Edited version of your private ruling

Authorisation Number: 1012136710571

This edited version of your ruling will be published in the public register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet.

Subject: Interest expenses

Questions

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the interest incurred on the money drawn down on the business line of credit?

Answer:

Yes

Will you obtain a tax benefit in connection with a scheme to which Part IVA of the Income Tax Assessment Act 1936 (Part IVA) applies in each of the Relevant Income Years if you enter into the Proposed arrangement described in the Relevant facts of this ruling?

Answer:

Yes, you will obtain a tax benefit in connection with a scheme to which Part IVA applies in each of the Relevant Income Years if you enter into the Proposed arrangement described in the Relevant facts of this ruling.

This ruling applies for the following period (Relevant Income Years)

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

The scheme will commence on

The date on which you enter into the proposed arrangement described in the Relevant facts of this ruling.

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.

Your home

You acquired a property in 2004. You hold the property as joint tenants with your spouse and use it as your private residence (your home).

To fund part of the purchase of your home, you obtained a joint loan with your spouse (home loan). The loan has since been drawn down to finance renovations of your home. Recent details of the home loan were:

· principal and interest repayments

· term: 30 years (approximately 23 years remaining);

· security: your home.

Your business

You carry on a business as a sole trader. You generate fees from that business. The fees are credited to a business transaction account held in your name solely (business account).

In the course of carrying on the business you incur expenses that are deductible under section 8-1 of ITAA 1997 (deductible business expenses). These expenses include staff salary and wages, PAYG withholding payments, rent, supplies, office supplies, business insurance, professional registration fees and subscriptions, telephone and electricity. You also purchase depreciating assets that are used exclusively for your business (depreciating business assets).

Private line of credit

You hold a line of credit jointly with your spouse (private line of credit) and is secured by your home.

Current arrangement

You currently use the funds from your business account to:

· pay the deductible business expenses and purchase the depreciating business assets,

· make minimum fortnightly repayments of principal and interest on the home loan, and

· pay your income tax and some of your family's private expenses (the rest are paid with your spouse's income).

Your and your spouse's combined income is sufficient to meet all of your private and business expenses. You sometimes draw on the private line of credit to meet private expenses when you do not have available cash. You repay the principal and interest on the private line of credit as soon as you or your spouse receive income.

You do not make any additional ad-hoc or lump sum repayments to the home loan.

Proposed arrangement

You anticipated that you would obtain a new line of credit prior to 30 June 2012 (the line of credit). The line of credit would be held in your name solely on the following terms and conditions (the terms and conditions):

· principal and interest repayments: not required while the balance remains under the approved limit;

· security: your home;

· term: not specified, but subject to annual review.

Once this ruling is issued, you will start using the line of credit as follows:

You will only draw on the line of credit to pay deductible business expenses and to purchase depreciating business assets;

You will use the funds from the business account to:

· make the minimum fortnightly repayments of principal and interest and additional repayments of the home loan,

· pay your income tax and some of your family's private expenses, and

· pay interest on the line of credit.

You will not make any repayments of principal on the line of credit while the facility remains under its approved limit.

You will not use the private line of credit in the proposed arrangement.

Other information about the Proposed arrangement

Additional funds that become available as a result of you using the line of credit to pay deductible business expenses and to purchase depreciating business assets will be directed to your home loan. You expect that paying for the deductible business expenses and the purchase costs of depreciating business assets with the funds drawn down under the line of credit will enable you to make additional repayments of your home loan each month.

The line of credit will reach its initial approved limit before the home loan is fully paid off. However, under the Proposed arrangement, as the line of credit balance increases, the home loan balance will decrease. This will enable you to seek to increase the limit of the line of credit when it reaches its initial approved credit limit. Your total indebtedness at any time during the period in which the Proposed arrangement is being carried out will remain the same.

The increase of the line of credit's approved limit is subject to your financier's approval at the time of application. It is noted that you have advised them of your intention to request an increase of the approved credit limit for the line of credit.

You estimate that the home loan will be fully repaid within 4 to 5 years. Once the home loan is fully repaid, you will use the funds from your business account to make repayments of principal on the line of credit.

It is possible that once the home loan is fully repaid you will revert to meeting the deductible business expenses and the purchase costs of depreciating business assets out of your own cash flow (rather than using the funds drawn down under the line of credit). You stated that whether or not you do this will depend on the circumstances that exist at the time the above business expenses are incurred.

You obtained the idea for the Proposed arrangement from your tax agent who provided you with an edited version of a private ruling previously issued on the topic. You also became aware of this sort of borrowing arrangement through peer discussions within your industry.

In explaining the financial, commercial and other advantages you seek in entering the Proposed arrangement, you provided the following explanation:

…Seeking to finance business with debt funding and to reduce interest on private borrowings by repaying private debt as soon as possible from funds derived from business income. Interest on borrowed funds used to pay business expenditure is deductible under the use test. Debt (private or business) is generally only ever able to be repaid out of income (other than through funds from asset sales or windfall gains).

You have not sought to enter this arrangement as a result of changes to your or your spouse's financial circumstances.

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

Section 8-1 of the ITAA 1997 allows you a deduction for any loss or outgoing that is incurred in gaining or producing your assessable income, or is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income, provided that it is not of a private, capital or domestic nature.

Whether interest has been incurred in the course of gaining or producing assessable income depends on the character of the interest expense which is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower: Taxation Ruling TR 95/25.

The interest on the borrowed funds that are applied to an income producing use, for example to acquire an assessable income producing asset or to discharge expenses of an assessable income producing activity, is generally considered to have the character of an expense incurred in the course of gaining or producing assessable income: Taxation Ruling TR 2000/2.

Your circumstances indicate that during the Relevant Income Years, the money borrowed under the line of credit will only be used to pay for the deductible business expenses and to purchase the depreciating business assets. It follows that in each of the Relevant Income Years the money borrowed under the line of credit will only be used for an income producing purpose. Therefore, the interest on the line of credit will have a character of an expense incurred in gaining or producing your assessable income or necessarily incurred in carrying on your medical practice business for the purpose of producing that assessable income.

Subject to the application of Part IVA, you are entitled to a deduction under section 8-1 of the ITAA 1997 in respect of the interest on the line of credit in each of the Relevant Income Years.

Part IVA

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

Part IVA is a general anti-avoidance rule. Part IVA gives the Commissioner the power 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 (see section 177A);

· a taxpayer has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme (see section 177B);

· the dominant purpose of a person who entered into or carried out the scheme, or any part of the scheme, was to enable the relevant taxpayer and another taxpayer or other taxpayers to each obtain a tax benefit in connection with the scheme (see section 177D(b)).

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

The analysis that follows represents the Commissioner's consideration of whether Part IVA applies to the Proposed arrangement. To form the opinion of whether Part IVA applies, the Commissioner has assumed that you have already entered into the Proposed arrangement.

Scheme

A scheme is defined by 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 your ruling application, the scheme for the purposes of subsection 177A(1) comprises establishing the line of credit according to the terms and conditions set out above and drawing on it to pay for deductible business expenses and to purchase depreciating business assets.

Tax benefit

Pursuant to paragraph 177C(1)(b), a taxpayer obtains a tax benefit 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.

The identification of a tax benefit in respect of the scheme requires a consideration of what would have happened if the scheme had not been entered into or carried out. (It is considered that it is possible to identify what would have happened if the scheme had not been entered into or carried out, therefore it is not necessary to consider what might reasonably be expected to have happened.) What would have happened if the scheme had not been entered into or carried out also forms the background against which the objective ascertainment of the dominant purpose will occur.

Having regard to the relevant facts, the Commissioner considers that if the scheme had not been entered into or carried out, you would have continued to pay for the deductible business expenses and purchase depreciating business assets with funds from your business account. You would not have drawn down money under the line of credit to pay for these expenses. It follows that you would not have incurred any interest on the money drawn down under the line of credit and so would not have been entitled to any deductions for such interest.

Accordingly, the relevant tax benefit you obtained in connection with the scheme under paragraph 177(1)(b) is the allowable deduction for the interest incurred on the money drawn down under the line of credit in each of the Relevant Income Years.

Dominant purpose

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

A taxpayer's commercial objective for entering into the scheme does not prevent Part IVA from applying to the scheme. 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 financing your business with debt funding and reducing your interest on private borrowings as soon as possible by repaying these borrowings with the funds derived from business income may attract the operation of Part IVA.

In the context of applying paragraph 177D(b) to the scheme identified above, the following observations are made:

The manner in which the scheme was entered into or carried out (subparagraph 177D(b)(i)) although straightforward, is more complicated than both your Current arrangement and what would have happened if the scheme had not been entered into or carried out. Under the scheme, you draw on the line of credit to pay deductible business expenses and to purchase depreciating business assets; out of your income you make both the compulsory repayments of the home loan and also additional repayments equal to the drawings on the line of credit. As both the line of credit and the home loan are secured against your home, the reduction in the home loan balance will allow you to seek to increase the line of credit balance and keep your total level of indebtedness the same. Under your Current arrangement, you meet both the expenses and the repayments of the home loan out of your income.

You have not entered into the scheme as a result of any change in your financial circumstances. You have entered into the scheme on the advice of your tax agent. The manner in which the scheme was entered into or carried out, when compared to what would otherwise have happened, points to the conclusion that you entered into or carried out the scheme for the dominant purpose of obtaining the tax benefit.

There is a discrepancy between the form and the substance of the scheme (subparagraph 177D(b)(ii)). The form of the scheme is the incurring of the business debt (which results in the purported availability of additional tax deductions for interest), in order to repay personal debt earlier: the increase in the line of credit balance is matched by an equal reduction in the balance of your home loan. However, you are a sole trader, and both the business debt, and the personal debt are your own personal liability, and both are secured against your home. As the business debt (the line of credit) has a higher interest rate than the personal debt (the home loan), your interest expenses under the scheme are greater than they would have been if you had not entered into the scheme. The substance of the scheme is that your overall level of indebtedness remains the same, whilst your interest expenses increase. The form and substance of the scheme supports the conclusion that your dominant purpose for entering into or carrying out the scheme was to enable you to obtain the tax benefit.

The timing of the scheme and the length of the period during which the scheme is proposed to be carried out (subparagraph 177D(b)(iii)) indicate that the scheme was entered into for the dominant purpose of enabling you to obtain a tax benefit. You entered into the scheme following the advice of your tax agent. Prior to entering the scheme, you had been incurring the business expenses and were able to meet them, together with the home loan repayments, out your income. The scheme is proposed to be carried out for at least as long as is required to repay the home loan, and once the home loan is repaid, it is proposed that the line of credit will be repaid. The timing of the scheme and the length of the period during which the scheme is proposed to be carried out strongly indicates that your dominant purpose for entering into the scheme was to enable you to obtain the tax benefit.

The tax result achieved (but for Part IVA) (subparagraph 177D(b)(iv)) is deductions for interest on the line of credit. The total interest deductions available to you under the scheme are greater than the deductions you would have been entitled to if you had not entered into the scheme. That is, if you had not entered into the scheme, you would not have incurred any deductible interest expenses.

Your financial position (subparagraph 177D(b)(v)) under the scheme, were it not for the deductions, is no better (and is possibly worse) than it would have been if you had not entered into the scheme. Your overall level of debt remains the same: the decrease in the balance of your home loan is matched by an increase in the line of credit balance. The interest rate on the line of credit is higher than the interest rate on the home loan, therefore absent the tax deductions, your financial position under the scheme would be worse as you would have been incurring more interest on the same amount of debt. This strongly suggests that your dominant purpose for entering into the scheme was to enable you to obtain the tax benefit.

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 you to obtain a tax benefit in connection with the scheme.

Conclusion on the application of Part IVA

If you enter into the Proposed arrangement described in the Relevant facts of this ruling, you will obtain a tax benefit in connection with a scheme to which Part IVA applies. The Commissioner will make a determination under paragraph 177F(1)(b) that the whole of the deduction for the interest incurred on the line of credit will not be allowable to you in each of the Relevant Income Years.