Edited version of your private ruling

Authorisation Number: 1012491365838

Ruling

Subject: Part IVA

Question

Will Part IVA of the Income Tax Assessment Act 1936 ('ITAA 1936') apply to deny deductions for expenses and interest the Trustees claim in respect of the apartment?

Answer

Yes, to the extent interest deductions relate to borrowings used for a private or domestic purpose in discharging the loan on the principal place of residence.

This ruling applies for the following periods:

On or before 30 June 2013

The scheme commences on:

The scheme has commenced

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 Trust is a discretionary trust. The trustees are A and B ('the Trustees').

The former principal place of residence of A and B, being an apartment has been listed for sale for a year without success. There is a bank loan over the apartment. This loan is interest only. A and B derive rental income from the apartment, which has been rented out to third parties for at least the last six months.

A and B decided to move to a quieter area. They funded their new principal place of residence with two loans. One loan relates to the purchase of the land. A and B intended the sale of the apartment to fund the construction of the house, but when the apartment failed to sell, they obtained a second loan.

The Commissioner is advised that A and B need to resolve the sale of the apartment to repay the additional borrowings on the principle residence.

Accordingly, the arrangement under consideration is the sale of the apartment to the trustees in order that A and B may use part of the purchase price to repay the loans on the principal residence.

The following steps are proposed:

1. the Trustees borrow sufficient funds at commercial rates from a bank or other financial institution to purchase the apartment at market price and to cover stamp duty, settlement fees, and additional funds to improve the apartment in order to gain additional rental returns. The loan is secured against the apartment with top up security against the principal residence;

2. the Trustees purchase the apartment from A and B at market value;

3. a portion of the purchase price from the sale of the apartment is applied by A and B to discharge the loans on the principal residence.

The Trustees intend to rent the apartment to third parties, and to derive rental income at commercial rates sufficient to pay all interests and costs.

It is expected that the rents achieved will result in the property being positively geared.

The Trustees will claim interest deductions on the loan used to purchase the apartment, and other rental expenses.

Initially, it is proposed that a real estate agent will manage the property however the Trustees may assume this responsibility at a later date.

The trust deed includes A and B as income and corpus beneficiaries of the Trust.

Any profit or capital gain upon a subsequent sale of the apartment will be distributed to A and B, and taxed at their marginal rates.

The Trust is not expected to be the recipient of any income distributions from other trusts or companies.

The Trust will not make distributions, make or receive loans or receive dividends from associated companies.

The Commissioner is advised that in the event the proposed arrangement does not take place, the apartment will be placed back on the market until sold.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 95(1).

Income Tax Assessment Act 1936 Section 177A.

Income Tax Assessment Act 1936 Section 177C.

Income Tax Assessment Act 1936 Section 177D.

Income Tax Assessment Act 1997 Section 6-5.

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1936 Section 177d.

Income Tax Assessment Act 1997 Section 25-25.

Income Tax Assessment Act 1936 Section 177A.

Income Tax Assessment Act 1936 Section 226.

Income Tax Assessment Act 1936 Section 226E.

Income Tax Assessment Act 1936 Section 177C.

Reasons for decision

Net income of the Trust

Division 6 of the Income Tax Assessment Act 1936 ('ITAA 1936') sets out the income tax treatment of the net income of a trust estate.

Subsection 95(1) of the ITAA 1936 provides that the net income of a trust is the total assessable income of the trust estate less all allowable deductions (except for certain deductions identified in the provision), and calculated as if the trustee were a resident taxpayer in respect of that income. Thereafter, Division 6 of the ITAA 1936 assesses the beneficiaries of the trust or the trustee on a share of the net income of the trust estate.

Under subsection 6-5(2) of the ITAA 1997 ordinary income that is derived directly or indirectly from all sources during the income year is included in assessable income.

In the present circumstances, the net income of the Trust would include any rental income derived from renting out the apartment.

Section 8-1 of the ITAA 1997 provides for deductions from assessable income where expenses are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, provided the loss or outgoing is not of a capital, private or domestic nature.

Paragraph 3 of Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v Roberts; FC of T v Smith ('TR 95/25') identifies general principles relevant to the question whether interest is deductible under section 8-1 of the ITAA 1997. The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower. Accordingly, whilst interest payable on a loan which has been used to acquire an income producing asset such as rental property would generally be deductible under section 8-1 of the ITAA 1997, interest on a loan which has been used to purchase a family home would not be deductible as it would be considered private or domestic in nature.

As the Trustees intend to purchase the apartment as an investment property to derive rental income, the interest which is incurred on the loan obtained to purchase the apartment would be deductible under section 8-1 of the ITAA 1997 as it is an expense incurred in gaining assessable income.

In respect of other expenses which are incurred in gaining or producing rental income from the apartment, these expenses would generally be deductible under section 8-1 of the ITAA 1997 provided they are not of a capital, private or domestic nature. Expenses associated with rental property that may be deductible include payments of rates, insurance premiums, and property agent fees and commissions.

Part IVA of the ITAA 1936

Part IVA of the ITAA 1936 is a general anti-avoidance provision that may apply in certain circumstances if a tax benefit is obtained in connection with a scheme, and it can be concluded that the scheme, or any part of it, was entered into for the dominant purpose of enabling a tax benefit to be obtained.

The following requirements must be satisfied in order for Part IVA to apply:

1. there must be a 'tax benefit' as defined in section 177C of the ITAA 1936, that was or would, but for subsection 177F(1) of the ITAA 1936, have been obtained;

2. the tax benefit was or would have been obtained in connection with a 'scheme' as defined in section 177A of the ITAA 1936, and

3. having regard to section 177D of the ITAA 1936, it would be concluded that the main or dominant purpose of entering into the scheme was to obtain the tax benefit.

In the event Part IVA applies, subsection 177F(1) of the ITAA 1936 provides the Commissioner with discretion to cancel a tax benefit.

Scheme

The definition of 'scheme' in subsection 177A(1) of the ITAA 1936 is broad:

(a) 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

(b) any scheme, plan, proposal, action, course of action or course of conduct.

In the present case, the following steps comprise the scheme:

1. the establishment of the Trust;

2. the Trustees borrow sufficient funds to purchase the apartment at market price and to cover certain expenses and the cost of improving the apartment. The loan is secured against the apartment with top up security against the principal residence;

3. the Trustees purchase the apartment from A and B at market value;

4. a portion of the purchase price from the sale of the apartment is applied by A and B to repay the loans on the principal residence;

5. the Trustees rent out the apartment to third parties and derive rental income at commercial rates which is sufficient to pay all interests and costs;

6. interest on the loan to purchase the apartment and rental expenses are claimed as deductions;

7. at a future date, the Trustees sell the apartment to a third party purchaser. Any profit or capital gain is distributed to A and B, and taxed at their marginal rates.

The scheme achieves the discharge of A and B's liability in respect of the principal residence as part of the amount borrowed by the Trust in effect refinances the loans on the principal residence.

Tax benefit

Subsection 177C(1) of the ITAA 1936 identifies four kinds of tax benefit. Relevantly, a taxpayer obtains a tax benefit in connection with a scheme if a deduction is allowed to the taxpayer in relation to a year of income where the whole or part of the deduction would not have been allowed, or might reasonably be expected not to have been allowed, to the taxpayer if the scheme had not been entered into or carried out.

The identification of a tax benefit necessarily requires consideration of the income tax consequences, but for the operation of Part IVA, of an 'alternative hypothesis' or an 'alternative postulate' (referred to herein as the 'counterfactual'). This is what would have happened or might reasonably be expected to have happened if the particular scheme had not been entered into or carried out. A reasonable expectation requires more than a possibility.

In identifying the counterfactual, it is useful to consider the most straightforward and usual way of achieving the commercial and practical outcome of the scheme (disregarding the tax benefit), the commercial and social norms, the behaviour of relevant parties before/after the scheme, and actual cash flow.

In the present circumstances, to realise the apartment in order to discharge the liability in respect of the principal residence and derive increased rental income in the interim, it might reasonably be expected that the most straightforward course would be the retention of the apartment by A and B as an investment property until such time as a sale to a third party purchaser occurs. In the interim, repayments on the borrowings in respect of the principal residence would be met by the cash flow of the individuals, including any rental income derived by them from the apartment. This is the arrangement currently in place, and the default position should the scheme not take place. Any improvements to be made to the apartment in order to enhance the apartment's income earning potential would be financed by the individuals or with additional borrowings over the apartment. As separate loan arrangements in respect of the two properties is maintained, whilst interest payable on the loan (and any additional borrowing) over the apartment would be deductible, interest on the borrowings in respect of the principal residence would not as it is of a private or domestic nature.

Under the scheme, additional tax deductions over and above those available under separate principal and interest loan arrangements in respect of the two properties are produced. The scheme achieves this by increasing the tax deductible interest in respect of the apartment by means of a corresponding reduction of principal, and therefore, non-deductible interest on the principal residence. In effect, non-deductible interest payments of A and B are converted under the scheme into deductible expenditure of the Trust.

The tax benefit that arises is the portion of the increased interest deductions obtained to the extent the loan is used for a private purpose in the discharge of the liability on the principal residence. Any interest on the portion of the loan used to improve the apartment would not form part of the tax benefit.

Thus, assuming all other expenses are comparable under the scheme as under the counterfactual, the tax benefit is calculated as the difference between the otherwise allowable deductions for interest incurred by the Trustees (excluding any deductible interest for improvements to the apartment), and the amount of interest that would have been an allowable deduction to the individuals under the counterfactual (including any deductible interest for improvements to the apartment).

An instance of the amount of tax benefit obtained would be the difference between the deductible interest on the projected loan amount (excluding any deductible interest for improvements), and the deductible interest on the current balance of the loan over the apartment (including any deductible interest for improvements).

Case Y4 91 ATC 114 involves similar facts to the present case. Part IVA of the ITAA 1936 was there applied to deny interest deductions claimed by a medical practice company on a loan used to acquire the goodwill of a doctor's general medical practice, the proceeds of which (in addition to a personal loan taken out by the doctor and his wife) were applied to discharge the mortgage on their private residence. The incorporation of the company was said to achieve a dual purpose: additional superannuation payments; and the interest on the borrowing. The loan to the company was secured by a third party mortgage over the private residence. As the loan was used, however fleetingly, to acquire the medical practice, it qualified for a deduction under former section 51(1) of the ITAA 1936. In considering the application of Part IVA of the ITAA 1936, P Gerber stated at 120:

However, put bluntly, the purpose of substituting one mortgagee for another was to create a tax deduction by recourse to an "incestuous" relationship of prohibited degree…Such "incest" creates a tax benefit to which Part IVA applies - in this case the conversion of a non-deductible interest payment on a domestic home into a deductible expenditure in the accounts of the company.'

Dominant purpose

Section 177D of the ITAA 1936 provides that Part IVA of the ITAA 1936 applies to a scheme in connection with which the taxpayer has obtained a tax benefit if, after having regard to the eight specified factors, it would be concluded that the person who entered into or carried out the scheme, or any part of it, did so for the purpose of enabling the taxpayer to obtain the tax benefit. The counterfactual forms the background against which the objective ascertainment of the dominant purpose of a person occurs in accordance with section 177D of the ITAA 1936.

Where section 177D of the ITAA 1936 refers to 'the purpose' of the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme, that person need not be the taxpayer.

In addition, Part IVA of the ITAA 1936 may apply notwithstanding that the dominant purpose of obtaining the tax benefit was consistent with the pursuit of commercial gain.

The eight factors in subsection 177D(2) of the ITAA 1936 are as follows.

(a) the manner in which the scheme was entered into or carried out

The context in which the scheme arises is the intention by A and B to realise the apartment in order to discharge the loans on their principal residence. The manner in which this is to be achieved under the scheme involves unnecessary complexity as it requires the establishment of a non-arm's length entity, where no commercial advantage is secured by the inclusion of the Trust in the arrangement, either in the derivation of rental income from the apartment, or in any eventual sale of the apartment to a third party purchaser. Potentially the apartment would be subject to two sale transactions incurring additional costs. Although the borrowing by the Trustees also provides funds to improve the apartment, A and B would in their individual capacities be able to obtain additional finance for that purpose independently of the Trust. It is not intended that the Trust will be the recipient of any income distributions from other trusts or companies. No benefit accrues from the involvement of the Trust in the arrangement; it has been established merely to facilitate the sale of the apartment under the scheme in the absence of a third party purchaser in order for A and B to refinance, and reduce the principal and attendant interest on the borrowings in respect of the principal residence. This factor indicates that the scheme was entered into in order to obtain a tax benefit.

(b) the form and substance of the scheme

There is divergence between the form and substance of the scheme as the form the scheme takes is the sale of an asset by A and B. In substance, the sale of the asset does not result in any real disposition as A and B hold the legal title to the asset, albeit in their capacity as trustees of the Trust, and continue to have the economic benefit of the asset as beneficiaries of the Trust. The divergence between the form and substance suggests that the scheme was entered into in order to obtain a tax benefit.

(c) the time at which the scheme was entered into and the length of the period during which the scheme was carried out

Once the arrangement is put in place it can be utilised over a number of years. The nature of the arrangement is such that the scheme can be entered into at any time during the income year. This factor is neutral.

(d) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme

As a result of the scheme, the Trustees are able to claim greater interest deductions in respect of the loan on the apartment than would have been claimed by A and B if the apartment had been retained by them.

It is reasonably likely that due to the increased interest deductions the share of net income of the Trust would be less than the net rental income derived by A and B under the counterfactual.

(e) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme

Under the scheme a change in the financial position of A and B in their individual capacities results in a corresponding change to their financial position as trustees of the Trust. Thus, as a result of the sale of the apartment to the Trust, A and B have discharged their liability in respect of the principal residence and the apartment. However, they are liable for the increased liability in respect of the apartment as trustees of the Trust.

(f) any change in the financial position of any person who has, or has had, 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

In addition to that noted in (e) above, A and B continue to have the economic benefit of the apartment notwithstanding its sale to the Trustees under the Scheme. Whereas under the counterfactual the benefit accrues to them in their individual capacities as they directly derive rental income from the apartment; under the scheme they derive the benefit as beneficiaries of the Trust.

The payment of real estate agent commissions is merely deferred and not saved under the scheme. Although A and B avoid the liability upon the sale of the apartment to the Trust, it is reasonably likely that in their capacity as trustees of the Trust they will incur the expense upon the sale of the apartment to a third party purchaser.

Overall, apart from the tax benefit gained, the sale of the apartment to the Trust under the scheme does not significantly effect a change in the financial position of A and B. This indicates that the scheme was entered into in order to obtain a tax benefit.

(g) any other consequences for the relevant taxpayer, or for any person referred to in paragraph (f), of the scheme having been entered into or carried out

As the principal residence is used as top up security for the borrowing made by the Trust, A and B will not actually own an unencumbered home any faster under the scheme than would have been the case if they had not entered into the arrangement. This factor indicates that the scheme was entered into in order to obtain a tax benefit.

(h) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in paragraph (f)

A and B are trustees, and are included in the trust deed as income and corpus beneficiaries of the Trust. By virtue of being trustees of the Trust, A and B retain control over the apartment, and by virtue of being a beneficiary or object of the Trust, they continue to have the economic benefit of the apartment. A and B have also provided their home as security for the loan to be obtained by the Trustees to purchase the apartment. This factor indicates that the scheme was entered into in order to obtain a tax benefit.

Conclusion

Having regard to the eight factors in subsection 177D(2) of the ITAA 1936, it would be concluded that the dominant purpose for entering into or carrying out the scheme is to obtain the tax benefit. Part IVA of the ITAA 1936 will apply.

In accordance with paragraph 177F(1)(b) of the ITAA 1936, interest deductions are disallowed to the extent the deduction relates to borrowings used for a private or domestic purpose in discharging the loan on the principal residence.