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Ruling

Subject: Rental property

Question 1

Is the rental income assessable in the year of receipt?

Answer

Yes.

Question 2

Is a deduction allowed for the property expenses incurred where no rental income has been derived in that year?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 2009

Year ending 30 June 2010

Year ending 30 June 2011

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

The scheme commenced on

I July 2008

Relevant facts

Entity A acquired an investment property.

The property was available for rent and rented out for approximately less than ten months.

After that, a relation moved into the property and is currently the tenant in the property.

As a result of the global financial crises, the tenant's personal wealth was significantly reduced and they sought rental relief from entity A.

The relief from rent was sought to minimise the crystallisation of significant losses which would arise if they were to sell assets to fund the payment of rent.

Entity A is proposing to agree to the rental relief on the basis that a rental amount 50% higher than the current market value will be payable at a future point in time. However this rent will not be immediately payable.

The accumulated amount will not be immediately due for payment and will not be payable until either the occurrence of the tenant's departure from the property or death or incapacity, whichever occurs first. Rent will also be paid if the value of the assets improved sufficiently.

Entity A has not received any rental income from this tenant.

Entity A currently and will continue to incur costs relating to the operation and maintenance of the property. These costs include interest, rates, insurance, repairs and other incidental costs.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Assessable income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Rent is regarded as ordinary income and assessable under subsection 6-5(2) of the ITAA 1997.

Taxation Ruling TR 98/1 sets out the Commissioner's policy on the derivation of income. Where income is earned in one year but received in another, it is necessary to determine when income is derived.

Paragraph 48 of TR 98/1 states that rent is generally assessable when received or applied at your direction. That is, rent is assessable on receipt even though it may relate to a past or future income period. However, where rent is business income, the earnings method may be appropriate in determining when the income is derived.

In this case, entity A is not currently receiving any rental income from the tenant. Rental income will be received upon the occurrence of a specified event. It is not considered that the rent income to be received is business income.

It is therefore considered that the rent is derived and assessable when received.

Where entity A does not receive any rental income in an income year, no rental income is included in the assessable income for that year. Where the rent is received in a later income year, then the rental income will be assessable in that year.

Allowable deductions

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

§ it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478, 

§ there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47 (Ronpibon's case) , and

§ it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Taxation Ruling IT 2167 examines the situation where a property is let to relatives and non arms length transactions. Where a property is let to relatives, the essential question is whether the arrangements are consistent with normal commercial practices. Where the arrangement is not at arms length, an apportionment of losses and outgoings incurred is generally required. Although the ruling mainly focuses on rent let at less than commercial rent, the principles are also relevant in this case.

The test that should be considered to show whether the arrangement is at arms length, is whether a reasonable person with no relationship to either party would enter into this arrangement using exactly the same terms and conditions. If the answer is yes, then it would be an arms length arrangement.

Whether parties are at arm's length in relation to a rental property is a question of fact. The rental amount to be paid by the tenant who is a related party should be indicative of parties acting at arm's length and reflect the commercial and economic standing of the parties.

It is questionable in this case whether entity A would enter into such an arrangement with an unrelated party. Furthermore, the willingness of a tenant to pay 50% more rent than the normal market rate does not reflect a normal commercial arrangement.

Where a tenant does not have the capacity to pay a weekly rent, an unrelated party would not generally let this situation continue indefinitely. Although it is said that the rent will eventually be received, it is considered that the arrangement is not at arm's length and not commercially realistic.

Although a written agreement is being prepared, this does not change the arrangement to being commercially realistic.

Taxation Ruling TR 95/33 considers the deductibility and apportionment of losses and outgoings where expenses are incurred for dual purposes. TR 95/33 states that if an outgoing produces an amount of assessable income greater than the amount of the outgoing, there would normally be no need to examine the taxpayer's motives and intentions when determining the deductibility of the expenditure.

However, if the outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is wholly deductible. This may, depending on the circumstances of the particular case, include an examination of the taxpayer's subjective purpose, motive or intention in making the outgoing.

If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective (for example, to derive exempt income or derive income for another entity or the obtaining of a tax deduction), then the outgoing must be apportioned between the pursuit of assessable income and the other objective: see Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 (Fletcher's case).

In Ure v Federal Commissioner of Taxation 81 ATC 4100 (Ure's case) the derivation of assessable income was not the sole purpose of the loan, and a deduction was only allowed up to the amount of assessable income.

In Case 26/94 94 ATC 258, a director, who borrowed money to on-lend to his family company that had no capacity to borrow in its own name, was denied a deduction for interest as the purpose of the loan was to assist the company in avoiding liquidation. The connection between the lending and the derivation of future income by the director was too remote.

Although the above circumstances are different to the Trust's circumstances, the principles are relevant.

In this case, the amount of assessable income derived from the property for several years is nil. This differs from the facts in Bocaz v Federal Commissioner of Taxation (2012 ATC 10-286) where the taxpayer received weekly rent. It is acknowledged that a commercial arrangement can be made with related parties. However this case is more in line with Ure's case in that the explanation for the nil rent for an extended period lies in the private relationship the parties have. It is not possible to say that the whole of the outgoings have the character of outgoings incurred in gaining or producing assessable income. The explanation is to be found rather in private or non-income earning considerations.

It is considered that entity A has two purposes in entering into the current arrangement - one to derive rental income and another to help out the relation. The purpose of such an arrangement cannot be seen as characterising the expenditure as incurred solely in gaining or producing assessable income. As such, any deduction for the associated expenses incurred will need to be apportioned.

When it is necessary to apportion a loss or outgoing, the appropriate method of apportionment will depend on the facts of each case. However, the method adopted in any particular case must be both 'fair and reasonable' in all the circumstances (Ronpibon's case). In Fletcher's case, it was 'fair and reasonable' to limit the amount of the deduction to the amount of the assessable income actually received in that year.

As in Ure's case and Fletcher's case, it is considered fair and reasonable in your circumstances to allow a deduction up to the amount of assessable income derived. No assessable income has been derived for several years. Consequently no deduction is allowable during the income years where no rent is received.

We acknowledge that a loss or outgoing can be deductible even if it is incurred before the relevant assessable income is derived.

Taxation Ruling TR 2004/4 considers deductions for interest expenses incurred prior to the commencement of income earning activities and the implications of the decision of the High Court in Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's case) as well as the decisions in the Full Federal Court .

Although TR 2004/4 discusses interest expenses, the principles outlined are applicable to other expenses also.

In Steele's case, the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. Taxation Ruling TR 2004/4 concludes that interest incurred in a period prior to the derivation of relevant assessable income will be incurred in gaining or producing the assessable income in the following circumstances:

· the interest is not incurred too soon, is not preliminary to the income earning activities, and is not a prelude to those activities,

· the interest is not private or domestic,

· the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost,

· the interest is incurred with one end in view, the gaining or producing of assessable income, and

· continuing efforts are undertaken in pursuit of that end.

In this case, we acknowledge that entity A purchased an investment property, however the property is not solely used for income producing purposes. The property is currently being used by a relation in a non arms length arrangement. Also continuing efforts are not being made to derive assessable income. The principles of TR 2004/4 therefore have little application in this case. Therefore no deductions are allowable for the income years where no rental income is received.

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