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Ruling

Subject: Investment in NRAS properties - deductibility of expenditure

Question 1

Are deductions claimed under section 8-1 of the Income Tax Assessment Act 1997 (the ITAA 1997) for expenses incurred by the Taxpayer in respect of an investment in a NRAS rental property subject to apportionment to the extent that the expenses are incurred to derive non-assessable non-exempt (NANE) income?

Answer

Yes.

Question 2

Are deductions claimed under section 25-25 of the ITAA 1997 for expenses incurred by the Taxpayer for borrowing money to finance the purchase of a NRAS rental property subject to apportionment to the extent that the expenses are incurred to derive non-assessable non-exempt (NANE) income?

Answer

Yes.

Question 3

Are deductions claimed under Division 40 of the ITAA 1997 for the decline in value of depreciating assets held by the Taxpayer in relation to a NRAS rental property subject to apportionment to the extent that those assets relate to derivation of non-assessable non-exempt (NANE) income?

Answer

Yes.

Question 4

Are deductions claimed under Division 43 of the ITAA 1997 for expenses incurred by the Taxpayer for capital works in relation to a NRAS rental property subject to apportionment to the extent that the expenses are incurred to derive non-assessable non-exempt (NANE) income?

Answer

Yes.

Question 5

To the extent that those expenses referred to in Questions 1 and 2 above are not deductible, will the non-deductible portion of all of those expenses form part of the cost base of a CGT asset under Subdivision 110-A of the ITAA 1997?

Answer

No.

Question 6

Will all of the elements of the cost base referred to in Question 5 above form part of the reduced cost base of the relevant CGT asset under Subdivision 110-B of the ITAA 1997?

Answer

No.

This ruling applies for the following periods:

1 July 2010 to 30 June 2011

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.

1. The Taxpayer purchased a number of rental properties that were approved under the National Rental Affordability Scheme (NRAS) for investment purposes. The Taxpayer has borrowed funds to finance the purchase of the rental properties, which have been rented as approved NRAS rental properties (NRAS rental property) since June 200X.

2. Under NRAS, Approved Participants acting on behalf of the Investors are eligible for a tax incentive if the NRAS approved rental property meets all compliance requirements during the relevant NRAS financial year, running 1 May to 30 April. Part of the requirements for compliance is to rent out the dwellings to eligible low and moderate income households at a rate that is at least 20 per cent below the prevailing market rate.

3. The tax incentive is income tax-free and is comprised of two components:

· An Australian Federal Government contribution per dwelling, per year for up to 10 years, received by the Approved Participant and passes on to the Investor as a refundable tax offset on the Investor's income tax return for the relevant year;

· A State or Territory Government Contribution per dwelling, per year, for up to 10 years, received as a non-assessable, non-exempt (NANE) payment or in-kind financial support (such as reduced stamp duty or land tax).

4. To receive the tax incentives, the following events must occur:

· The Investor owns a dwelling that has NRAS approval through an NRAS Approved Participant, who regularly monitor whether the rental property are NRAS compliant.

· Within 14 days of the NRAS Financial Year End, 30 April of the relevant year, the Approved Participant must submit all necessary paperwork to be the Federal Government confirming that the Investor's approved rental properties are NRAS compliant at the NRAS Financial Year End, 30 April of the relevant year.

· Once the Federal Government has confirmed the Investor's NRAS compliance, the Federal Government provides the Approved Participant with a Compliance Certificate stating the Federal Incentive Amount and submits the approval paperwork to the State Government for processing of their portion of the NRAS Incentive.

· Once the State or Territory Government has confirmed NRAS compliance from the Federal Government, the State Government issues the cash Incentive payment to the Approved Participant for distribution to the Investor.

· The Approved Participant then deducts their fees from the State Incentive Payment and distributes the net cash payment to the Investor. Since the creation of NRAS, the State Incentive Payment has not been received before the subsequent August after the NRAS Financial Year End.

5. During the financial year ended 30 June 20YY, all NRAS rental properties were rented for the entire financial year.

6. The Taxpayer received a Compliance Certificate from the Federal Government in relation to his eligible NRAS rental properties for the NRAS financial year ended 30 April 20YY that confirmed their receipt of a Refundable Tax Offset incentive. This Tax Offset was claimed in their 20YY income tax return.

7. The Taxpayer also received a cash NRAS incentive payment from the State Government during the 20YY income tax year for their compliant NRAS rental properties for the NRAS financial year ended 30 April 20ZZ

8. The Taxpayer is an individual taxpayer and accounts for their income and expenses on a cash or receipts basis. The taxpayers tax return is prepared to account for income when it is actually received and deductions are claimed in the year that the expenses are incurred.

9. The Taxpayer derived two types of income during the 30 June 20YY financial year: the rental income from rent receipts for the period that his NRAS rental properties were rented out during that year that was treated as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (the ITAA 1997) and the cash incentive received in September 20ZZ from the State Government for the 30 April 20ZZ NRAS Financial Year that was treated as NANE under section 380-35 of the ITAA 1997. The State cash Incentive was not included in the Taxpayer's 20YY income tax return.

10. The Taxpayer has incurred loss, the following losses and outgoing to enable the taxpayer to derive the NANE income:

· loss in revenue by renting out the NRAS rental properties at 20% less than market rate for the period 1 May 2009 to 30 April 2010; and

· fees paid to the NRAS Approved Participant engaged by the Taxpayer.

11. In The Taxpayer's income tax return for the income year ended 30 June 20YY, pursuant to paragraph 8-1(1)(b) of the ITAA 1997, the following expenses were deducted in full on the basis that they were fully and necessarily incurred in deriving assessable rental income received during the 20YY income year:

i. body corporate fees;

ii. council rates;

iii. interest on loans;

iv. property agent fees/ commission;

v. water charges;

vi. bank charges;

vii. administration fees and sundry expenses; and

viii. inspection fee.

12. The following expenses were incurred when the NRAS rental properties were purchased and the amortised portion of those expenses were also treated as deductible in the 20YY income year under the relevant provisions of the ITAA 1997:

i. borrowing expenses (section 25-25 of the ITAA 1997);

ii. depreciation (Division 40 of the ITAA 1997); and

iii. capital works deductions (Division 43 of the ITAA 1997).

13. Fees payable by the Taxpayer to the NRAS Approved Participant were deducted from the State incentive payment prior to distributing the net cash payment and were not claimed as a deduction as they were considered to be incurred solely in deriving the State incentive payment which is non-assessable non-exempt (NANE) income for tax purposes (paragraph 8-1(2)(c) of the ITAA 1997).

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-25

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Division 43

Income Tax Assessment Act 1997 Subdivision 110-A

Income Tax Assessment Act 1997 Subdivision 110-B

Income Tax Assessment Act 1997 Division 380

Reasons for decision

Question 1

Are deductions claimed under section 8-1 of the Income Tax Assessment Act 1997 (the ITAA 1997) for expenses incurred by the Taxpayer in respect of an investment in a NRAS rental property subject to apportionment to the extent that the expenses are incurred to derive non-assessable non-exempt (NANE) income?

Summary

Yes. The Taxpayer must apportion those deductions claimed under section 8-1 of the ITAA 1997 to the extent that the expenses are incurred in relation to gaining or producing NANE income on a reasonable basis.

Detailed reasoning

Section 8-1 of the ITAA 1997

1. Section 8-1 of the ITAA 1997 governs the deductibility of the following expenses incurred by the Taxpayer in respect of an investment in his NRAS rental properties in the 20YY ncome tax year;

i. body corporate fees;

ii. council rates;

iii. interest on loans;

iv. property agent fees/ commission;

v. water charges;

vi. bank charges;

vii. administration fees and sundry expenses;

viii. inspection fee; and

ix. fees paid to NRAS Approved Participant in receiving the State incentive payment.

2. As relevant, section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or necessarily carrying on a business for the purpose of gaining or producing assessable income. However subsection 8-1(2) of the ITAA 1997 states you cannot deduct a loss or outgoing to the extent it is of capital or of a capital nature, of a private or domestic nature, or it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income (NANE) income.

3. Expenses incurred in respect of a rental property are generally considered to be incurred in gaining or producing assessable income and, subject to the operation of subsection 8-1(2) of the ITAA 1997, are therefore deductible.

4. While derivation of assessable income by way of rent is one objective achieved by participation in the National Rental Affordability Scheme (NRAS), the receipt of government incentives, including state government NANE income may be another objective. The extent to which deriving NANE income is an object of participating in the NRAS requires an examination of the Taxpayer's subjective purpose, motive or intention in incurring the loss or outgoing. This analysis may also have regard to those who advised or acted on behalf of the taxpayer (Fletcher & Ors v. FC of T 92 ATC 2045).

5. To participate in the NRAS the Taxpayer must meet certain requirements. In order to receive government incentives, including state government NANE income, the Taxpayer must rent out the properties at 20% less than the market rate. The disproportion between the outgoings and the relevant assessable income can in part be explained by reference to the reduction in assessable income and the Taxpayer's pursuit of another objective, to derive NANE income.

6. If expenditure related to the NRAS rental properties had been incurred solely for the purpose of gaining assessable income, it would be wholly deductible; but as it was incurred in part for that purpose, and in part for the pursuit of NANE income, the expenditure must be apportioned between the pursuit of assessable income and other purposes: see Fletcher at 91 ATC 4957-8. The items of expenditure are of the latter kind described in the following extract from High Court judgment in Ronpibon Tin NL v FC of T (1949) 8 ATD 431:

"It is perhaps desirable to remark that there are at least two kinds of items of expenditure that require apportionment. One kind consists in undivided items of expenditure in respect of things or services of which distinct and severable parts are devoted to gaining or producing assessable income and distinct and severable parts to some other cause. In such cases it may be possible to divide the expenditure in accordance with the applications which have been made of the things or services. The other kind of apportionable items consists in those involving a single outlay or charge which serves both objects indifferently. Of this directors' fees may be an example. With the latter kind there must be some fair and reasonable assessment of the extent of the relation of the outlay to assessable income. It is an indiscriminate sum apportionable, but hardly capable of arithmetical or ratable division because it is common to both objects.''

7. Expenses are not deductible to the extent they are incurred in relation to gaining or producing NANE income (paragraph 8-1(2)(c) of the ITAA 1997). Accordingly, rental expenses incurred in respect of an NRAS rental property must be apportioned on a reasonable basis, limiting a claim for any deduction to the portion of costs relating to the derivation of assessable income.

Negative gearing

1. A disproportion between deductible outgoings and the relevant assessable income sometimes results in apportionment between an assessable income producing purpose and another purpose. There is a practice in relation to the acquisition of income producing assets known as 'negative gearing'. An inherent feature of negatively gearing an asset is that the interest payable on the funds borrowed to acquire the asset, in addition to other related expenditure, exceeds the income derived from the asset, at least in the initial years of ownership. Rental properties are commonly negatively geared.

2. According to Taxation Ruling TR 95/33, a commonsense or practical weighing of all the relevant factors could, in the usual case, be expected to lead to the conclusion that the relevant expense is properly to be characterised as genuinely, and not colourably, incurred in gaining or producing assessable income.

3. The present circumstances are not considered to be directly comparable to the usual case in which negative gearing would be allowed. This is because the disproportion between the outgoings and relevant assessable income can be clearly referenced to the Taxpayer's participation in the NRAS. As one of the stated objectives of an NRAS investment is to derive NANE income, the Taxpayer will not be allowed to deduct a portion of his rental expenses pursuant to sub-section 8-1(2) of the ITAA 1997.

Question 2

Are deductions claimed under section 25-25 of the ITAA 1997 for expenses incurred by the Taxpayer for borrowing money to finance the purchase of a NRAS rental property subject to apportionment to the extent that the expenses are incurred to derive non-assessable non-exempt (NANE) income?

Summary

Yes. The Taxpayer must apportion those deductions claimed under section 25-25 of the ITAA 1997 to the extent that the expenses are incurred to gaining or producing NANE income on a reasonable basis.

Detailed reasoning

Section 25-25 of the ITAA 1997

1. Subsection 25-25(1) of the ITAA 1997 provides that:

You can deduct expenditure you incur for *borrowing money, to the extent that you use the money for the *purpose of producing assessable income. In most cases the deduction is spread over the period of the loan.

2. Subsection 995-1(1) of the ITAA 1997 provides that something is done for the "purpose of producing assessable income" if it is done: (a) for the purpose of gaining or producing assessable income, or (b) in carrying on a *business for the purpose of gaining or producing assessable income.

3. The explanatory memorandum to the Tax Law Improvement Bill 1997 notes that the words 'to the extent that' in section 25-25 of the ITAA 1997 refers to the 'use' to which the borrowed money is put. Where the borrowed money is used partly for a non income producing purpose, it is necessary to apportion the deduction claimed for the borrowing expenses. This interpretation is supported by the decision in Ure v. F.C of T 81 ATC 4100 (Ure).

4. In the present circumstances, the borrowed money is used partly for a non income producing purpose as the NRAS rental properties will be used to derive the non assessable State Incentive payment as well as assessable rental income. The allowable deduction for borrowing expenses under section 25-25 of the ITAA 1997 must therefore be apportioned on a reasonable basis.

Question 3

Are deductions claimed under Division 40 of the ITAA 1997 for the decline in value of depreciating assets held by the Taxpayer in relation to a NRAS rental property subject to apportionment to the extent that those assets relate to derivation of non-assessable non-exempt (NANE) income?

Summary

Yes. The Taxpayer must apportion those deductions claimed under Division 40 of the ITAA 1997 on a reasonable basis.

Detailed reasoning

Division 40 of the ITAA 1997

1. Under subsection 40-30(1) of the ITAA 1997 a depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used, however, the following items are not depreciating assets:

a. land; or

b. an item of trading stock; or

c. an intangible asset, unless it is mentioned in subsection 40-30(2) of the ITAA 1997.

2. Under subsection 40-25(1) of the ITAA 1997 you can deduct an amount equal to the decline in value for an income year (as worked out under the rules in Division 40 of the ITAA 1997) of a depreciating asset that you held for any time during the year. You must reduce the deduction by any part of the asset's decline in value that is attributable to your use of the asset, or you having it installed ready for use, for a purpose other than a taxable purpose: subsection 40-25(2) of the ITAA 1997. The meaning of the term "taxable purpose" is given in subsection 40-25(7) of the ITAA 1997, and includes "the *purpose of producing assessable income."

3. To the extent depreciating assets held by the Taxpayer during the 20YY income year relate to his investment in the NRAS rental properties, those assets are in part used to produce NANE income. As a result, the use of those depreciating assets is partially attributable to a purpose other than a taxable purpose and therefore the deduction must be reduced (subsection 40-25(2) of the ITAA 1997). To the extent that the depreciating assets are used to derive amounts of NANE income, the deduction claimed must be apportioned on a reasonable basis. Note: A capital gain or capital loss from the disposal of a depreciating asset will only arise to the extent that the asset has been used for a non-taxable purpose.

4. A depreciating asset that relates to a NRAS rental property in respect of which a decline in value deduction has been allowed under Division 40 of the ITAA 1997 is taken to be a separate CGT asset from the property. When a CGT event happens to the Taxpayer's NRAS rental properties, the capital gain or loss must be worked out for each CGT asset separately (or balancing adjustment in the case of depreciating assets sold with the property).

Question 4

Are deductions claimed under Division 43 of the ITAA 1997 for expenses incurred by the Taxpayer for capital works in relation to a NRAS rental property subject to apportionment to the extent that the expenses are incurred to derive non-assessable non-exempt (NANE) income?

Summary

Yes. The Taxpayer must apportion those deductions claimed under Division 43 of the ITAA 1997 on a reasonable basis.

Detailed reasoning

Division 43 of the ITAA 1997

1. To deduct an amount for capital works the area to which the Taxpayer's construction expenditure relates must be used for the purpose of producing assessable income or conducting research and development (R&D) activities (subsection 43-140(1) of the ITAA 1997). For the purposes of the ITAA 1997 something is done for the "purpose of producing assessable income" if it is done for the purpose of gaining or producing assessable income, or in carrying on a business for the purpose of gaining or producing assessable income (subsection 995-1(1) of the ITAA 1997).

2. Taxation Ruling TR 97/25 discusses where the deduction allowable for capital works expenditure is subject to apportionment. As per paragraph 13 "Indirect costs, in the context of construction activities, are those that, by reference to accounting records or other documentation, cannot be allocated wholly to an individual element of a construction project, such as the building or plant. In determining construction expenditure in respect of capital works, indirect costs generally are allocated between elements to which they relate in the same proportion that the direct costs of those elements bear to one another: see BP Refinery (Kwinana) Ltd v. FC of T (1961) ALR 52; (1960) 12 ATD 204. Where any other method is employed, it must be justified by sound accounting principles and practical considerations."

3. Taxation Ruling TR 97/25 also provides that where capital works expenditure is wholly attributable to a construction expenditure area that is used partly in a deductible way then apportionment of the allowable deduction for capital works will be necessary.

4. To the extent that the Taxpayer's construction expenditure, as defined in subsection 43-115(2) and subsection 43-85(1) of the ITAA 1997, relates to his NRAS rental properties, it will be taken to be used partly for the purposes of producing assessable income and partly for the purposes of deriving NANE income. Any capital expenditure incurred in relation to the properties will be included in the formula in section 43-210 of the ITAA 1997. The deduction for capital works must be reduced under section 43-210 of the ITAA 1997 to the extent the investment in the NRAS properties produces NANE income. Note: The Taxpayer must exclude from the cost base (or reduced cost base) of a CGT asset (including a building, structure or other capital improvement to land that is treated as a separate asset for CGT purposes) the amount of construction expenditure for which the Taxpayer is allowed a capital works deduction under Division 43 of the ITAA 1997.

Question 5

To the extent those expenses referred to in Questions 1 and 2 above are not deductible, will the non-deductible portion of all of those expenses form part of the cost base of a CGT asset under Subdivision 110-A of the ITAA 1997?

Summary

No. See detailed reasoning below.

Detailed reasoning

Cost Base

1. To the extent the following expenses are not deductible under a provision of the ITAA 1997, the non-deductible portion of those expense may form part of the cost base of a CGT asset under Subdivision 110-A of the ITAA 1997:

i. body corporate fees;

ii. council rates;

iii. interest on loans;

iv. water charges;

v. borrowing expenses.

2. Under subsection 110-25(4) of the ITAA 1997, the third element of the cost base is the costs of owning the CGT asset you incurred. These costs include:

a. interest on money you borrowed to acquire the asset; and

b. costs of maintaining, repairing or insuring it; and

c. rates or land tax, if the asset is land; and

d. interest on money you borrowed to refinance the money you borrowed to acquire the asset; and

e. interest on money you borrowed to finance the capital expenditure you incurred to increase the asset's value.

3. The interest on money borrowed by the Taxpayer to acquire the NRAS rental properties (CGT assets) is included in the third element of the cost base under paragraph 110-25(4)(a) of the ITAA 1997 to the extent that a deduction has not been claimed under section 8-1 of the ITAA 1997.

4. The council rates incurred by the Taxpayer in respect to his NRAS rental properties are specifically included in the third element of the cost base under paragraph 110-25(4)(c) of the ITAA 1997 to the extent that a deduction has not been claimed under section 8-1 of the ITAA 1997.

5. The water charges and body corporate fees incurred by the Taxpayer in respect of his NRAS rental properties are also included in the third element of the cost base under subsection 110-25(4) of the ITAA 1997 to the extent the expenses are not deductible under section 8-1 of the ITAA 1997.

6. Under subsection 110-25(3) of the ITAA 1997, the second element of the cost base includes the incidental costs incurred. Incidental costs are defined in section 110-35 of the ITAA 1997. Borrowing expenses incurred by the Taxpayer would ordinarily fall within the cost base of the NRAS rental properties under subsection 110-35(9) of the ITAA 1997 to the extent they are not deductible under section 25-25 of the ITAA 1997.

Certain amounts neither fully deductible nor included in the cost base of a CGT asset

1. The following expenses are not costs of owning the NRAS rental properties and therefore are not included in the third element of the cost base under section 110-25(4) of the ITAA 1997 to the extent the expenses are not deductible under section 8-1 of the ITAA 1997:

i. property agent fees/commission;

ii. bank charges (that are not borrowing expenses);

iii. administration fees and sundry expenses; and

iv. fees paid to NRAS Approved Participant in receiving the State incentive payment.

Question 6

Will all of the elements of the cost base referred to in Question 5 above form part of the reduced cost base of the relevant CGT asset under Subdivision 110-B of the ITAA 1997?

Summary

No.

Detailed reasoning

Reduced cost base

1. All of the elements (except the third one) of the reduced cost base of a CGT asset are the same as those for the cost base (subsection 110-55(2) of the ITAA 1997). Under subsection 110-55(3) of the ITAA 1997 the third element of the reduced cost base does not include:

i. interest incurred on money borrowed to acquire the NRAS rental properties

ii. council rates

iii. water charges;

iv. body corporate fees.

Therefore, while these amounts do form part of the cost base they are not included in the reduced cost base.