For an Investor in the scheme, a Put Option is a capital asset. As the cost of capital protection is the cost of the Investor's Put Options, this expense is capital in nature. The interest charged on the loan will be deductible under section 8-1 only to the extent that it does not constitute the cost of capital protection.

Subdivision H of Division 3 of Part III

11. Subdivision H of Division 3 of Part III of the ITAA 1936 (Subdivision H) deals with the timing of deductions for certain advance expenditure incurred under an arrangement in return for the doing of a thing under that agreement that will not be wholly done within the same year of income. Separate rules apply depending on whether the expenditure is incurred in carrying on a business, whether the Investor is a small business entity, whether the employee is an individual and whether the Investor is not an individual and incurs the expenditure otherwise than in carrying on a business. This Subdivision does not apply to 'excluded expenditure' which is defined in subsection 82KZL(1) of the ITAA 1936 to include amounts of less than $1,000 or amounts that are of a capital nature.

12. The term of the Investment Loan will be from 1 June 2012 to 30 June 2012. On or around 1 June 2012, the Investor will prepay their interest for the period from 1 June to 30 June. On 30 June 2012, the Investor will redeem their units in the trust and use the proceeds to repay their Investment Loan.

The eligible service period for the purposes of Subdivision H

13. The interest paid in advance on the Investment Loan is in relation to a prepayment of interest for a period that is 12 months or less. Paragraph 82KZL(2)(a) of the ITAA 1936 provides that a payment of interest that is made in return for the making available of a loan principal is to be taken, for the purposes of Subdivision H, to be expenditure incurred under an agreement in return for the doing of a thing under the agreement for the period to which the interest payment relates. The eligible service period in relation to a payment of loan interest is determined by reference to the period to which the interest relates, which is 1 June 2012 to 30 June 2012. Therefore Subdivision H will not apply to apportion the interest paid in advance on the Investment Loan.

Sections 82KZME and 82KZMF - prepaid expenditure and 'tax shelter' style arrangements

14. The rules in sections 82KZME and 82KZMF of the ITAA 1936 apply, subject to the exceptions in section 82KZME of the ITAA 1936, where expenditure is incurred in relation to a 'tax shelter' style arrangement for the doing of a thing that is not to be wholly done within the expenditure year.

15. For the purposes of section 82KZME of the ITAA 1936, 'agreements' are broadly defined to include an entire arrangement of which a contract may form part. Under subsection 82KZME(4) of the ITAA 1936, the relevant 'agreement' is all the contractual arrangements and activities associated with the participation in the scheme, including the financing, share and/or unit purchase, share and/or unit holding and disposal arrangements.

16. As the loan is provided and repaid within the same income year, the doing of the thing is done wholly within the expenditure year. Accordingly, sections 82KZME and 82KZMF of the ITAA 1936 do not apply to an Investor in the NRAS Product.

17. Deductibility of the prepaid interest must therefore be considered under the prepayment rules.

Section 82KZM - prepaid expenditure incurred by certain small business entities and individuals incurring non-business expenditure

18. Section 82KZM of the ITAA 1936 operates to spread over more than one income year a deduction for prepaid expenditure incurred by a taxpayer that is either:

· a small business entity for the year of income that has not chosen to apply section 82KZMD of the ITAA 1936 to the expenditure; or

· is a taxpayer that is an individual and the expenditure is not incurred in carrying on a business.

19. The expenditure must not be excluded expenditure and must be incurred otherwise than in carrying on a business. Section 82KZM of the ITAA 1936 applies if the eligible service period for the expenditure is longer than 12 months, or the eligible service period for the expenditure is 12 months or shorter but ends after the last day of the year of income after the one in which the expenditure was incurred and the expenditure would otherwise be immediately deductible under section 8-1 of the ITAA 1997.

20. As the eligible service period is not longer than 12 months and does not end after the last day of the year of income after the one in which the expenditure was incurred, section 82KZM of the ITAA 1936 has no application to Investors.

21. As a result, Investors should be able to claim an immediate deduction, under section 8-1 of the ITAA 1997, for the interest expense incurred under the Investment Loan.

Question 2

Is the Loan Establishment Fee payable on an Investment Loan allowable as an income tax deduction to the Taxpayer?

Summary

Yes, the Loan Establishment Fee will be deductible under section 25-25 of the ITAA 1997 as it is incurred for borrowing money that is used solely for income producing purposes. As the period of the loan is less than one year, the deduction is allowed in the income year in which the Loan Establishment Fee is paid.

Detailed reasoning

1. Subsection 25-25(1) of the ITAA 1997 provides that:

You can deduct expenditure you incur for * borrowing money, to the extent that you use the money for the * purpose of producing assessable income. In most cases the deduction is spread over the * period of the loan.

2. The Explanatory Memorandum to the Tax Laws Improvement Act 1997 (121 of 1997) notes that the words 'to the extent that' in section 25-25 of the ITAA 1997 refers to the 'use' to which the borrowed money is put. Where the borrowed money is used partly for a non-income producing purpose, it is necessary to apportion the deduction claimed for the Loan Establishment Fee. This interpretation is supported by the decision in Ure v. F.C. of T 81 ATC 4100.

3. In the present case, the investment loan is used solely to acquire units in the Trust. The Loan Establishment Fee is therefore deductible to the Investor under section 25-25 of the ITAA 1997 as expenditure incurred by the Investor for borrowing money, on the basis that the Investor uses those borrowed funds for the purpose of producing assessable income, being the assessable distributions from the Trust.

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