Edited version of your private ruling

Authorisation Number: 1011974731562

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Ruling

Subject: Interest deductions

Questions

1. Are you entitled to a deduction for your share of the rental expenses and interest incurred on your home loan (as defined in the facts below) under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer: No. However the expenses are included in calculating the net income or loss of the tax law partnership, as described in the reasons for decision.

2. Are you entitled to a deduction for your share of the interest incurred on your investment line of credit facility, as described in the facts below, under section 8-1 of the ITAA 1997?

Answer: No. However the expenses are included in calculating the net income or loss of the tax law partnership, as described in the reasons for decision.

3. Will Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to deny a deduction to your tax law partnership for the interest incurred on your line of credit?

Answer: No

This ruling applies for the following period<s>:

Year of income ended 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

In June 20xx you were seeking to sell your former home (your former home or rental property) and buy a larger home suitable for a growing family. In order to do this, you thought you would have to sell your former home, as you expected that you could not afford to keep it as a rental property once you had purchased your new home.

In June 20xx you sought advice on how much you could afford to pay for your new home and whether you would be able to keep your former home as a rental property. You were advised that by entering your current arrangement, as described below, you would be able to afford to keep your former home as a rental property. After tax, your rental property makes a net profit each month. That is it is positively geared.

However your total monthly expenses were expected to exceed your net after tax income. This deficit was expected to be temporary and would only exist while one of you was working part time, and would cease when they resumed full time work. You were advised you that you would be able to cover this short term deficit by taking out a short term line of credit (of up to five years) to fund the expenses associated with keeping your former home as a rental property. Based on this advice you decided to enter your current arrangement. You applied for the loans making up your borrowing arrangement on 30 June 20xx.
At the time you entered your current arrangements on 27 August 20xx, you owed funds to your bank in respect of the purchase price of your former home. You repaid this using money borrowed under your rental property loan.

You own your home and rental property as joint tenants. The legal and equitable interest in your home and rental property are identical.

Your Current arrangements

On 27 August 20xx, you entered into your current arrangements. This involved:

· Purchasing your current home (your home or current home) on 27 August 20xx. The purchase price was funded by using money borrowing under your home loan.

· Starting to rent out your former home. You started to receive rental income in September 20xx.

· Taking out all the loans as described below

· Using money borrowed under your line of credit to pay for all the expenses associated with your rental property.

· Your taking steps to minimise or reduce the amount of your private expenditure

In order to fund the temporary shortfall of income compared to your expenses, you chose to pay for the expenses related to your rental property using money borrowed under you line of credit, rather than entering an equivalent arrangement to fund private expenditure.
Your line of credit is only used to pay for your rental property expenses and is not used to pay for any personal, private or any other type of expenditure.
Your Home loan (home loan)

· This is an ANZ Home loan in both your names on which you are jointly and severally liable to repay.

· The interest rate was 8.67% as at 11 July 20xx when you received the offer of the loan. This is calculated as the ANZ Home loan index less a margin of 0.8%

· The loan amount is $XX,500

· The loan is interest only for 5 years, followed by 25 years of principal and interest repayments.

· This is secured by a mortgage over your home and rental property

Your rental property loan (rental loan)

· This is a home loan in both your names which you are jointly and severally liable to repay.

· The interest rate was 8.67% as at 11 July 20xx when you received the offer of the loan. This is calculated as the home loan index less a margin of 0.8%

· The loan amount is $xxx,000

· The loan is interest only for 5 years, followed by 25 years principal and interest repayments.

· This is secured by a mortgage over your home and rental property.

Your Line of Credit account (line of credit)

· This is an line of credit in both your names which you are jointly and severally liable to repay.

· The credit limit is $xx,000

· The interest rate was 8.77% as at 11 July 20xx when you received the offer of the loan. This is calculated as a rate less a margin of 0.7%

· Repayments are only required if the closing balance on a particular day exceeds the credit limit.

· It has an indefinite term, subject to periodic reviews and your bank's right to call for repayment should you fail to meet the lending criteria in the future.

· While it has an indefinite term, you will terminate the line of credit after five years and combine it with your rental property loan into an interest only loan and commence making repayments on the loan at this time.

· This is secured by a mortgage over your home and rental property.

Each loan product in the arrangement is on the standard terms offered by your bank and there are no special terms in any the loans. There are no links between them other than the common security you have provided to your bank.
As a result of and after entering your current arrangements:

· You obtained a new source of assessable income - rent from your rental property.

· You incurred new expenses in relation to your rental property.

· Your rental property is produces an excess of assessable income over the expenses and outgoings associated with it.

Under your current arrangements:

· You will be making only the minimum repayments that you are required to make on all the loans in your current arrangement.

· you pay for all the expenses related to your rental property using draw downs from your line of credit.

In 2013, after your expected temporary reduction in income ends:

· you will start making principal and interest repayments on your home loan

· you will combine the line of credit and rental property loan into a single interest only loan and start making the required repayments on this loan.

You do not intend to repay your home loan early and do not expect to repay it until 2038, in accordance with the original schedule set out in the terms of the loan.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 8-1(1)(a)

Income Tax Assessment Act 1997 Section 995-1(1)

Income Tax Assessment Act 1936 Section 90

Income Tax Assessment Act 1936 Section 92

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 Section 177A (1)

Income Tax Assessment Act 1936 Section 177C (1)(b)

Income Tax Assessment Act 1936 Section 177D (b)(i)

Income Tax Assessment Act 1936 Section 177D (b)(ii)

Income Tax Assessment Act 1936 Section 177D (b)(iii)

Income Tax Assessment Act 1936 Section 177D (b)(iv)

Income Tax Assessment Act 1936 Section 177D (b)(v)

Income Tax Assessment Act 1936 Section 177D (b)(vi)

Income Tax Assessment Act 1936 Section 177D (b)(vii)

Income Tax Assessment Act 1936 Section 177D (b)(viii)

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Interest deduction

As you are the joint owners of the income producing property and are in receipt of income from the property jointly, you are in a tax law partnership: subsection 995-1(1) of the ITAA 1997; FCT v McDonald (1987) 18 ATR 957; 87 ATC 4541. The interest on your line of credit is therefore an outgoing of your tax law partnership and is taken into account in determining the net income or partnership loss of your tax law partnership under section 90 of the ITAA 1936 and you are therefore not directly entitled to a deduction under section 8-1 of the ITAA 1997 for any part of it. The income received from your rental property is income of your tax law partnership and you are therefore not directly assessable on this amount.
Your share of the net income of your tax law partnership is however included in your assessable income and you are entitled to a deduction for your share of any partnership loss: section 92 of the ITAA 1936. Because you own your rental property in equal shares, both legally and equitably, your share of these amounts is 50%: TR 93/32 & FCT v McDonald (1987) 87 ATC 4541.

Position of your tax law partnership

The rental income received from your rental property is ordinary income of your tax law partnership and this is included in its assessable income when working out its net income or partnership loss under section 92: section 6-5 and subsection 995-1(1) of the ITAA 1997; FCT v McDonald (1987) 18 ATR 957; 87 ATC 4541
As discussed above, the interest on your line of credit is an outgoing incurred by your tax law partnership. Under the first limb of section 8-1(1)(a) of the ITAA 1997, your tax law partnership is entitled to a deduction for an outgoing, if the occasion for it being incurred was productive of your assessable income or, if none was produced, would be expected to produce its assessable income. See Lunney v. Commissioner of Taxation [1958] HCA 5; (1958) 100 CLR 478; Ronpibon Tin N.L. v F.C of T (1949) 78 CLR 47.

Whether interest on money borrowed satisfies this test depends on the character of the interest incurred. The character of interest flows from the purpose of the borrowing. In a simple case this is generally determined by reference to what the borrowed money was used for. To the extent the money was borrowed for multiple purposes, a reasonable apportionment between the different purposes is required.
The character of compound interest is to be determined by reference to the same principles as ordinary interest: See Hart & Anor v FCT 2002 ATC 4608 and TD 20xx/27. That is, what was the purpose of borrowing the money?

Character of money borrowed under your rental property loan

Where borrowed money is used to acquire an income producing asset, such as a rental property, the occasion for it being incurred is something that is productive of assessable income, or would be expected to produce assessable income and your tax law partnership will generally be entitled to a deduction for that amount: See Hart & Anor v FCT 2002 ATC 4608; Macquarie Finance Ltd v FCT 2005 ATC 4829 at 4863 per French J; Steele v DFCT (1999) 197 CLR 459.
Under the refinancing principle, the amounts borrowed under the rental property loans to refinance the loans originally taken out to purchase those properties have the character of the original borrowing: See TR 95/25. Here that was to refinance the debt on your former home. It would ordinarily follow that your rental property loan would have the character of a borrowing taken out to pay for your home and would therefore not be deductible under section 8-1: FCT v Faichney (1972) 129 CLR 38.
However, immediately after taking out the rental property loan you started to rent your former home out. This has the result that the character of the refinanced money has changed from being used to pay for the purchase price of your home, to being used to pay for the purchase price of an income producing rental property. It follows that interest on this loan would be deductible: Hart & Anor v FCT 2002 ATC 4608.
Can your tax law partnership claim a deduction for interest on your line of credit
Each individual drawdown under a line of credit is a separate borrowing and its deductibility must be determined by reference to the purpose of that borrowing: See TR 2000/2
The money borrowed under your line of credit is being used to pay for expenses and outgoings related to the cost of acquiring and the day to day running and maintenance of your rental property. These outgoings are therefore productive of your tax law partnership's assessable income, i.e. the rent from your rental property. Applying the use test, the interest on your line of credit therefore has this character and is, therefore, productive of assessable income. It therefore satisfies paragraph 8-1(1)(a) of the ITAA 1997 and your tax law partnership is therefore entitled to a deduction for it.

Does Part IVA apply to deny the deduction?

All legislative references in the following discussion refer to the Income Tax Assessment Act 1936.

Part IVA of the ITAA 1936 is a general anti-avoidance provision that allows to Commissioner to make a determination under section 177F cancelling a tax benefit, where a scheme was entered into for the dominant purpose of obtaining a tax benefit. The Commissioner may make a determination where:

· There is a scheme

· A taxpayer obtains a tax benefit in connection with the scheme; and

· Having regard to the 8 factors set out in paragraph 177D(b), it would be concluded that the person, or one of the persons who entered into or carried out the scheme, or any part of it, did so for the sole or dominant purpose of enabling the taxpayer to obtain a tax benefit.

Scheme
Scheme is defined by subsection 177A(1) to mean:

· Any agreement, arrangement, understanding, promise or undertaking, whether express or implied an 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.

You have entered into a scheme comprising all of the steps and actions described above.

Tax Benefit

Under paragraph 177C(1)(b) of the ITAA 1936, a tax benefit includes a deduction being allowable to a taxpayer in relation to a year of income, where the whole or part of that deduction would not have been allowable, or might reasonably have expected to not have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out.
In order to identify whether a tax benefit has been obtained by the taxpayer it is necessary to identify what would have happened or might reasonably have been expected to happen had the scheme not been entered into or carried out. This alternative must amount to more than a mere possibility and involves a prediction as to what events would have taken place had the relevant scheme not been entered into or carried out. That prediction must be sufficiently reliable for it to be reasonable.
The taxpayer's overall objective in undertaking a scheme is relevant to identifying what the taxpayer would have done, or might reasonably be expected to have done had they not entered into the scheme. On the basis of the facts set out above, your overall objective was to retain your former home as an income producing asset.
Based on the scheme and facts described above, it is not reasonable to expect that you would have disposed of your former home. As a positively geared rental property, it had the effect of increasing your income and reducing the expected temporary deficit in income compared to expenses. It is reasonable to expect that in the absence of the scheme you would have retained it.
In the absence of disposing of your rental property, there are only two alternative options available to you that you could reasonably be expected to have undertaken in order to achieve your goals:

· reducing your private expenditure to a level where you could afford to pay for your rental expenses and rental property repayments using your income; or

· to use the money you have / will borrow under the line of credit to pay for private expenditure rather than rental expenses.

Under either alternative you would not be entitled a deduction for interest on your line of credit and the result would be the same. However, the later is the more likely alternative. It follows that it is reasonable to expect you would not be entitled to a deduction for the interest on your line of credit and that you have obtained a tax benefit as a result of the scheme. The amount of the tax benefit is the amount of interest you incur on your line of credit.

Purpose - the eight factors

Having established there is a tax benefit obtained in connection with the scheme, it is then necessary to work out by reference to the 8 factors in 177D(b), whether you or anyone else who carried out the scheme or any part of the scheme did so for the sole or dominant purpose of enabling you to obtain a tax benefit in connection with the scheme.
Where a scheme has two or more purposes, a reference to the purpose of the scheme includes a reference to the dominant purpose for undertaking all or part of the scheme. This is the prevailing or most influential reason for undertaking the scheme.

177D(b)(i) - the manner in which the scheme was entered into or carried out

There is nothing in the way you have entered the scheme that suggests it was entered into for a dominant purpose of obtaining a tax benefit.

· The arrangement was not marketed to you in a way which emphasised the tax benefits.

· There is nothing artificial or unnecessarily complex about the way in which you entered into or carry out the scheme that would suggest it had a purpose other than allowing you to earn assessable income:

(a) You took steps to minimise and reduce private expenses during the period of reduced income and

(b) It was a mere choice to fund particular expenses you expected to be unable to fund out of your income, due to a temporary reduction in the amount of your income, using a commonly available loan product.
The line of credit has no special terms and is on the standard terms available for this product to any borrower who meets ANZ's lending criteria.

177D(b)(ii) - the form and substance of the scheme
Here, in form you are borrowing money to pay for expenses incurred in the course of earning assessable income from your rental property. This is also the substance of what you are doing. The borrowed money has the economic effect of paying for your rental property expenses.
This factor suggest your purpose was other than to obtain a tax benefit.

177DB(iii) - the time at which the scheme was entered into and the length of the period during which the scheme was carried out.

Here there is nothing in the timing of the scheme that would lead to the conclusion that the scheme was done for a tax purpose. Rather it suggests that you undertook the scheme for the dominant purpose obtaining a new source of assessable income. It is:

· linked to a need for funds to pay for expenses necessarily incurred to earn assessable income.

· not linked to a legislative change or a potential tax liability; and

· was carried out over a period of time was connected to a temporary change in your circumstance,i.e. an expected temporary reduction in income, and is to be wound up on that circumstance ceasing to exist;

This factor suggests the purpose for carrying out the scheme was to allow you to earn assessable income.
177D(b)(iv) - the result in relation to the operation of this act that, but for this part would be achieved by the scheme

But for the operation of Part IVA you would be entitled to a deduction for interest incurred on the line of credit.
The scheme also produces for you assessable income from your rental property that exceed the deductions you are entitled in respect of it. It therefore has the overall effect of increasing your income tax liability under the ITAA 1936 and ITAA 1997.
This factor suggests the purpose of the scheme was to earn assessable income.
177D(b)(v) - any change in the financial position of the relevant taxpayer that has resulted, will result, or may be expected to result from the scheme

As a result of entering the scheme:

· you obtained a new source of assessable income,

· you obtained assessable income exceeding the deductible outgoings relating to your rental property

· You pay more income tax as a result of the scheme than you would have in the absence of the scheme

· your debt in relation to your rental property increases between now and 2013

· you do not obtain a collateral benefit such as the accelerated repayment of your home loan.
These facts suggest that the scheme was entered into for the dominant purpose of earning assessable income.

177D(b)(vi) - any change in the financial position of any person who has, or has hand any connection (whether of a business, family or other nature) with the relevant taxpayer being a change that has resulted, will result, or may reasonably be expected to result from the scheme.
The scheme changes the financial position of your spouse in the same way it changes your financial position. Your spouse had the same purposes for entering the scheme and the same outcomes from the scheme as you do. For the reasons discussed here under the other Part IVA factors, this was other than to obtain a tax benefit. This tends to confirm the view you had no purpose of obtaining a tax benefit.
177D(b)(vii) - any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi) of the scheme having been carried out.
As a result of the scheme, you have a new income producing asset you would not otherwise have.
When considered in light of the fact your rental property produces more assessable income than deductible outgoings, this factor suggests a purpose the purpose of the scheme was to earn assessable income

177D(b)(viii) - the nature of the connection between the relevant taxpayer and any person referred to in sub paragraph (vi).
The person referred to in (vi) is your spouse. The connection is a family one. However, in light of the discussion above, this does not assist in determining what your purpose in entering the scheme was. This factor is therefore considered to be neutral.

Conclusion

When all the facts are considered as a whole, in particular the fact that:

The scheme results in an increase in your income tax liability, that is it produces more assessable income that deductions,

· The scheme is temporary in nature and only exists for a limited period of time during which you have a temporary reduction in your income,

· You took steps to minimise and reduce your private expenses during the period of reduced income, and

· The scheme does not have the effect of funding accelerated payments on your home loan or new private expenditure.

A reasonable person would conclude that the scheme was entered into for the dominant purpose of earning assessable income. A mere choice to borrow to pay for deductible expenses incurred in the course of earning assessable income rather than private expenses is not sufficient to attract the operation of Part IVA.
It follows that Part IVA does not apply to your scheme.