Edited version of your written advice

Authorisation Number: 1051300726413

Date of advice: 31 October 2017

Ruling

Subject: Deductions and the application of Part IVA to a rental property arrangement

Question 1

Is the rental income derived in respect of the property, assessable income of the Trust under section 6-5 of the Income Tax Assessment Act 1997?

Answer

Yes

Question 2

Are the expenses incurred in maintaining the property, as set out in the facts below, deductible to the Trust under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 3

To the extent that the expenses claimed by the trustee in relation to the arrangement described are allowable deductions pursuant to section 8-1 of the Income Tax Assessment Act 1997, will Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) be applied to deny some or all of the deductions?

Answer

No

This ruling applies for the following periods:

1 July 2017 to 30 June 2022

The scheme commences on:

1 July 2017

Relevant facts and circumstances

The Trust is a discretionary trust.

The corporate trustee of the trust is Company A (the taxpayer).

Person A and Person B are directors of the corporate trustee.

Person A and Person B are included as general beneficiaries of the trust.

The taxpayer, as trustee for the trust, will purchase a property for the purchase price of $X (the property).

A home loan will be taken out by the taxpayer, as trustee for the trust, from a commercial bank to purchase the property. The trust funds will be used to fund the remaining purchase price and associated acquisition costs.

The property will be leased to Person A and Person B under a legally enforceable lease arrangement as a furnished apartment in order to derive rental income for the trust.

The lease will be for a period of 12 months (with the option to renew).

The rental amount will be at the current market value.

Rent will be physically paid to the trust bank account per the rental agreement.

The taxpayer will continue to rent the property until the property is 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

Reasons for decision

Rental income and deductions

Summary

Rental income derived by a trust is assessable income to the trust and expenditure incurred in deriving that income is deductible, so long as the outgoing is not of a private, capital or domestic nature and the deduction is not denied by another section of the Act.

Detailed reasoning

The net income of a trust is the total assessable income of the trust calculated as if the trustee were a resident taxpayer in respect of that income, less all allowable deductions (subsection 95(1) of the ITAA 1936).

The assessable income of the trust consists of all the statutory and ordinary income earned by the trust property (section 6-5 of the Income Tax Assessment Act 1997 (ITAA1997)).

Where a taxpayer grants a lease of property, the amount received in respect of such a lease will ordinarily be assessable income to the taxpayer.

Federal Commissioner of Taxation v. Janmor Nominees Pty Ltd (1987) 75 ALR 15; (1987) 15 FCR 348;19 ATR 254;87 ATC 4813 considered the situation whether the rent received from a residential property rented by a trust to associates at a market rate constitutes assessable income. The Full Court held that the rental receipts did constitute assessable income to the trust.

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 except where the outgoings are of a capital, private or domestic nature or a deduction is denied by another section of the Act.

For example, whether interest on a loan to purchase a rental property has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. Where a borrowing is used to acquire an income producing asset or relates to an income producing activity, the interest on this borrowing is considered to be incurred in the course of producing assessable income.

This will include arrangements where the parties are related, if the arrangement is consistent with normal commercial practices; see Federal Commissioner of Taxation v Janmor Nominees Pty Ltd (1987) 75 ALR 15; (1987) 15 FCR 348; 19 ATR 254; 87 ATC 4813 referred to above.

In your case, you will borrow funds, as trustee for the trust, to purchase a rental property. You will incur other expenses to maintain the rental property.

You will enter into a legally enforceable rental agreement with related parties. Rent will be paid to the trust at market rates.

It is therefore considered that the rent received by the trust will constitute assessable income and any losses or outgoings to the extent to which they are incurred in gaining or producing the rental income and are not of a capital or private nature will be allowable deductions.

Application of Part IVA

Summary

Part IVA will not be applied to deny deductions in relation to the arrangement described, where the expenses claimed are allowable deductions incurred in gaining or producing the rental income.

Detailed reasoning

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance provision that gives the Commissioner the power to cancel 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.

The requirements of Part IVA are:

(i) a 'tax benefit', as identified in section 177C, was or would, but for subsection 177F(1), have been obtained,

(ii) the tax benefit was or would have been obtained in connection with a 'scheme' as defined in section 177A, and

(iii) having regard to section 177D, the scheme is one to which Part IVA applies.

Scheme

For Part IVA to apply, the identified scheme must fall within the wide definition of 'scheme' in subsection 177A(1).

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.

The arrangement for the trustee, on behalf of the trust, to purchase and lease a property to Person A and Person B is a 'scheme' as defined in section 177A of the ITAA 1936. The scheme includes borrowing funds from a commercial bank (80% of the purchase price), purchasing, furnishing and maintaining a property, and entering into a legally enforceable rental agreement with related parties.

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 a '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. This alternative 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.

Alternatives to the scheme are the trust rent the property to a non-related person, or alternatively, Person A and Person B purchase the property directly, which renders the leasing arrangement unnecessary.

Under the first alternative, there is no tax benefit, but it also does not achieve the objectives of the taxpayer (being asset protection). Under the second alternative, there is no income derived and therefore no deductions would be available in relation to the property.

Objective purpose test

Section 177D of the ITAA 1936 provides that Part IVA applies to a scheme in connection with which you have 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 you to obtain the tax benefit.

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. The person need not be you.

The objective test in paragraph 177D(b) of the ITAA 1936 is the core of Part IVA and has been described by the High Court as the 'pivot' or 'fulcrum' on which Part IVA turns. It is frequently referred to as the 'statutory predication test'.

The consideration of purpose or dominant purpose under paragraph 177D(b) of the ITAA 1936 requires an objective conclusion to be drawn. The conclusion required by section 177D of the ITAA 1936 is not about a person's actual, i.e., subjective, dominant purpose or motive. It is possible for Part IVA to apply notwithstanding that the dominant objective purpose of obtaining the tax benefit was consistent with the pursuit of commercial gain.

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.

Consideration of the eight factors involves comparison of the scheme with the alternative arrangement. In other words, the conclusion about the dominant purpose of a person entering into or carrying out the scheme, or any part of it, necessarily requires consideration of what may otherwise have occurred.

These eight factors are as follows:

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

(ii) the form and substance of the scheme

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

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

(v) any change in the financial position of the relevant taxpayer that has resulted, or 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, being a change 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 subparagraph (vi), of the scheme having been entered into or carried out

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

Conclusion:

Having regard to eight specified factors, in this case the Commissioner has formed the view that the dominant purpose of a person in entering into or carrying out the relevant scheme as described above is not to enable the taxpayer to obtain a tax benefit in connection with the scheme.

Therefore, Part IVA of the ITAA 1936 will not apply to deny the deductions for the expenses that are deductible under section 8-1 of the ITAA 1997 in the proposed arrangement the subject of this Ruling Application.