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Ruling

Subject: NRAS Product

Question 1

Is the interest payable on the Loan allowable in full as an income tax deduction to the Investor under section 8-1 of the Income Tax Assessment Act 1997 (the ITAA 1997)?

Answer

No. The interest payable on the Loan will be deductible up to the amount of cash received by the Investor under the Product, being the Investor's share of net income of the Trust plus the Investor's share of tax offsets that arise under Division 380 of the ITAA 1997.

Question 2

Does Part IVA of the Income Tax Assessment Act 1936 (the ITAA 1936) apply to deny the Investor a deduction for the deductible interest expense on the Loan?

Answer

No.

This ruling applies for the following periods:

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 2013

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. The scheme is ascertained from your private ruling application. 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.

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.The objectives of the NRAS include encouraging large-scale investment in and innovative delivery of affordable housing.

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 or an in-kind payment per dwelling. The entitlement to the Federal tax offset (the Division 380 tax offsets) is the subject of Division 380 of the Income Tax Assessment Act 1997 (the 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.

A pre-condition of entitlement to the 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 of the ITAA 1997 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.

The Product consists of only a loan and acquisition of units in a trust. The transactions will be undertaken:

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

· the Investor must pay to the Lender interest on the Loan (in advance);

Investors on the register of the Trust immediately before the end of the relevant 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 immediately before the end of that income year;

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

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

The interest expense payable by the Investor on the Loan is expected to exceed the aggregate of the income distribution on the Investor's Units and the Federal tax offsets.

The transaction steps are intended to be repeated each year for the duration of the relevant consortium agreement.

Assumptions

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

The Investor 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;

· all dealings between the Investor and all members of the Issuer's group will be at arm's length;

· the Loan will not extend beyond its original maturity date;

The Investor will not repay the Loan prior to its maturity or terminate the scheme early;

The Investor will be presently entitled to, and will have a vested and indefeasible interest in, a share of the income of the Trust in the relevant income year;

That the Approved Participant will make the relevant election pursuant to section 380-11 of the ITAA 1997, and as such, the trustee of the Trust will be deemed to have been issued with the NRAS certificate and the tax offsets will ultimately flow through to the Investor, as a Unitholder.

Relevant legislative provisions

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Question 1

Is the interest payable on the Loan allowable in full as an income tax deduction to the Investor under section 8-1 of the Income Tax Assessment Act 1997 (the ITAA 1997)?

Summary

No. The interest payable on the Loan will be deductible up to the amount of cash received by the Investor under the Product, being the Investor's share of net income of the Trust plus the Investor's share of tax offsets that arise under Division 380 of the ITAA 1997.

Detailed reasoning

Section 8-1

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 income distribution on the Units for the purposes of paragraph 8-1(1)(a) of the ITAA 1997.

Fletcher & Ors v FCT 91 ATC 4950 and Taxation Ruling TR 95/33 state that if an outgoing produces no assessable income, or the amount of the assessable income is less than the amount of the outgoing, then it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is wholly or partly deductible.

The approach outlined in Fletcher and Taxation Ruling TR 95/33 was also reflected in Taxation Determination TD 1999/33, where the Commissioner indicated that where a Land Transport Facilities (LTF) lender is in a cash negative position (inclusive of the tax offset) then deductions in respect of their own funding cost may be reduced. Under the Product, the Investor's share of the net income of the Trust (including cash distributions and the tax offsets under Division 380 of the ITAA 1997) is expected to be less than the interest expense payable by the Investor on the Loan.

An investment in the Product is structured to run for a pre-ordained period of time and provide a benefit to the Investor that includes the availability of tax deductions. The Investor will be in a cash negative position (inclusive of the amount of the tax offset) and therefore deductions for interest incurred on the Loan are reduced. The Investor will only be allowed a deduction for interest up to the amount of cash received by the Investor under the Product, being the sum of the Investor's share of net income of the Trust and the Investor's share of tax offsets that arise under Division 380 of the ITAA 1997. Note: Upon the disposal of the Investor's Units, the un-deducted portion of the interest payable under the Loan will not increase a capital loss where the capital proceeds are less than the reduced cost base for those Units: see subsections 110-25(4) and 110-55(3) of the ITAA 1997.

Division 247

Division 247 of the ITAA 1997 is designed to apply to capital protected borrowings where an amount charged as interest is, in substance, paid for capital protection. Subject to the exclusions in section 247-15 of the ITAA 1997, capital protection provided under a relevant capital protected borrowing to the extent that it is not provided by an explicit put option is treated (for the borrower) as if it were a put option. An amount attributable to capital protection under any relevant capital protected borrowing is treated (for the borrower) as a payment for a put option.

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 option under subsection 247-20(6) of the ITAA 1997.

Under step 1 of the method statement in subsection 247-20(3) of the ITAA 1997, the Investor is required to work out the total amount incurred by the borrower under or in respect of the capital protected borrowing for the income year, ignoring amounts that are not in substance for capital protection or interest.

As the capital protected borrowing is at a fixed rate, the amount reasonably attributable to the cost of capital protection in an income year is the amount by which the step 1 amount exceeds 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) of the ITAA 1997).

For the Investor, a put option is a capital asset. As the cost of capital protection is the cost of the Investor's put option, this expense is capital in nature.

Under the NRAS Product, the borrowed money is invested in the Trust; these funds are subsequently placed by the responsible entity of the Trust on deposit in an interest bearing account. The deposited funds represent the entirety of the Investor's investment which has simply been placed in interest bearing account issued by an Authorised Deposit taking Institution who is part of the same economic group as the entity that has lent funds to the Investor.

As the likelihood that the responsible entity's investment in the interest bearing account is at risk is minimal, especially an investment for such a short time period of time (the expected period of time in which the funds are expected to be invested in the interest bearing account is on, or near to 30 days) it is considered that, in substance, the interest charged (in whole or in part) does not represent the cost of providing capital protection to the Investor¹.

Therefore to the extent that interest expenditure exceeds 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, in an income year, during the term of the Loan (subsections 247-20(4) and (5) of the ITAA 1997), it must be ignored for the purposes of calculating the cost of capital protection under the method statement in Division 247 of the ITAA 1997.

Question 2

Does Part IVA of the Income Tax Assessment Act 1936 (the ITAA 1936) apply to deny the Investor a deduction for the deductible interest expense on the Loan?

Summary

No.

Although an Exposure Draft of legislation to amend Part IVA of the ITAA 1936 has been released and it is intended the amendments will apply in relation to schemes that were entered into or that were commenced to be carried out, on or after 16 November 2012, the amendments have not yet received Royal Assent. In accordance with Law Administration Practice Statement PS LA 2004/6, the ATO is not permitted to provide advice on legislation prior to its Royal Assent. Accordingly, this Ruling has been prepared on the basis of the provisions of Part IVA of the ITAA 1936 as currently enacted. The legislative amendments to Part IVA of the ITAA 1936, if enacted, may affect the advice provided in this Ruling. Subject to this necessary qualification, provided that the arrangement ruled on is entered into and carried out as disclosed (see the Relevant facts and circumstances part of this Ruling), it is accepted that Part IVA of the ITAA 1936 will not apply.

Detailed reasoning

Had the relevant scheme not been entered into the Issuer would not, or it could reasonably be expected that the Issuer would not, provide the taxpayer with a comparable investment.

Except to the extent any deduction is already limited by the principles set out in Fletcher and Taxation Ruling TR 95/33, the deduction for interest on the Loan is potentially a "tax benefit" under paragraph 177C(1)(b) of the ITAA 1936. This is because absent the Scheme, any such deduction would not be allowed, or might reasonably be expected not to be allowed.

Weighing each of the factors in applying the applicable purpose test

The Commissioner is required to consider the application of Part IVA of the ITAA 1936 on the facts and circumstances of the particular scheme where, having regard to all of the matters set out in paragraph 177D(b) of the ITAA 1936, it would be concluded that a person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the taxpayer (or the taxpayer and another taxpayer or other taxpayers) to obtain a tax benefit in connection with the scheme.

The purposes of any relevant taxpayer in entering into the scheme would include a profit making purpose, a purpose of accessing the Federal tax offsets and a purpose of enabling the Investor to obtain a tax benefit. The question is whether the purpose of enabling the Investor to obtain a tax benefit is the sole or dominant purpose.

Certain features of significance relating to the NRAS Product are considered to support the requisite purpose under Part IVA of the ITAA 1936. These features include the short duration of the investment in the NRAS Product; the highly structured nature of the arrangements comprising the NRAS Product; and the Investor's lack of exposure to any risk associated with an NRAS property through lack of any investment in any underlying NRAS properties. These matters appear to support a conclusion that at least a significant purpose of the Investor's participation in the Product was to access the further tax benefits arising from the interest deduction.

However, there are other matters which may be taken into account. As set out above, the operation of section 8-1 of the ITAA 1997 (leaving aside Part IVA of the ITAA 1936) would result in the Investor obtaining only a partial deduction for interest on the Loan. The Investor would include in their assessable income their share of net income of the Trust (which is expected to be relatively small) and would become entitled to the Division 380 of the ITAA 1997 tax offsets (which are not of themselves defined as "tax benefits" for purposes of Part IVA of the ITAA 1936). The distribution of net income from the Trust together with the amount of the Division 380 of the ITAA 1997 tax offset will not be less than that deductible interest expense.

In weighing up the relevant matters set out in paragraph 177D(b) of the ITAA 1936, the ATO has concluded that provided that the arrangement ruled on is entered into and carried out as disclosed (see the Relevant facts and circumstances part of this Ruling), it will not seek to apply Part IVA of the ITAA 1936.

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