Edited version of private advice

Authorisation Number: 1052190305001

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Date of advice: 8 November 2023

Ruling

Subject: Derivation of interest income out of an agreement with a body corporate

Question 1

Will you derive any interest income under section 6-5 of the Income Tax Assessment Act 1997 from an agreement entered into with the relevant body corporate as part of a loan product offered by a Financial Institution?

Answer

No.

Question 2

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997, for the lump sum payment you make to the relevant body corporate pursuant to an agreement under the loan product offered by a Financial Institution, in the income year you make that lump sum payment?

Answer

Yes.

This ruling applies for the following periods:

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

The scheme commenced on:

DD MM 20XX

Relevant facts and circumstances

Background

You are or expect in the future to be a participant in a loan product offered by a Financial Institution, which is a financing arrangement for strata body corporates that require funds to conduct rectification work on common properties within their strata plan.

Common properties within strata plans are legally owned by relevant body corporates.

Any rectification work in respect of building defects encompasses work on the common property which is held by the relevant body corporate on behalf of the proprietors within the strata plan at the relevant time.

Strata Levy System

Strata Law is the law applicable in the relevant Australian state or territory that applies to the management of body corporates.

The Levy System is the procedures to be followed under the applicable Strata Law applying to the particular state or territory under which a levy is imposed upon a proprietor.

Strata Law stipulates that proprietors must be charged levies consistently in accordance with the Levy System, typically in direct proportion to each proprietors' ownership stake in the relevant body corporate.

A restriction of the Levy System is that it does not provide flexibility to individual proprietors in how they each fund their respective share of the rectification work cost. Where the rectification work cost exceeds the body corporate's existing available funds, the two funding choices available to the body corporate are:

• The body corporate charges each proprietor a one-off levy for their share of the rectification work; or
• The body corporate takes out a strata loan, and then charges each proprietor an ongoing levy to cover the principal and interest loan repayments over the life of the loan.

In many cases there are two cohorts of owners in a strata plan building:

• Those owners who have surplus funding available, and wish to pay a one-off levy so as to avoid paying interest on a strata loan (Self-Funding Owner or SFO); and
• Those owners who do not have surplus funding available, and have no ability to pay a one-off levy and therefore want/need to utilise a strata loan (Non-SFO).

In the absence of a solution, the outcome has historically been one of the following:

• A consensus cannot be reached amongst the owners on how to fund the rectification work cost, meaning the works are delayed and/or scope of works is reduced and/or the works are not completed at all, with associated health and safety consequences, insurance implications etc; or
• A one-off levy is approved, resulting in some owners who cannot afford to pay this levy being forced to sell their apartment; or
• A strata loan is approved, resulting in some owners who have surplus funds available paying interest on a strata loan when they don't need a loan.

The Loan Product

A Financial Insitution has developed a product to overcome the restrictions imposed by the relevant Levy System. This can be broadly set out as below:

• The Financial Insitution lends money to the body corporate to enable the body corporate to finance the rectification work cost (Rectification Loan). Repayments on this Rectification Loan are interest only for the term of this loan, and interest levies are charged to all proprietors to meet the loan repayments during this period.
• At the completion of rectification work, the Rectification Loan is refinanced into the Loan Product. This is achieved by having two cohorts of loans:
  • The Financial Institution arranges for those proprietors within the relevant strata plan who wish to self-fund their proportionate cost of the rectification work (SFOs) to pay the respective body corporate their proportionate part of the rectification work cost by way of a loan (SFO Loan). These SFO Loans are made pursuant to the terms and conditions of the SFO Agreement, between the body corporate and the SFO. The funds received by the body corporate repay that proportionate part of the Rectification loan as is applicable to the SFOs; and
  • The Financial Institution refinances that part of the Rectification Loan for the Non-SFOs who do not wish and/or do not have the financial capacity to 'self-fund' their proportionate share of the rectification work (Non-SFO Loan).
• The body corporate under the Levy System charges all proprietors, including the SFOs, levies over the life of the loans (SFO Loan and Non-SFO Loan) to fund the Loan repayments to the Financial Institution.
• The key terms and conditions of the SFO Loans and the Non-SFO Loan are identical, for example length of loan, interest rate, and timing of repayments. These key terms being identical results in the total loan repayments, and the levies required to be charged to the proprietors to cover the loan repayments, being exactly the same regardless of the mix of SFOs Loan amount and the Non-SFO Loan amount.
• The key commercial outcome for SFOs is that the levies they are charged by the body corporate are perfectly offset by the notional loan repayments. The charging of levies and the loan repayments by the body corporate over the life of the loans are notional paper entries only.
• The key commercial outcome for the Non-SFO's is that the levies they are charged by the body corporate are required to be paid to the body corporate, the proceeds of which are utilised by the body corporate to repay the Non-SFO Loan.
• While the body corporate will issue identical levy invoices to all owners, the SFOs' levy invoices will also contain a loan repayment credit such that a nil net amount is due and payable.
• The SFOs will sign the SFO Loan documentation and pay to the body corporate their respective portion of the Rectification Loan (SFO Loan amount) at or as soon as practicable after completion of the rectification project once the total actual cost is known. As such the proportionate part of the Rectification loan as is applicable to the SFOs are immediately repaid in full and no interest (time value of money) will accrue.
• The body corporate will not give any benefit, payment, refund, credit or reimbursement of any kind (financial or otherwise) to the SFOs for agreeing to pay the full amount of the equivalent of the Rectification Loan upfront/early. This is notwithstanding that the other Non-SFO owners have longer to pay their levy amount/s as the levies issue in the future over the life of their loan.

Your circumstances

You are a Committee Member and Owner in a strata scheme.

You own a unit in the strata scheme as an investment property.

You have received rental income from the unit previously, but the unit hasn't been able to be rented out due to the building remediation issue, which will be resolved with the amount you will provide to the body corporate pursuant to the SFO Agreement.

You intend to rent the unit out again in the future after the remediation works are complete.

It is expected the building works in the relevant strata scheme will commence in the near future, to be funded initially by a Rectification Loan provided by the Financial Institution and then refinanced at project completion via the Loan Product.

You have indicated your intention to become an SFO at completion of the project works.

Relevant legislative provisions

Section 6-5 of the Income Tax Assessment Act 1997

Section 8-1 of the Income Tax Assessment Act 1997

Reasons for decision

Issue 1

Question 1

Summary

You will not derive any interest income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) from the SFO Agreement entered into with the relevant body corporate under the Loan Product offered by the Financial Institution.

Detailed reasoning

Section 6-5 of the ITAA 1997 provides that the assessable income of an Australian resident includes all ordinary income derived directly or indirectly from all sources.

Interest income is considered ordinary income for the purposes of section 6-5 of the ITAA 1997 and therefore assessable income.

Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings (TR 98/1) provides the general principles of when interest is derived. At paragraph 47, it states:

47. The general principles is that interest is only derived, or arises, when it is received or credited. This general rule is subject to the overall principle that the appropriate method is that giving substantially correct reflex of income...

For your circumstances, you are a Committee Member and Owner in a strata scheme. The body corporate of the strata scheme is planning to conduct rectification work and finance the rectification cost through the Loan Product. You have indicated your intention to become an SFO at completion of the project works.

You as the SFO, will sign the SFO Loan documentation as part of the Loan Product to pay the body corporate, your respective portion of the Rectification Loan (SFO Loan amount) at or as soon as practicable after completion of the rectification project once the total actual cost is known. The funds received by the body corporate repay that proportionate part of the Rectification loan as is applicable to you as the SFO. At the point in time when you pay the SFO Loan amount, your obligation to pay for the rectification work cost is immediately paid in full and no interest (time value of money) will accrue.

The body corporate will not give any benefit, payment, refund, credit or reimbursement of any kind (financial or otherwise) to you as the SFO for agreeing to pay the full amount of the equivalent of the Rectification Loan upfront. This is notwithstanding that the other Non-SFO owners have longer to pay their levy amounts as the levies issue in the future over the life of their loan.

The Financial Institution developed the Loan Product to overcome the restrictions imposed by the relevant Levy System whereby all proprietors within a Strata scheme must be charged levies consistently in accordance with the Levy System, typically in direct proportion to each proprietors' ownership stake in the relevant body corporate. In other words, for the body corporate to charge interest levies to Non-SFOs who have the obligation to pay interest on their proportionate part of the Rectification loan funded by way of Non-SFO Loan taken out by the relevant body corporate, all SFOs within the strata scheme would also need to be charged interest levies.

The sole reason for an SFO to enter into the SFO Loan agreement with the relevant body corporate is to allow the body corporate to set up a mechanism whereby the body corporate charges all proprietors within a strata scheme, including the SFOs, levies over the life of the loans (SFO and Non-SFO Loan) to fund the Loan repayments without requiring further financial contributions from the SFOs. This mechanism recognises that the SFO Loan amount and the SFO's obligation to pay for the rectification work cost has been repaid in full at the time the SFO Loan amount is provided to the relevant body corporate.

The key commercial outcome for SFOs by entering into the SFO Loan agreement is that the levies they are charged by the body corporate are perfectly offset by the notional loan repayments. The charging of levies and the loan repayments by the body corporate over the life of the loans are notional paper entries only.

These notional entries are required to reflect equal treatment of all proprietors, even though the SFOs within the strata scheme will have already prepaid in full. In this way the levies will be shown for SFO proprietors as credits (with no amount to pay). These credits on the levies do not mean that a further physical amount will be paid to the SFO but are to recognise their prepayment.

As specified in TR 98/1, interest is only derived, or arises, when it is received or credited. For your case, interest will only be derived by you from the SFO agreement you enter into with the relevant body corporate when an amount over and above what you have paid as your proportionate part of the rectification work cost is received by you or credited to you.

The SFO Loan amount you will provide to the body corporate, while called a loan amount, represents the principal levy amount you would be charged by the relevant body corporate to repay your proportionate part of the Rectification Loan amount. When the SFO Agreement is signed and the SFO Loan amount is provided by you to the body corporate, the body corporate utilises that fund to repay the Financial Instution your proportionate part of the Rectification Loan amount.

There is no principal amount for interest (time value of money) to accrue on any underlying amount payable. You have paid your full obligation to any loan and interest upfront. Therefore, despite the notional paper entries representing charging of levies and receiving of loan repayments, the purpose of these entries and execution of SFO Loan agreement is for the purpose of establishing mechanism for the body corporate to comply with relevant Levy System and you will not derive any interest income under section 6-5 of the ITAA 1997 from the SFO Agreement you will enter with the relevant body corporate under the Loan Product offered by the Financial Institution.

Question 2

Summary

You are entitled to a deduction under section 8-1 of the ITAA 1997, for the lump sum payment you make to the relevant body corporate pursuant to the SFO Agreement under the Loan Product offered by the Financial Institution, in the income year you make that lump sum payment.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for 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.

Taxation Ruling TR 97/7 Income Tax: section 8-1 - meaning of 'incurred' - timing of deductions (97/7) sets out the Commissioner's view on timing of deductions. It provides that while there is no statutory definition of the term 'incurred', as a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape.

For your circumstances, you own a unit in a strata scheme as an investment property. You have received rental income from the unit previously, but the unit hasn't been able to be rented out due to the building remediation issue, which will be resolved with the amount you will provide to the body corporate pursuant to the SFO Agreement. You intend to rent the unit out again in the future after works are completed.

As established in question 1, the SFO Loan amount you pay to your body corporate represents the principal levy amount you would be charged by the body corporate to repay your proportionate part of the Rectification Loan amount. As you hold the unit in the strata scheme as an investment property and intend to rent the unit out again in the future, the SFO Loan amount you will provide upon signing the SFO Loan Agreement is an outgoing you will incur in gaining or producing assessable income. The SFO Loan amount you will incur is not of a capital, private or domestic nature.

Upon execution of the SFO Loan agreement, you will pay the SFO Loan amount to the body corporate as a lump sum payment. You will incur the expenses at the time you make that lump sum payment.

Therefore, you will be entitled to a deduction under section 8-1 of the ITAA 1997, for the lump sum payment you make to the relevant body corporate pursuant to the SFO Agreement under the Loan Product offered by the Financial Institution, in the income year you make that lump sum payment.

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