Edited version of your private ruling

Authorisation Number: 1011985703407

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Ruling

Subject: interest expenses and the application of Part IVA

Questions

Is the trustee entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for all interest that accrues on the line of credit facility that the two trust beneficiaries hold jointly (LOC2) when calculating the net income of the trust under subsection 95(1) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer:
No, the trustee is not entitled to a deduction under section 8-1 of the ITAA 1997 for any amount of interest that accrues on the LOC2 when calculating the net income of the trust under subsection 95(1) of the ITAA 1936.

Would the Commissioner make a determination under paragraph 177F(1)(b) of the ITAA 1936 that any deduction for interest on the LOC2 shall not be allowable to the trustee when calculating the net income of the trust under subsection 95(1) because the trustee has obtained a tax benefit in connection with a scheme to which Part IVA applies?

Answer:

The Commissioner declines to rule on this issue. As the trustee is not entitled to a deduction for any amount of interest that accrues on the LOC2 when calculating the net income of the trust, Part IVA cannot apply.

The Commissioner notes that if the trustee was entitled to a deduction for an amount of interest on the LOC2 when calculating the net income of the trust, the Commissioner would be entitled to make a determination to cancel that deduction because the trustee would have obtained a tax benefit in connection with a scheme to which Part IVA would apply.

This ruling applies for the following periods

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commences on

1 July 2008

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.

The Family Trust ("the Trust") is a discretionary trust settled by a Deed of Settlement.

The Company A is the trustee of the Trust ("the Trustee"). The Trustee has one director ("you"). You are married to your spouse. You and your spouse are listed as general beneficiaries of the Trust.

Details of the relevant properties

You and your spouse jointly own your main residence ("your home").

In your personal capacity and the capacity of the director of the Trustee, you control the following rental properties ("all rental properties"):

· the rental property with a security value of $xxx,000 that you solely own ("your rental property"), and

· the rental properties that the Trustee owns ("the Trust rental properties") being:

o the properties with a security value of $xxx,000 each ("the initial Trust rental properties"):

§ rental property A

§ rental property B

§ rental property C

§ rental property D

§ rental property E.

The rental property E was purchased on 15 March 2011. The Trustee is the sole legal owner of the rental property E. You said that the Trustee acquired the rental property E to improve your cash flow position. You paid the deposit for the property with the funds drawn down under the line of credit that you took out jointly with your spouse ("LOC2"). The Trustee funded the remainder of the purchase price with the rental loan E.

Details of the relevant accounts and loans

In your personal capacity and in the capacity of the director of the Trustee, you control the following accounts:

· your personal savings account ("your savings account"),

· your personal VISA account ("your VISA card"),

· the joint home loan account in your and your spouse's name ("your home loan") used to refinance the loan funding the purchase cost of your home ("your old home loan") on the following terms:

§ loan amount: $xxx,000

§ security: your home

§ repayments: interest only until xx/xx

§ interest rate: Variable Rate less 0.xx% p.a. (as at 01/07/10, x.xx% p.a.)

§ term: xx years

· the rental loans funding all rental properties ("all rental loans") being:

o the loans funding the purchase cost of your rental property that are in your name only ("your rental loans"), and are:

§ rental loan 1 on the following terms:

· loan amount: $xxx,000

· security: your rental property

· repayments: interest only until xx/xx

· interest rate: fixed at 0.xx% p.a. below the investment home loan 15 year fixed rate for the first xxyears, then variable rate at 0.70% p.a. below the investment home loan standard variable rate (as at 01/07/10, the interest rate was x.xx% p.a.)

· term: xx years

§ rental loan 2 on the following terms:

· loan amount: $xxx,000

· security: your rental property

· repayments: interest only until xx/xx

· interest rate: variable rate of 0.xx% p.a. below the investment home loan standard variable rate (as at 0x/0x/xx, the interest rate was x.xx% p.a.)

· term: xx years

o the loans funding the Trust rental properties ("the Trust rental loans") that are in the name of the Trustee for the Trust, and are:

§ the loans funding the initial Trust rental properties ("the initial Trust rental loans") being:

· the loan funding the purchase cost of the rental property A ("rental loan A") on the following terms:

o loan amount: $xxx,000

o security: rental property A, separate guarantees by you and the Trustee

o repayments: interest only until xx/xx

o interest rate: fixed at 0.xx% p.a. below the investment home loan xx year fixed rate for the first xx years, then variable rate at 0.xx% p.a. below the investment home loan standard variable rate (as at 01/07/10, the interest rate was x.xx% p.a.)

o term: xx years

· the loan funding the purchase cost of the rental property B ("rental loan B") on the following terms:

o loan amount: $xxx,000

o security: rental property B, separate guarantees by you and your spouse

o repayments: interest only until xx/xx

o interest rate: fixed at 0.xx% p.a. below the investment home loan xx year fixed rate for the first xx years, then variable rate at 0.xx% p.a. below the investment home loan standard variable rate (as at 0x/0x/xx, the interest rate was x.xx% p.a.)

o term: xx years

· the loan funding the purchase cost of rental property C ("rental loan C") on the following terms:

o loan amount: $xxx,000

o security: rental property C, separate guarantees by you and your spouse

o repayments: interest only until xx/xx

o interest rate: variable rate of 0.xx% p.a. below the investment home loan standard variable rate (as at 01/07/10, the interest rate was x.xx% p.a.)

o term: xx years

· the loan funding the purchase cost of rental property D ("rental loan D") on the following terms:

o loan amount: $xxx,xxx

o security: rental property D, separate guarantees by you and your spouse

o repayments: interest only until xx/xx

o interest rate: Variable Rate less 0.xx% p.a. (as at 0x/0x/xx, x.xx% p.a.)

o term: xx years

§ the loan funding the purchase cost of rental property E (less the deposit), ("rental loan E") on the following terms:

· loan amount: $xxx,xxx

· security: rental property E, separate guarantees by you and your spouse

· repayments: interest only until xx/xx

· interest rate: Variable Rate less x.xx% p.a. (as at 01/07/10, x.xx% p.a.)

· term: xx years

o two line of credit accounts ("the LOCs") that you hold jointly with your spouse:

§ the line of credit ("LOC1") on the following terms:

· credit limit: $xx,000

· security: your home

· repayments: no repayments required until the end of the term provided LOC1 is within the credit limit that cannot be varied during the term of the loan

· interest rate: Line of Credit Rate less 0.xx% p.a. (as at 0x/0x/xx, x.xx% p.a.)

· term: xx years

§ the line of credit ("LOC2") on the following terms:

· credit limit: $xxx,000

· security: your home

· repayments: no repayments required until the end of the term provided LOC2 is within the credit limit that cannot be varied during the term of the loan

· interest rate: line of credit less 0.xx% p.a. (as at 0x/0x/xx, x.xx% p.a.)

· term: xx years

Prior loan and expense payment arrangement

Before taking out the LOCs, you paid for your and the Trust's expenses, including loan repayments, as follows ("old repayment arrangement"):

· All income you and the Trustee received was deposited into your savings account;

· You used drawings on your savings account as follows:

o to pay for your personal expenses,

o to make repayments of your old home loan on a principal and interest basis,

o the balance of funds in your savings account not used as described above was used to make additional repayments on your home loan;

· You used your VISA card to pay for:

o the deductible expenses of your rental property ("your rental expenses"),

o the deductible expenses of the initial Trust rental properties,

o your personal expenses;

· You used the redraw component of your old home loan to make the interest payments required on all rental loans and repay the balance outstanding on your VISA card.

Under this old loan repayment arrangement, your cash flow position (taking into account your personal income and the rental income from the initial Trust rental properties) was neutral.

Current loan and expense payment arrangement

On 1 January 20xx, you refinanced your old home loan, being a home loan account in your and your spouse's name, with your home loan.

On 1 July 20xx, you took out the LOCs with your spouse and commenced a new loan and expense payment arrangement ("new loan repayment arrangement").

Under this arrangement:

· All income you and the Trustee receive is deposited into your savings account;

· You use drawings on your savings account as follows:

o to pay for your personal expenses,

o to make repayments on your home loan on a principal and interest basis,

o to make payments on your VISA card to 'reverse' the amounts charged on the card for your personal expenses,

o the balance of any income deposited into your savings account and not used as described above is used to make additional repayments on your home loan;

· You use your VISA card to pay for:

o your personal expenses,

o your rental expenses, and

o the deductible expenses of the Trust rental properties ("the Trust rental expenses");

· You always pay of the outstanding amounts on your VISA card in full on or before the due date for payment. You are never liable for interest on expenses you charge to your VISA card.

In this document, your rental expenses and the Trust rental expenses are together referred to as "all rental expenses".

· You now make drawings on LOC1 to pay interest on your rental loans and repay a portion of the monthly balance outstanding on your VISA card equal to the monthly total of amounts charged on the card for your rental expenses;

· You now make drawings on LOC2 to pay interest on the Trust rental loans and repay a portion of the monthly balance outstanding on your VISA card equal to the monthly total of the amounts charged on the card for the Trust rental expenses;

· You will not make any repayments on the LOCs provided that their balance remains below the credit limits. As a result, the interest and other charges on the LOCs will be allowed to capitalise and compound. You expect that you will not reach the credit limit of the LOCs until your home loan is paid off in approximately 2012. You have stated that the credit limits on the LOCs were calculated so that they will reach their approval limit at the same time your home loan is paid off.

· Once you have paid off your home loan in approximately 20xx, you:

o will start making principal and interest repayments on the LOCs and all rental property loans out of your and the Trust's income; and

o expect to have fully repaid all these loans by 1 June 2030. In particular, you expect to completely repay:

§ all rental loans by approximately the end of August 20xx, and

§ the LOCs by June 20xx.

In this document the period between 1 July 2010 and the day on which you make the last repayment on the LOCs is referred to as the "relevant period".

Other relevant information

· On 30 June 20xx, the Trustee passed a resolution to distribute the Trust net income. The Trustee distributed $x,000.00 of the Trust net income to a beneficiary and balance of $xx,xxx.00 to you. The Trustee resolved that it holds the income so distributed on behalf each of the beneficiaries, with an option to reinvest the money as an interest free loan by the beneficiaries to the Trust payable on demand.

· There are no agreements between you and the Trust in respect of the payment of the interest on the Trust rental loans and the Trust rental expenses.

· You calculated the LOCs credit limits by reference to the average interest rate on all rental loans, historical monthly VISA card payments, and the time it would take you to pay off your home loan with the funds that the LOCs will replace.

· It would have taken you xx years to pay off your home loan under the old loan repayment arrangement. You estimated that it will take you x.xx years to pay it off without interest and x.x years with interest, under the new loan repayment arrangement.

· You entered into the new loan repayment arrangement with an aim of paying off your home loan sooner and improving your cash flow position to allow for 'servicing of debt' on the additional investment properties. You also aimed to:

o live better

o worry less

o feel more financially secure

o expand your business

o grow your income

o provide more for your family (generally and by paying off a personal loan to later be used to fund education expenses)

o create ease of accounting by preventing mixed purpose loan accounts,

o only have a "good debt" and no "bad debt".

· You and your spouse were not provided with any promotional material in relation to any of the rental loans or the LOCs. You have not paid anyone to advise you on the new loan repayment arrangement or to set it up for you.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 Division 393

Income Tax Assessment Act 1997 Division 36

Income Tax Assessment Act 1936 Section 95(1)

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.

Section 8-1

Net income of a trust is the total assessable income of the trust calculated as if the trustee were a resident taxpayer in respect of that income less all allowable deductions, except certain deductions otherwise allowable under Division 393 and Division 36 of ITAA 1997: section 95(1) of ITAA 1936.

An interest expense will be an allowable deduction under section 8-1 of ITAA 1997 if it can be characterised as an outgoing the taxpayer incurs in gaining or producing the taxpayer's assessable income or an outgoing the taxpayer necessarily incurs in carrying on a business for the purpose of gaining or producing the taxpayer's assessable income, and is not capital, or of a capital, private or domestic nature: Taxation Ruling TR 95/25.

A loss or outgoing is incurred by the taxpayer when the taxpayer has a presently existing liability to discharge that loss or outgoing: Taxation Ruling TR 94/26 and TR97/7; FC of T v James Flood Pty Ltd 88 CLR 492; New Zealand Flax Investments Ltd v FC of T 61 CLR 179.

While you use some funds drawn down under the LOC2 to discharge the expenses of the Trust, the Trustee is not a party to the LOC2 loan agreement and has not entered into any agreements in respect of those funds. Rather, you and your spouse took out the LOC2 in your personal capacities and are using it to pay for your personal expenses and the expenses of the Trust.

As you and your spouse are jointly and severally liable for the repayment of the LOC2, including payments of interest on the LOC2, you and your spouse jointly incur all interest on the LOC2 as an expense. The Trustee does not incur any interest on the LOC2 because the Trustee is not liable to pay any interest on the LOC2.

It follows that the Trustee would not be entitled to deduction for interest on the LOC2 and cannot take into account when calculating the net income of the Trust.

Part IVA

* All legislative references in this section are to the ITAA 1936 unless otherwise stated.

Given that the Trustee cannot take into account the interest on the LOC2 when calculating the net income of the Trust, the Commissioner declines to rule on the application of Part IVA to that interest.

The Commissioner notes that if the Trustee were to establish its entitlement to a deduction for the interest on the LOC2 when calculating the net income of the Trust, Part IVA would apply to enable the Commissioner to cancel that deduction. The Commissioner's reasons for that opinion are set out below.

Part IVA is a general anti-avoidance rule. Part IVA gives to Commissioner the discretion to cancel a 'tax benefit' (or part of a 'tax benefit') that has been obtained, or would, but for section 177F, be obtained, by a taxpayer in connection with a scheme to which Part IVA applies.

In broad terms, Part IVA will apply where the following requirements are satisfied:

· there is a scheme,

· a taxpayer has, or would obtain, but for section 177F, a tax benefit in connection with the scheme,

· the dominant purpose of any person entering into or carrying out the scheme, or any part of the scheme, was to enable the relevant taxpayer and/or another taxpayer to obtain a tax benefit in connection with the scheme.

The application of Part IVA depends on a careful weighing of all the relevant facts and surrounding circumstances of each case.

Each of the requirements of Part IVA is discussed below in relation to the scheme.

The 'scheme'

A scheme is defined under subsection 177A(1) as 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.

Based on the limited facts stated in the ruling application, the scheme under subsection 177A(1) comprises the following course of action:

· You taking out the LOCs jointly with your spouse according to all their terms and conditions,

· You directing all income flows (including the rent from the Trust rental properties) into your savings account and using them to pay for:

· your private expenses,

· a portion of balance outstanding on your VISA card attributable to your private expenses, and

· to pay off your home loan,

· You using the funds drawn down under the LOCs to pay for interest on all rental loans and a portion of balance outstanding on your VISA card attributable to your rental expenses and the Trust rental expenses,

You not making any repayments on the LOCs until you pay off your home loan.

The 'tax benefit'

The identification of a tax benefit in respect of this scheme requires a consideration of what would have happened or might reasonably be expected to have happened if this scheme had not been entered into or carried out. This reasonable expectation forms the background against which the objective ascertainment of the dominant purpose occurs.

Considering the facts, particularly your objective of paying of your home loan sooner, it might reasonably be expected that had you not entered into the scheme, you would have continued using the income flows available to you in your personal capacity and in the capacity of the director of the Trustee to pay off your home loan and then pay interest on all rental loans and the portion of balance outstanding on your VISA card from the redraw component of your home loan, rather than use the LOCs to pay for these expenses.

This is less complicated than the scheme and satisfies the key commercial requirements of the arrangement. The Commissioner also notes that what you might reasonably be expected to have done had you not entered the scheme is consistent with your old loan repayment arrangement.

Under paragraph 177C(1)(b), a tax benefit is obtained in connection with a scheme if a deduction is allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out.

It might reasonably be expected that had you not entered into the scheme, the Trustee would not have incurred any interest on the LOC2 and so would not have been entitled to a deduction for interest on the LOC2 when calculating the net income of the Trust. Therefore, the tax benefit that the Trustee obtains in connection with the scheme for purposes of paragraph 177C(1)(b) is a deduction for all interest incurred on the LOC2 during the relevant period.

The 'dominant purpose'

A key question, for Part IVA purposes, is whether you entered into or carried out the scheme with the dominant purpose of enabling the Trustee to obtain a tax benefit in connection with the scheme. This requires the drawing of a conclusion about the objective purpose of you undertaking the scheme by reference to the eight objective factors identified in paragraph 177D(b). The conclusion to be reached is the conclusion of a reasonable person.

An objective purpose of a taxpayer of 'paying their home loan off sooner' or similar, does not prevent Part IVA from applying to this type of arrangement. As was noted in the joint judgment of the High Court in FC of T v. Spotless Services Ltd & Anor (1996) 186 CLR 404 at 416; 96 ATC 5201 at 5206:

A particular course of action may be…both 'tax driven' and bear the character of a rational commercial decision. The presence of the latter characteristic does not determine the answer to the question whether, within the meaning of Part IVA, a person entered into or carried out a 'scheme' for the 'dominant purpose' of enabling the taxpayer to obtain a 'tax benefit.'

Further, Gleeson CJ and McHugh J of the High Court noted in FC of T v. Hart [2006] HCA 26 at [16]; 2004 ATC 4599 at [16] that:

…a transaction may take such a form that there is a particular scheme in respect of which a conclusion of the kind described in s 177D is required, even though the particular scheme also advances a wider commercial objective.

Callinan J in FC of T v. Hart [2006] HCA 26 at [96]; 2004 ATC 4599 at [96] similarly distinguished between objectives that are 'entirely irreproachable and proper' and the 'means adopted to achieve these results'.

Therefore, the means by which you achieve your objective of 'paying your home loan off sooner' may result in the requirements of Part IVA being satisfied.

In the context of applying the eight factors in paragraph 177D(b) to this scheme, the following observations are made:

The scheme involves you using the LOCs to pay interest on all rental loans and portion of balance outstanding on your VISA card attributable to your rental expenses and the rental expenses of the Trust, whilst depositing all rental income (including the Trust rental income) into your home loan. Further, you will not make any repayments on the LOCs until your home loan is paid off. Interest on the LOCs will thereby be capitalised and compounded. The effect is the deferral of the payment of interest on all rental loans in order to enable the repayment of an equivalent amount on your home loan.

The manner in which the scheme in question is entered into or carried out is explicable only by the taxation consequences. For instance, apart from the purported availability of additional tax deductions, it makes no financial sense to, in effect, fund repayments on a borrowing for the home using the LOCs and at a higher rate of interest.

The effect and substance of the scheme is that the borrowings under the LOCs are financing additional repayments on the home loan, on which interest is not deductible, that you would otherwise not be able to make.

The scheme will only last for the period during which the balance on your home loan on which interest is not deductible is outstanding. Once you repay your home loan, you will revert to making the payments on all rental loans and balance outstanding on your VISA card out of the income flows available to you.

The total interest deductions available to the Trustee when calculating net income of the Trust under the scheme are greater than the deductions that the Trustee might reasonably be expected to be entitled to if you hadn't entered into the scheme. That is, if you hadn't entered into the scheme, the Trustee would reasonably be expected to be entitled only to interest deductions on the Trust rental loans when calculating the net income of the Trust.

The availability of these additional tax deductions for interest under the scheme could significantly reduce the net income of the Trust, and consequently the tax payable by the Trustee or beneficiaries of the Trust, in each of the income years of the relevant period.

Apart from the purported availability of the additional tax deductions, your financial position under the scheme is no better, and possibly worse given the higher rate of interest on the LOCs, than it would be compared with what you would reasonably be expected to have done if you had not carried out the scheme.

Accordingly, it is open for a reasonable person to conclude (and the Commissioner is satisfied) that you entered into or carried out the scheme, or part of the scheme, for the dominant purpose of enabling the Trustee to obtain a tax benefit in connection with the scheme.

Conclusion on the application of Part IVA

The Trustee has obtained a tax benefit in connection with a scheme to which Part IVA applies when calculating the net income of the Trust under subsection 95(1). The Commissioner is entitled to, and would, make a determination under paragraph 177F(1)(b) that the whole of the deduction for the interest incurred on the LOC2 shall not be allowable to the Trustee when calculating the net income of the Trust in each of the income years of the relevant period.