Edited version of your private ruling

Authorisation Number: 1012541474048

Ruling

Subject: Interest on funds borrowed to purchase property from spouse - Part IVA

Question 1

Are you able to claim a deduction for interest paid by you on funds borrowed to acquire your spouse's share of a property that is to be kept for investment purposes?

Answer

Yes.

Question 2

Will the provisions of Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to deny you a deduction for the interest?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 2014

Year ending 30 June 2015

The scheme commences on:

1 July 2013

Relevant facts and circumstances

You and your spouse lived in a property (property 1) which you owned together as joint tenants. The property is an apartment in a complex.

Some time later you and your spouse purchased a second property (property 2) as joint tenants.

You and your spouse have moved into property 2 and it is now your principle place of residence.

Property 1 has become an investment property.

You and your spouse currently have mortgage loans on both properties and an investment loan which is secured by property 1.

You have conducted some research on the property market in the local area and based on this research you believe property 1 to be a good investment property with potential for capital growth. You would like to retain property 1 as an investment, declaring rental income as taxable income and claiming deductible expenditure incurred associated with generating income on the property.

Your spouse would like to reduce your debt levels and consider diversification into other investment classes, and would like to sell property 1.

Your spouse also has concerns as to property 1's viability as an investment property following a recent settlement of a particular Court action.

While you share your spouse's concerns that the recent action may concern potential buyers of apartments in the complex in the short term, you do not believe that the issue would concern potential tenants in a rental scenario.

You and your spouse's investment objectives and level of risk tolerance are not compatible and you are both unlikely to agree as to whether property 1 should be held or sold. You and your spouse believe the best way to resolve this is for your spouse's share (or a significant percentage or your spouse's share) of the property to be transferred to you at market value and you will borrow the funds to finance the purchase of the share from your spouse.

You and your spouse believe that an ownership structure of tenants in common (your share being 99% and your spouse's share being 1%) may be appropriate to allow your spouse some control over the asset whilst it is a martial asset.

You and your spouse have also considered an external sale of property 1, but considering your desire to keep the property and the agent fees that would apply in a third party sale, you prefer the options of spouse to spouse transfer.

For the purposes of this private ruling, you will purchase the majority of your spouse's share of the property some time in the 2013-14 or 2014-15 income year for its market value and will borrow the funds to finance the purchase. You will use the property as a rental property.

You have advised that if you did not enter into this particular arrangement, you would have purchased another investment, not necessarily property.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 177A,

Income Tax Assessment Act 1936 Section 177C,

Income Tax Assessment Act 1936 Section 177D and

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

You will be incurring interest on a loan which you obtained to acquire an investment property. It is accepted this interest is incurred in producing assessable income and accordingly you are entitled to a deduction for this expense.

Part IVA of the ITAA 1936 will not apply to the arrangement.

Detailed reasoning

Deductibility of interest

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature.

Taxation Ruling TR 95/25 provides the Commissioners view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

Accordingly, it follows that if a loan is used for investment purposes from which assessable income is to be derived, the interest incurred on the loan will generally be deductible.

In your case, you will be incurring interest on a loan which you will obtain to acquire an investment property. The property is being purchased at market value in an arms length transaction. As the borrowed funds are being used for income producing purposes, the associated interest expenses are an allowable deduction. The fact that you are purchasing the property from your spouse does not change the deducibility of the expense in your specific circumstances. The interest expenses incurred are an allowable deduction under section 8-1 of the ITAA 1997.

Application of Part IVA

Part IVA of the ITAA 1936 is a general anti-avoidance provision that can 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. Part IVA is a provision of last resort.

The application of Part IVA depends on the facts of the particular case.

In order for Part IVA to apply, the following questions must be addressed:

· Is there a scheme as defined by section 177A of the ITAA 1936?

· Is there a tax benefit which was obtained in connection with the scheme as defined by section 177C of the ITAA 1936?

· Is the scheme a scheme to which Part IVA applies, as determined by section 177D of the ITAA 1936, where it would be concluded that your main or dominant purpose of entering into the scheme was to obtain the tax benefit?

Scheme

For Part IVA to apply, the identified scheme must fall within the following wide definition of 'scheme'.

The definition applies to 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 (subsection 177A(1) of the ITAA 1936).

Tax benefit

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'. 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. This alternative arrangement also 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.

Objective purpose test

Section 177D of the ITAA 1936 provides that Part IVA applies to a scheme in connection with which the taxpayer has obtained a tax benefit if, after having regard to eight specified factors, it would be concluded that a 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.

A conclusion about a relevant person's purpose for section 177D of the ITAA 1936 is the conclusion of a reasonable person based on all the facts and evidence that are relevant to considering the eight factors for the scheme. However, not all of the factors will be equally relevant in every case.

These eight factors are as follows:

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

This first factor enables contrivance and artificiality to be identified by comparing the manner in which the scheme was entered into or carried out with the manner in which the alternative arrangement would have been implemented. If a scheme is entered into and carried out in the manner in which ordinary business or family dealings are conducted, the manner of the scheme will not indicate the purpose of obtaining the tax benefit.

(ii) the form and substance of the scheme

The second factor requires that substance, rather than form, be the subject of inquiry. Put simply the factor directs attention to whether there is a discrepancy between the form of the scheme and its substance, meaning its commercial and economic substance. A discrepancy between the business and practical effect of a scheme on the one hand, and its legal form on the other, may well indicate the scheme has been implemented in a particular form as the means to obtain a tax benefit if the substance of the scheme may be achieved or available by some other more straightforward or commercial transaction or dealing.

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

The third factor draws attention to particular 'timing' aspects of the manner in which a scheme is entered into or carried out. It will include consideration of the time the scheme, or any part of it, was entered into or carried out, and the length of the period during which it was carried out. This factor will enable consideration of the extent to which the timing and duration of the scheme go towards delivering the relevant tax benefit or are related to commercial opportunities or requirements.

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

The fourth factor expressly focuses on the tax benefit and any other tax consequences resulting from the scheme.

(v) 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

(vi) 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 that has resulted, will result, or may reasonably be expected to result, from the scheme

(vii) any other consequence for the relevant taxpayer, or for any person referred to in (vi), of the scheme having been entered into or carried out

The fifth, sixth and seventh factors involve identifying changes in financial position or any other consequences that may be reasonably expected to result from the scheme, not just changes that have resulted or will result.

These factors focus on the non-tax effects of the scheme, not only for the relevant taxpayer, but also for all connected parties. These factors look to the practical financial, legal, economic and any other outcomes achieved by the scheme for the taxpayer and connected parties. For example, the change in the position of a taxpayer may mean little if there is an inverse change in the position of another person as a result of the scheme, and that other person is an associate or alter ego of the taxpayer such as a spouse or a wholly-owned company. These factors will often require consideration in conjunction with the second factor.

The absence of any practical change in the overall financial, legal or economic position of a taxpayer and connected parties that are affected by the scheme is likely to add weight to the dominance of the tax purpose when all the factors are weighted together.

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

The eighth factor inquires into the nature of the connection between the taxpayer and any other person whose financial position is reasonably expected to change as a result of the scheme or for whom there are any other consequences from the scheme. The existence of any connection between the taxpayer and these other persons is relevant to the identification of the other factors, such as the manner of the scheme, the form and substance of the scheme, and the tax, financial and other consequences of the scheme.

This factor requires attention to be paid to the existence of any family relationship between the taxpayer and the persons who are affected in any way by the scheme. This could assist a taxpayer in some cases. Many dealings which would be decidedly odd between strangers may be entirely explicable between family members.

In your case

Scheme

You will purchase the majority of your spouse's share of an investment property.

You will borrow an amount to finance the purchase.

You will use the property as a rental property.

You will return all income derived from the property and claim all expenses relating to the property as deductions.

The alternative arrangement

You would purchase another investment, though not necessarily property.

Tax benefit

You will be able to claim the interest that you incur in respect of your loan as a deduction.

Objective purpose test

You have indicated that your reasons for entering into the scheme are:

· you regard property 1 to be a good investment property with potential for capital growth and would like to retain the property as an investment

· your spouse does not wish to retain the property and would rather sell it and reduce your overall debt levels and consider diversification into other investment classes

· you and your spouses investment objectives and level of risk tolerance are not compatible and entering into the scheme would provide a resolution to these differences.

The eight factors will be considered in turn.

(i) There is no contrivance or artificiality in the manner in which this scheme is to be carried out. The proposed arrangement is consistent with normal commercial arms length dealings.

(ii) There is no discrepancy between the form of the scheme and the substance, in that there are no material steps present in the scheme that exist with no other explanation than the purpose of obtaining a tax benefit.

In other words, there is no air of artifice or contrivance in the manner in which the scheme is to be carried out that could separate form from substance.

(iii) The timing of length of duration of the scheme will have no effect on the final determination.

(iv) This factor requires an examination of the result that would have been achieved by the scheme from the normal operation of the ITAA 1997 or the ITAA 1936, excluding the operation of Part IVA of the ITAA 1936. Your spouse will lose rental and interest deductions on the property and will potentially be subject to a capital gain liability. You will obtain a greater deduction for the associated interest expenses in relation to your investment property.

(v) There will be a change in the make-up of your financial position with you being the owner of the majority of the investment property. The financial advantage obtained from the scheme is the deduction of the associated interest expenses.

(vi) There is a change in the financial position of your spouse as a result of your involvement in the scheme. Your spouse will own only a small portion of the investment property and will not be liable for the loan. The deductions that your spouse will be entitled to in relation to the property will be significantly reduced. Your spouse wants to sell the majority of their interest in the property and by entering into this arrangement, there will be a reduction in selling costs such as real estate fees and commissions that would have applied had the sale been completed on the open market.

(vii) There are no consequences for you or any other person, other than those already described.

(viii) You will purchase the majority of your spouse's interest in an investment property which you both already own jointly. The investment property will remain within the family unit, albeit with a change in legal ownership.

Conclusion

Based on the facts, the arrangement as outlined is a scheme. You will obtain a tax benefit in the form of an interest deduction on the borrowed money used for this property.

It is considered that a reasonable person would consider the further economic, financial and personal benefits that flow from entering into this arrangement to be significant in making a decision to enter into the arrangement. The Commissioner considers that, having regard to the eight factors referred to above, the obtaining of the tax benefit is not the dominant purpose of entering into the scheme.

Therefore the scheme is not one to which Part IVA of the ITAA 1936 applies.