ATO to reject capitalisation of interest on investment property loans?

[Terry_w]

Don't know about you, but I think the observations made in the ruling at 17 (e) and (f) are big news. It would be interesting to run a poll here to find out how many people runniging the int. capitalisation approach would fit neatly into those examples.

17. In the context of applying paragraph 177D(b) to an investment loan interest payment arrangement the following general observations can be made:
...

(e)
In many of these arrangements a careful analysis of the all the facts (including the taxpayer(s)' financial circumstances and the relevant terms and conditions of the relevant agreements) indicates that the investment loan interest payment arrangement will have only a limited lifespan. The circumstances often demonstrate that the arrangement will only last for the period during which the taxpayer(s) have non-deductible interest expenses (for example home loan interest), and that once the debt that gave rise to the non-deductible interest expense is repaid the taxpayer(s) are likely to revert to making the payments on their investment loan out of their cash flow rather than using the line of credit. In many cases the taxpayer(s) are simply reverting to what they were doing prior to entering the arrangement.

(f)
If the taxpayer(s)' residence is used as security for either the investment loan or the line of credit, the taxpayer(s) 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.

http://law.ato.gov.au/atolaw/view.htm?docid="TXD/TD20121/NAT/ATO/00001"

and,

INCOME TAX ASSESSMENT ACT 1936 - SECT 177D
Schemes to which Part applies

This Part applies to any scheme that has been or is entered into after 27 May 1981, and to any scheme that has been or is carried out or commenced to be carried out after that date (other than a scheme that was entered into on or before that date), whether the scheme has been or is entered into or carried out in Australia or outside Australia or partly in Australia and partly outside Australia, where:

(a) a taxpayer (in this section referred to as the relevant taxpayer ) has obtained, or would but for section 177F obtain, a tax benefit in connection with the scheme; and

(b) having regard to:

(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 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, 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; and

(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);

it would be concluded that the person, or one of the persons, who entered into or carried out the scheme or any part of the scheme did so for the purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme or of enabling the relevant taxpayer and another taxpayer or other taxpayers each to obtain a tax benefit in connection with the scheme (whether or not that person who entered into or carried out the scheme or any part of the scheme is the relevant taxpayer or is the other taxpayer or one of the other taxpayers).

Note: Section 960- 255 of the Income Tax Assessment Act 1997 may be relevant to determining family relationships for the purposes of subparagraphs (b)(vi) and (viii).

http://www.austlii.edu.au/au/legis/cth/consol_act/itaa1936240/s177d.html

 

[Belbo]

Okay TF & TerryW, I'm stumped. Could you please explain for us little folk what 17 e & f imply?

 

[MichaelW]

I don't think you'd get many respondents.

I don't capitalise any interest, never have. I reckon most investors would be in the same boat. I have all my loans as IO, but I pay the interest out of my cash flow, most of the time covered by my rental income, sometimes subsidised by salaried income.

Capitalising interest has never made sense to me. The big benefit of long term property investing is the fact that the loan reduces in "real" terms but your rental income does not. Rents keep pace with inflation. If you capitalise interest then this cash flow benefit is gone.

Cheers,
Michael

 

[Aaron_C]

The only time you'd really capitalise interest is for short-term funding like construction. Other than that you seem to be asking for trouble.

 

[Token Funder]

Okay TF & TerryW, I'm stumped. Could you please explain for us little folk what 17 e & f imply?

Terry can correct me if I'm wrong, but for the avoidance provisions to apply, the existance of a "scheme" as defined in 177(d) is required. The ATO ruling would appear to be making the observation that capitalised interest arrangements where the capitlisation occurs only while the non-deductiable debt exists and/or still leave a property encumbered (albeit with deductible) debt, would have the charateristics of a scheme uner 177(d).

Given my experience is that most capitalisation regimes have one or both of those characteristics, methinks they're schemey.

 

[Rolf Latham]

Terry can correct me if I'm wrong, but for the avoidance provisions to apply, the existance of a "scheme" as defined in 177(d) is required. The ATO ruling would appear to be making the observation that capitalised interest arrangements where the capitlisation occurs only while the non-deductiable debt exists and/or still leave a property encumbered (albeit with deductible) debt, would have the charateristics of a scheme uner 177(d).

Given my experience is that most capitalisation regimes have one or both of those characteristics, methinks they're schemey.

Using such derivation, almost all forms of investing and/or business that cap interest, and have a common owner that has non ded debt are schemes, indeed anything that maximises tax benefit without a specific PBR would be.

I now know how the current gov will fix the unemployment fall out from the Carbon Tax et al.....


Hold on tight because next week we have this ruling coming out


having a PI loan on a PPOR and an IP loan on an IP..........


Anyways, onto more productive ways for gov to raise a dollar, did I hear somewhere that the cash economy is being targetted with rulings


ta
rolf

 

[Shadow]

Capitalising interest has never made sense to me. The big benefit of long term property investing is the fact that the loan reduces in "real" terms but your rental income does not. Rents keep pace with inflation. If you capitalise interest then this cash flow benefit is gone.

If you have multiple loans, some deductible and some non-deductible, then it makes financial sense to allow the deductible loans to capitalise, if doing so enables you to pay down the non-deductible loans more quickly. I've been doing it for a couple of years, since the ATO ruling discussed in this thread...

http://somersoft.com/forums/showthread.php?t=55298

At that time, the ATO deemed an acceptable reason to be that one wanted to pay off one's home sooner. Now they're saying this is no longer a valid reason. Julia has proposed some alternative reasons that might be deemed acceptable to the ATO.

Worst case scenario, if I was audited, and if they apply the rule retrospectively, and if they don't accept my reasons for entering into such an arrangement, then they could hit me up for about $5K in back taxes over the past two years... not a big deal, but just wish the ATO would be more consistent in their rulings. As it is, you never really know where you stand since the rules can change at any time, especially if they apply their new rules retrospectively.

I know other people who have been using arrangements like this for a much longer time. There is a lengthy thread here on Somersoft all about it... 'debt recycling thread', started by corsa I believe, going back to 2006. However, I was always reluctant to do it, until the ATO ruling I linked to above finally seemed to give the green light in 2009.

(It's still be be confirmed whether the rule does apply retrospectively, although mentioned in the SMH article, I haven't seen anything official).

 

[Aaron Sice]

See the other threads on TD 2012/1.

Your heading to the threat is misleading, the ATO hasn't rejected capitalisation. It is still possible, but if it is done as a scheme with a dominant purpose of paying off the home loan sooner then they can deny the extra deductions.

that's how i read it, but this thread quickly dissolved into hearsay so there wasn't much point squeaking amongst the noise.

 

[Shadow]

Capitalising interest has never made sense to me. The big benefit of long term property investing is the fact that the loan reduces in "real" terms but your rental income does not. Rents keep pace with inflation. If you capitalise interest then this cash flow benefit is gone.

If you have multiple loans, some deductible and some non-deductible, then it makes financial sense to allow the deductible loans to capitalise, if doing so enables you to pay down the non-deductible loans more quickly. I've been doing it for a couple of years, since the ATO ruling discussed in this thread...

http://somersoft.com/forums/showthread.php?t=55298

At that time, the ATO deemed an acceptable reason to be that one wanted to pay off one's home sooner. Now they're saying this is no longer a valid reason.

Obviously PBRs are private rulings, but they do, or should, set a precedent.

Julia has proposed some alternative reasons that might be deemed acceptable to the ATO.

Worst case scenario, if I get audited, and if they apply the rule retrospectively, and if they don't accept my reasons for entering into such an arrangement, then they could hit me up for about $5K in back taxes over the past two years... not a big deal, but just wish the ATO would be more consistent in their rulings. As it is, you never really know where you stand since the rules can change at any time, especially if they apply their new rules retrospectively.

(It's still to be confirmed whether the new rule does apply retrospectively, although mentioned in the SMH article, I haven't seen anything official).

Here is Corsa's original 2006 thread on interest capitalisation... Interest on Interest and Capitalising Interest - the Facts

I know other people who have been doing this type of 'debt recycling' for a long time, but I was always reluctant, until the 2009 ATO ruling linked above seemed to give the green light.

 

[Propertunity]

Expanding Part IVA Anti Tax Avoidance Provisions

Using such derivation, almost all forms of investing and/or business that cap interest, and have a common owner that has non ded debt are schemes, indeed anything that maximises tax benefit without a specific PBR would be.

Just to add to the conversation with some more recent of Julia H's musings:
http://bantacs.com.au/newsflash/Newsflash_245_15th-April-2012.pdf
Page 3 headed: Expanding Part IVA Anti Tax Avoidance Provisions

If you think I am exaggerating, consider that the ATO has already used Part IVA to prevent taxpayers offsetting a capital gain they have made during the year by, before 30th June, selling off shares that have a capital loss and later buying those shares back. This simple choice is now already considered a tax scheme, what next? The first thought that comes to mind is choosing an interest only loan rather than principle and interest on your rental property.
If we allow the ATO to decide what your action should be without at least requiring them to consider what a reasonable person would do, we may as well throw out the rest of the tax law and just let them decide each year just how much they would like of your hard earned dollars.

 

[Aaron_C]

'Washed sales'. It's funny how the ATO wastes time on red herrings like this when all they need to do is audit any restaurant in Chinatown to collect money easily.

 

[Terry_w]

I think even negative gearing could be a scheme with a dominant purpose of making tax deductions.

 

[Propertunity]

I think even negative gearing could be a scheme with a dominant purpose of making tax deductions.

Perhaps, if you were a conspiracy theorist, you might think that they are getting to this end point by stealth.....slowly, slowly so they avoid any outcry from removing neg. gearing in one fell swoop.

 

[Aaron_C]

I think even negative gearing could be a scheme with a dominant purpose of making tax deductions.

Guess businesses better stop making tax deductions on their business expenses too since this could be a scheme too!

 

[Terry_w]

Guess businesses better stop making tax deductions on their business expenses too since this could be a scheme too!

Aaron, those pens you bought at the end of the financial year to bring forward $5 in deductions could have been done with the dominant purpose of tax savings

 

[Token Funder]

I think even negative gearing could be a scheme with a dominant purpose of making tax deductions.

For some of the posters that come and go through this forum, you'd probably be right. For some, a positively geared property appears to be a negative.

 

[Ed Barton]

For some of the posters that come and go through this forum, you'd probably be right. For some, a positively geared property appears to be a negative.

I've heard people say reducing tax is the reason for investing in property. "I'm going to have to sell my IP in xxx because it's making a profit"

 

[Terry_w]

I've heard people say reducing tax is the reason for investing in property. "I'm going to have to sell my IP in xxx because it's making a profit"

Strange but I have heard similar too. One person added a new kitchen, when I asked why she said her accountant recommended it as she was making a profit.

 

[HotRod]

I've had frieds that have reduced the rent to keep the property negatively geared.

When I asked them shy, they said they did not want to pay extra tax.

When I tried to explain that if you pay tax it means you are making money, they said that thet accountant said it was more important to reduce tax.

OMG!!!

Some people should not give advice.

 

[Ed Barton]

Strange but I have heard similar too. One person added a new kitchen, when I asked why she said her accountant recommended it as she was making a profit.

i think (or hope at least) that these people don't quite hear what their accountant is saying. "is there anything you can do to the IP which will increase deductions, while increasing rent and value? perhaps it's time for a new kitchen or bathroom?" the client hears "my accountant recommended a new kitchen as i was making a profit".