Edited version of your written advice

Authorisation Number: 1051184787063

Date of advice: 8 February 2017

Ruling

Subject: Leasing of residential property by trustees to beneficiaries of family trusts

Question 1

Where the Property owned by the Taxpayers is leased to beneficiaries of the Taxpayers at commercial rates and on commercial terms, is the rent paid by the beneficiaries assessable income of the Taxpayers under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Where the Property owned by the Taxpayers is leased to beneficiaries of the Taxpayers at commercial rates and on commercial terms, can the Taxpayers claim deductions under section 8-1 of the ITAA 1997 for losses or outgoings incurred in respect of the Property?

Answer

Yes

This ruling applies for the following periods:

Years ending 30 June 20YY to 30 June 20ZZ

The scheme commences on:

20XX

Relevant facts and circumstances

In your application for private ruling dated DDMM20XX, you set out the facts describing the scheme as follows:

1. The Taxpayers are discretionary trusts that both own a 50% interest each in the Property as tenants in common. The Taxpayers are related entities.

2. The Property was acquired on DDMM20XX.

3. The Property is a residential home in Australia.

4. The Taxpayers have each borrowed funds from related companies to fund the investment. The loans from the related companies are on terms compliant with section 109N of the Income Tax Assessment Act 1936 (ITAA 1936) for the purposes of Division 7A.

5. The Taxpayers intend to lease the Property on a permanent basis to related individuals for commercial rent and on commercial terms. The related individuals are both beneficiaries of the Taxpayers. The parties will enter into a general tenancy agreement (as obtained from the Residential Tenancies Authority) which includes standard lease terms and conditions.

6. The Property is expected to be negatively geared. Consistent with common negative gearing strategies, it is anticipated that the expenditures and outgoings relating to the Property, including interest expense, will exceed the commercial rent received. However, it is anticipated that in the longer term, the capital value of the Property will increase.

7. The commercial rent will be reviewed and adjusted from time to time to reflect any changes in the market rates.

On DDMM20YY, you responded to our request for further information as follows:

a)      What is the value of the loans from the related companies? 

The amount of the Div 7A loans from each related company is $X. 

b)      What is the value of the property? 

The property was acquired in 20XX for $X from an unrelated third party. 

c)       What is the commercial rental amount? 

The commercial rental amount is yet to be confirmed however the Taxpayers (“trusts”) have obtained market rental appraisals in the range of $X per week on a permanent, fully maintained basis. 

d)      What are the estimated losses the property will produce? 

The property is expected to make a profit in the 20YY income year as no interest is payable. If assuming the abovementioned commercial rent is charged and the current 2016/17 Div 7A interest rate of 5.4% is payable in 20WWFY, the property will produce an estimated loss of approximately $X for each taxpayer plus their share of annual maintenance costs and depreciation.  

e)      Please detail what the losses in the trust will be used for and the purpose for creating these losses? 

The trusts do not have any other major investments other than their respective interest in the property. In the event that the trusts have no other assessable income in a particular year, the losses will be carried forward. 

f)       How will the trusts pay expenses for the property if they are in a loss position? Especially how the trusts will fund the ongoing expenses of the property? 

The trusts are likely to borrow funds from other related entities to the extent that funds are required and/or may receive distributions of trust income. 

g)      How long is the term of the loan and how does the trust plan to repay this loan in full by the required date? 

The loan is a 25 year Div 7A loan secured against the property. As the property is valuable and is a capital growth asset, a number of repayment or refunding options would be available to the trusts. 

h)      What is the expected capital growth of the property? 

The trusts are optimistic about the property market and anticipate significant capital growth over the medium to long term.  

i)        Are there any other arrangements or business activities that the trusts are involved in or plan to be involved in? 

No. 

j)        Who currently owns the property? eg unrelated party 

The trusts currently own the property. The property was acquired in 20XX from an unrelated party.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Section 6-5 of the ITAA 1997 provides that assessable income of an Australian resident taxpayer includes the ordinary income it derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Section 8-1 of the ITAA 1997 provides that a taxpayer may deduct from its assessable income any loss or outgoing to the extent that:

a) it is incurred in gaining or producing the taxpayer's assessable income; or

b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing the taxpayer's assessable income.

The ATO view on the tax treatment of the purchase of a residence by a family trust and the subsequent leasing of it to family beneficiaries in the trust is set out in Taxation Ruling No. IT 2167 (issued on 4 July 1985).

Paragraphs 29 and 30 state:

Purchase of a residence by a family trust and the subsequent leasing of it to family beneficiaries in the trust.

29. Situations under this heading are designed to obtain an income tax deduction for losses and outgoings which would otherwise be characterized as private or domestic expenditure. By way of illustration, a family trust may be established to acquire what is in fact the private residence of the beneficiaries of the trust. Financial arrangements for the purchase of the residence by the trustee may be highly geared. The trustee will let the residence to one or both parents at a commercial rental and the family would occupy the residence as the family home. The trustee lodges a return of income disclosing the rental as assessable income and claiming income tax deductions for the losses and outgoings attributable to the residence. Income from other sources is channelled into the trust to absorb the losses arising from the rental of the residence to the parents.

30. In situations such as this it is apparent that, had the parents acquired the residence in their own right, the losses and outgoings attributable to the residence would not have been allowable as income tax deductions - they would have been private or domestic expenditure. In cases of this nature that have arisen, the deductions claimed by the trustee have been reduced. A case in point has been heard by a Taxation Board of Review and is currently awaiting decision. In the meantime it should not be accepted in cases of this nature that the rent payable by the parents is assessable income of the trustee or that the losses and outgoings attributable to the residence are allowable as income tax deductions.

The Full Federal Court decision in FCT v. Janmor Nominees Pty Ltd 87 ATC 4813; (1987) 15 FCR 348 was made after Taxation Ruling IT 2167 was issued in 1986. In this case the taxpayer was a trustee company of a doctor's family trust. The trust purchased a residential property using mortgage finance and, in turn, leased the property to the doctor at a commercial rate. The doctor and his family occupied the residence.

The trust included the rent from the property in its tax return as assessable income and claimed a deduction for its expenditure on mortgage interest, borrowing expenses, insurance, rates and part of the cost of repairs. The outgoings of the trust on the property exceeded the income of the trust so there was a net loss claimed. The Commissioner sought to deny the taxpayer a deduction for the interest that was above the rental income.

The full Federal Court allowed the taxpayer a deduction for the interest in full. The Court held that despite the transaction being motivated by familial considerations, that fact was not conclusive of the nature of the receipt of rent by the taxpayer or of the character of the payments of the interest. Despite the Commissioner's attempts to argue that the rental payments received by the taxpayer were some kind of familial payments (in essence a sham), the Court recognised that the doctor and his wife intended to provide the property as an asset for themselves and their family and that the property was to be negatively geared to achieve that aim. On the basis that the leases and other legal documents were legally effective, the taxpayer and the doctor created a lessor-lessee relationship and the rental receipts were held to be assessable income of the taxpayer.

In terms of the taxpayer's deduction claimed for interest payments, Lockhart J held that the high gearing of the property did not deprive the interest payments of their character as outgoings incurred in gaining or producing the assessable income of the taxpayer. The Commissioner was unable to argue that the interest payments were of a private or domestic nature, given the legal relations created between the parties.

A Note was added to Taxation Ruling IT 2167 on 8 August 2013, noting the effect of the decision in Janmor Nominees in altering the position taken in that Taxation Ruling. The Note states:

Note: Where a residence is purchased by a family trust and is leased to beneficiaries in the trust at commercial rates (paragraph 29), the rent paid by the beneficiaries is assessable income of the trustee and losses and outgoings attributable to the residence are deductible, unlike the view expressed in paragraph 30. This reflects the decision of the Federal Court in FCT v. Janmor Nominees Pty Ltd 87 ATC 4813; (1987) 15 FCR 348. The priority given to updating/rewriting this ruling to correctly reflect the law depends on the ATO resources available to do so when weighed against other ATO priorities (Note added on 8 August 2013).

To date, Taxation Ruling IT 2167 has not been formally updated or rewritten. The Note should then be taken to be the ATO view on the matter under consideration.

The current facts are similar to those in Janmor Nominees:

● The Taxpayers acquired the Property for investment purposes with the intention that the Property will increase in capital value over the long term, thereby benefitting the Taxpayers' beneficiaries;

● The associated individuals will pay to the Taxpayers rent at commercial rates and on commercial terms to use the property under a general tenancy agreement;

● The Taxpayers have borrowed funds from related companies on loan terms in compliance with Division 7A of the ITAA 1936, which is based on the Commissioner of Taxation's accepted arm's length commercial loan terms.

All dealings between the Taxpayers and the beneficiaries will be conducted in a commercial manner with respect to the purchase and lease of the Property.

Based on the judgment in Janmor Nominees, the excess of losses and outgoings over rental income does not deprive the outgoings of their character as outgoings incurred in gaining or producing the assessable income.

Furthermore, while the decision in Janmor Nominees was made with respect to subsection 25(1) and subsection 51(1) of the ITAA 1936, it is also equally applicable with respect to section 6-5 and section 8-1 of the ITAA 1997.

Accordingly, consistent with the Commissioner's view in his note to Taxation Ruling IT 2167, on the basis that commercial rent will be paid by the beneficiaries to the Taxpayers:

● the rent paid by the beneficiaries to the Taxpayers will be assessable income to the Taxpayers under section 6-5 of the ITAA 1997 (Question 1); and

● all losses and outgoings relating to the Property will be deductible under section 8-1 of the ITAA 1997 (Question 2).