Edited version of your private ruling

Authorisation Number: 1012492926611

Ruling

Subject: rental deductions

Question 1

Is interest incurred on funds borrowed to acquire my spouse’s share of an apartment, which is kept for investment purposes, deductable for income tax purposes?

Answer

Yes

Question 2

To confirm whether the ATO is satisfied that part IVA (anti avoidance provisions) does not apply in my circumstance?

Answer

Yes

This ruling applies for the following period(s)

1 July 2013 – 30 June 2017

The scheme commences on

1 July 2013

Relevant facts and circumstances

You and your spouse have purchased a new property which will become your principal place of residence. You are looking at purchasing your spouse’s share of your current home and leasing the existing property to a third party. You will engage an independent valuer and the transfer will be conducted by a conveyancer who will be formally engaged to facilitate the transfer.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 177A

Income Tax Assessment Act 1936 Section 177C

Income Tax Assessment Act 1936 Section 177D

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Question 1

Is interest incurred on funds borrowed to acquire my spouse’s share of an apartment, which is to be kept for investment purposes, deductable for income tax purposes under Section 8-1 of the Income Tax Assessment Act 1997?

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) states that you can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income except where the loss or outgoing is capital, private or domestic in nature or relates to the earning of exempt income.

Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith states:

General principles governing deductibility of interest

2. The deductibility of a loss or outgoing comprising interest under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) (formerly subsection 51(1) of the Income Tax Assessment Act 1936 ) depends upon satisfying the words of the section, that is, being able to show that the loss or outgoing (or the part of the loss or outgoing in an appropriate case of apportionment) is:

(a)

incurred by the taxpayer in gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature ('first limb'); or

(b)

necessarily incurred by the taxpayer in carrying on a business for the purpose of gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature ('second limb').

3. The cases clearly indicate that whether or not a loss or outgoing incurred by a taxpayer satisfies the requirements of section 8-1 is dependent on all the facts and matters relating to the loss or outgoing incurred by the taxpayer in question. However, the following general principles are relevant to the question whether interest is deductible under section 8-1:

(a)

The interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature. The test is one of characterisation and the essential character of an expense is a question fact to be determined by reference to all the circumstances.

(b)

The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower. However, regard must be had to all the circumstances, including the character of the taxpayer's undertaking or business, the objective purpose of the borrowing, and the nature of the transaction or series of transactions of which the borrowing of funds is an element. In some cases, the taxpayer's subjective purpose, intention or motive may be relevant in deciding the deductibility of interest.

(c)

A tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity. Normally this would be the case for non-business taxpayers. It might also be the case where a business makes a specific borrowing which goes to the structure of the business - for example, where a business makes a large borrowing to fund an offshore acquisition.

(d)

A rigid tracing of the borrowed money will not always be necessary or appropriate (e.g., where the borrowing finances the replacement of funds withdrawn from the business by a person entitled to be paid those funds). In such cases the relevant question is whether borrowed funds are being used to replace another source of funding for business purposes.

(e)

Interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets.

(f)

Interest on borrowings will not continue to be deductible if the borrowed funds cease to be employed in the borrower's business or income producing activity.

(g)

The interest will not be deductible, to the extent to which it is private or domestic in nature, or is incurred in relation to the gaining or production of exempt income.

ATO ID 2001/79 Income Tax Interest expense: Funds Borrowed and Taxation Ruling TR 95/25 provide the Commissioners view regarding the deductibility of interest. The use test is the basic test relied upon to establish the deductibility of interest and looks at the application of the borrowed funds as the main criterion. Accordingly, where borrowed funds are used for income producing purposes the interest on those funds is deductible.

In your situation the interest incurred on borrowed funds used to purchase your spouse's share of a property for the purpose of producing assessable income will be deductible under section 8-1 of the ITAA 1997.

Question 2

To confirm whether the ATO is satisfied that part IVA (anti avoidance provisions) does not apply in my circumstance?

Detailed reasoning

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance provision that can apply in certain circumstances if a tax benefit is obtained in connection with a scheme, and it can be concluded that the scheme, or any part of it, was entered into for the dominant purpose of enabling a tax benefit to be obtained. Part IVA is a provision of last resort.

The application of Part IVA depends on the facts of the particular case.

In order for Part IVA to apply, the following questions must be addressed:

· Is there a scheme as defined by section 177A of the ITAA 1936?

· Is there a tax benefit which was obtained in connection with the scheme as defined by section 177C of the ITAA 1936?

· Is the scheme a scheme to which Part IVA applies, as determined by section 177D of the ITAA 1936, where it would be concluded that your main or dominant purpose of entering into the scheme was to obtain the tax benefit.

Scheme

For Part IVA to apply, the identified scheme must fall within the following wide definition of 'scheme'.

The definition applies to 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 (subsection 177A(1) of the ITAA 1936).

In the present case, there will be a 'scheme' as defined in section 177A of the ITAA 1936, being the following arrangement:

You will purchase your spouses half share of a property using borrowed funds. This property will be rented to a third party.

Tax benefit

The identification of a tax benefit necessarily requires consideration of the income tax consequences, but for the operation of Part IVA, of an 'alternative hypothesis' or a 'counterfactual'. This is what would have happened or might reasonably be expected to have happened if the particular scheme had not been entered into or carried out. This alternative arrangement also forms the background against which the objective ascertainment of the dominant purpose of a person occurs in accordance with section 177D of the ITAA 1936.

Objective purpose test

Section 177D of the ITAA 1936 provides that Part IVA applies to a scheme in connection with which you have obtained a tax benefit if, after having regard to eight specified factors, it would be concluded that a person who entered into or carried out the scheme, or any part of it, did so for the purpose of enabling you to obtain the tax benefit.

Section 177D of the ITAA 1936 refers to 'the purpose' of the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme. The person need not be you.

The objective test in paragraph 177D(b) of the ITAA 1936 is the core of Part IVA and has been described by the High Court as the 'pivot' or 'fulcrum' on which Part IVA turns. It is frequently referred to as the 'statutory predication test'.

The consideration of purpose or dominant purpose under paragraph 177D(b) of the ITAA 1936 requires an objective conclusion to be drawn. The conclusion required by section 177D of the ITAA 1936 is not about a person's actual, i.e., subjective, dominant purpose or motive. It is possible for Part IVA to apply notwithstanding that the dominant objective purpose of obtaining the tax benefit was consistent with the pursuit of commercial gain.

A conclusion about a relevant person's purpose for section 177D of the ITAA 1936 is the conclusion of a reasonable person based on all the facts and evidence that are relevant to considering the eight factors for the scheme. However, not all of the factors will be equally relevant in every case. Provided the eight factors are each taken into account, it is possible to arrive at the conclusion as to purpose by making a global assessment of purpose.

Consideration of the eight factors involves comparison of the scheme with the alternative arrangement. In other words, the conclusion about the dominant purpose of a person entering into or carrying out the scheme, or any part of it, necessarily requires consideration of what may otherwise have occurred.

These eight factors are as follows:

(i) the manner in which the scheme was entered into or carried out

There is no artificiality in the arrangement. The transaction will be at market value and normal duties and other imposts will be incurred. The available interest deduction will be as a result of borrowings to purchase an income producing property, which is a normal commercial practice. It is within normal commercial practice and family dealings for taxpayers to buy and sell properties or otherwise arrange their affairs to improve their tax position. Your assertion that you will deal with the property at arms length and that the interest deduction would be allowable is valid, and a further example of normal commercial practice. This points against the application of Part IVA.

(ii) the form and substance of the scheme

The form is that you will borrow funds to purchase a rental property and will subsequently derive arms length rental income and be entitled to a deduction for interest on the borrowings and other relevant expenses. But because there is no contrivance or artificiality present, the arrangement actually does exactly what it appears to do, and nothing else. The available interest and other deductions occur legitimately as a result of the normal commercial dealing of borrowing to purchase an income producing property. Hence, the substance is consistent with the form. This points against the application of Part IVA.

(iii) the time at which the scheme was entered into and the length of the period during which the scheme was carried out

The timing aspects are not significant to you purchasing a property. Hence, this factor is neutral with regard to the application of Part IVA

(iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by this scheme

The tax result is that you can claim a deduction for interest and other rental expenses in relation to the proposed property but will become liable for capital gains tax on the disposal of that property. In isolation, an enduring tax deduction would point to the application of Part IVA. However, when considered in conjunction with the other factors, this factor is neutral.

(v) any change in the financial position of the relevant taxpayer that has resulted, or will result, or may reasonably be expected to result, from the scheme

As your financial changes are consistent with what would be expected from such an arrangement, this factor is therefore neutral as to the application of Part IVA.

(vi) any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, being a change that has resulted, will result, or may

The financial changes of persons connected to the scheme are consistent with what would be expected from such an arrangement this factor is therefore neutral with regard to the application of Part IVA.

(vii) any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out

The main residence exemption for capital gains tax purposes would not be available to you should the property be sold. There is no indication of any other consequence as a result of you entering into the proposed scheme.

This is consistent with normal practice, this factor is therefore neutral.

(viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in subparagraph (vi)

The connections are outlined at (vi) above. This factor will be neutral with regard to the application of Part IVA.

Conclusion:

All these factors either point against the application of Part IVA or are neutral. Part IVA will therefore not apply to this arrangement

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).