Edited version of private ruling

Authorisation Number: 1011499089305

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Ruling

Subject: capital protected product

1. Does a proportion of the "fixed interest refund" remitted to you following termination of your geared equities' investment need to be returned as income under Division 6 of the Income Tax Assessment Act 1997 (ITAA 1997) for the year ended 30 June 2009?

Yes.

2. Is the "option cost" incurred in breaking the investment deductible under section 25-30 of the ITAA 1997 in the year incurred?

No.

This ruling applies for the following period:

Year ended 30 June 2009

The scheme commenced on:

1 July 2008

Relevant facts:

You invested in a geared equities investment.

The entity lent you a sum of money which was invested in shares. Interest on the loan was prepaid just before the end of the relevant financial year and also during the later financial years.

The product was promoted as being capital guaranteed.

You had concerns over income levels, so you decided to unwind your geared equities prior to the maturity date. You incurred an early termination cost. This cost consisted of:

· One month interest penalty

· Fixed loan break cost

· Option cost.

The option cost can be referred to the cost of protection. The cost of the put option was paid by the entity upfront and amortised over the life of the loan.

The combination of a number of personal events and the potential for reduced future income, led you to unwind the investment and incur the costs of unwinding.

You claimed a proportionate deduction of the interest charged by the entity each year in. As part of the unwinding of the investment, you received a credit from the entity for a refund of fixed interest.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 25-30

Income Tax Assessment Act 1997 Section 247

Income Tax Assessment Act 1997 Section 247-15

Reasons for decision

Subsection 25-30(1) of the ITAA 1997 allows a deduction for an amount incurred to discharge a mortgage that was given as security for the repayment of money used solely for the purpose of producing assessable income.

As a general rule, expenses incurred in discharging a liability which is associated with, or ancillary to, a mortgage will not be deductible.

In this case, you were required to pay a penalty on your investment for an early exit from the scheme. A proportion of the penalty payment is related to the put option.

Is a 'put option' itself a mortgage?

In essence, there are three practical requirements of a mortgage:

· there must be a promise by A to B to repay money or to perform some obligation

· as security for repayment or performance, A must transfer or assign his interest in property to B, and

· the transfer must be subject to the proviso that, if A repays or performs, then B will retransfer or reassign the property to A.

In simple terms a 'put option' is a contract that gives the buyer of the 'put' the right, but not the obligation, to sell something in the future at a pre-determined price. The seller of the 'put' is obligated to buy the thing in question if the buyer exercises the option. The buyer pays a fee or premium to the seller for the option contract.

Clearly, by ordinary definition, a put option is not a mortgage. Whilst the first requirement is arguably satisfied, that there is a promise to repay money or perform some obligation, the last two requirements are absent. There is no transfer or assignment of an interest in property as security for the promise. In the present case, there was no transfer of property as security from the Bank to the Investor. The promise was purchased by the one who is promising. It was simply a contractual obligation to perform in certain circumstances.

Therefore, unless the payment to terminate the put option was considered to be inherently connected with the mortgage, it will not be a payment incurred to discharge a mortgage for the purposes of section 25-30 of the ITAA 1997.

Analogy with penalty interest

An amount paid to terminate the put option in circumstances such as the present may be considered to be analogous with an amount paid by way of 'penalty interest'.

Generally speaking, provided loan moneys were borrowed for the purpose of gaining or producing assessable income, penalty interest payable on early repayment of the loan will be deductible under section 8-1 of the ITAA 1997, unless it is of a capital nature.

Taxation Ruling TR 93/7 deals with the deductibility of penalty interest payments. It indicates that penalty interest is not considered to be in the nature of interest. It is not paid for the use of the lender's money. It is paid in respect of a period when the borrower has repaid the loan and does not have the use of the money. It is incurred to release the payer from a contractual obligation to pay recurrent interest on the loan.

Division 247

Division 247 of the ITAA 1997 applies to borrowers under capital protected borrowings. Part of the borrower's expenditure in relation to the capital protected borrowing is treated as being incurred only for a put option granted under the arrangement.

In effect, part of the payment is treated as being revenue in nature (the part that is treated as properly being interest) and part of the payment is treated as being capital in nature (the part that is treated as properly being related to a put option). It follows that, where a payment is made to gain a release from a recurrent obligation which is treated as being partly revenue and partly capital, then the release is also related to this dual purpose.

TR 93/7 proceeds on the basis that penalty interest is for release of the recurrent obligation to pay interest. Release from that recurrent obligation is considered in that Ruling to be sufficiently connected to a discharge of a mortgage appended to the instrument of loan to be a mortgage discharge expense.

However, where part of the penalty interest is for release of capital protection costs, it relates to the surrender of a right to dispose of assets acquired with the loan capital. This is a discrete contractual right to the loan agreement and appended security. Surrender of this asset by the borrower could not be said to be 'connected' to the security held over the loan by the lender.

Allowable deduction

In circumstances where an amount of expenditure is incurred which relates in part to discharging a relevant mortgage and in part to some other purpose which would not be deductible under section 25-30 of the ITAA 1997 in its own right, the expenditure is deductible under section 25-30 of the ITAA 1997 only to the extent that it relates to the discharge of the relevant mortgage.

Fixed interest refund

Receipts in the nature of a return on capital invested, such as interest, are income according to ordinary concepts. Accordingly, the payment of a refund of fixed interest would represent income.

Conclusion

In your case, the whole of the loan capital was required to be used to purchase assessable income producing shares. Therefore, to the extent that the discharge expenditure relates to a mortgage given as security for the repayment of the loan monies, the expenditure will be deductible. The termination costs are not deductible to the extent that the costs relate to the put option.

A proportionate amount of the fixed interest refund should be returned as income in the 2008-09 income year.