Edited version of private ruling

Authorisation Number: 1011677636846

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Ruling

Subject: Interest expenses

Question 1:

Are you entitled to a deduction for the interest expenses you incur on your loan used to acquire an investment property from your spouse?

Answer: Yes.

Question 2:

Will the provisions of Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the arrangement of purchasing the property from your spouse for market value?

Answer: No.

This ruling applies for the following period

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commenced on

1 July 2010

Relevant facts

Your spouse owns a residential property, currently used as your main residence.

Your spouse does not have any outstanding debts in relation to this property.

Your spouse also owns another residential property which is currently undergoing renovations.

You and your spouse intend to move into this property when renovations are completed.

Your spouse wishes to sell the original main residence as the property will be surplus to the spouse's needs.

You want to acquire an investment property with a view to hold it long term for the purpose of deriving rental income and provide for yourself in retirement.

You wish to purchase your spouse's property at its market value as your investment property, as the property is well located.

You believe that it is a good investment for the purpose of deriving rental income.

Buying this property will save you time in looking for another investment property and there is also a saving on stamp duty when you acquire a property from your spouse.

You would finance the property acquisition by taking out an interest only loan from a bank up to the market value of the property.

You expect the property to be positively geared within 10 years.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 8-1

Income Tax Assessment Act 1936 - Section 177A

Income Tax Assessment Act 1936 - Section 177C

Income Tax Assessment Act 1936 - Section 177D

Reasons for decision

Summary

You will be incurring interest on a loan which you obtained to acquire an investment property. It is accepted this interest is incurred in producing assessable income and accordingly you are entitled to a deduction for this expense.

Part IVA of the ITAA 1936 will not apply to the arrangement.

Detailed reasoning

Interest expense

Section 8-1 of the Income Tax Assessment Act 1997 (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.

Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

Accordingly, it follows that if a loan is used for investment purposes from which assessable income is to be derived, the interest incurred on the loan will generally be deductible.

In your case, you will be incurring interest on a loan which you will obtain to acquire an investment property. The property is being purchased at market value in an arms length transaction. As the borrowed funds are being used for income producing purposes, the associated interest expenses are an allowable deduction. The fact that you are purchasing the property from your spouse does not change the deductibility of the expense in your specific circumstances. The interest expenses incurred are an allowable deduction under section 8-1 of the ITAA 1997.

Application of Part IVA

Part IVA of the 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 your case, there is a 'scheme' as defined in section 177A of the ITAA 1936. The scheme is:

· You will purchase an investment property from your spouse at market value.

· You will borrow money from a bank which will be used to purchase the property.

· You will use the property for rental purposes.

· You will claim interest on your new loan as a deduction against your rental income from the investment property.

Tax benefit

Paragraph 177(C)(1)(b) of the ITAA 1936 provides that a taxpayer may be found to have obtained a tax benefit if they entered into or carried out a scheme that generates an allowable deduction that would not have been allowable, or might reasonably be expected not to have been allowable to the taxpayer in relation to a year of income if the scheme had not been entered into or carried out.

An alternate postulate 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, that is, what the taxpayer would have done without the scheme.

In identifying a reasonable alternate postulate, the following factors are taken into account:

· the most straightforward and usual way of achieving the commercial and practical outcome of the scheme,

· commercial and social norms,

· behaviour of relevant parties before and after the scheme, and

· the actual cash flow.

A tax benefit will not arise for a particular taxpayer in connection with a scheme if:

· there is a reasonable alternate postulate that shows how the taxpayer would have undertaken or might reasonably be expected to have undertaken a particular arrangement without the scheme, and

· the alternate postulate would or might reasonably be expected to have resulted in an allowable deduction of the same kind as the deduction claimed by the taxpayer under the scheme.

Therefore, getting a deduction is not of itself a tax benefit. A tax benefit only arises if a taxpayer can get something, such as a deduction, more than they would otherwise get but for the scheme.

In your case, the scheme results in an allowable deduction under section 8-1 of the ITAA 1997 for the interest paid to finance the investment loan that you will take out with a bank at commercial interest rates to fund the purchase of the investment property. Had you not entered into or carried out this scheme, you have stated that you would have still obtained finance from a bank at commercial interest rates to purchase another rental property. Under this alternate postulate, the interest on the loan to fund the purchase of the rental property would be deductible under section 8-1 of the ITAA 1997. In fact, the amount of the allowable deduction claimed under the alternate postulate would be the same amount under the scheme if the loan taken out under the alternate postulate was for the same amount at the same interest rates.

The alternate postulate is a plausible alternate transaction which does not raise doubt as to what you would have done in the absence of the identified scheme. In your circumstances it is a comparable way of achieving the practical outcome, it is considered to be within commercial and social norms and it is reasonable to conclude that the allowable deductions would have been obtained absent of the scheme. The fact that you are dealing with a related party under the scheme does not of itself deny the deduction of the allowable deduction under section 8-1 of the ITAA 1997 or compel the application of Part IVA of the ITAA 1936 particularly where it is found that you are dealing with each other at arm's length. Based on the facts of this ruling, it is considered that you are dealing with each other at arm's length, as parties would normally do.

The Commissioner accepts that there are a number of ways of doing a transaction or organising your affairs. In this matter, the Commissioner accepts that there is no tax benefit as defined in section 177C of the ITAA 1997, having regard to the alternate postulate and the manner in which the scheme is implemented. Therefore, Part IVA of the ITAA 1936 will not apply to deny the deduction for the interest expense otherwise deductible under section 8-1 of the ITAA 1997 in the proposed arrangement of this private ruling.

Please note, that as it is considered that there is no tax benefit, the eight factors outlined in section 177D of the ITAA 1936 in relation to the purpose of the scheme are not relevant in your case.

Also, whilst it is acknowledged that you have a saving of stamp duty with your proposed scheme, this is not regarded as a tax benefit for Part IVA of the ITAA 1936 purposes.