capitalised interest and tax

[talbashan]

hi all,
this is the situation:
i have money in a fund which i geared with a 50% margin loan.
rather than paying the interested on the margin loan every month, i have let it capitalise.
the fund has given me income in the form of distributions during the year and i have used those to reduce a non-deductable debt, my PPOR.
now the questions:
can i use the capitalised part of the margin loan against the income from the share fund as a tax deduction???

thanks
tal

 

[michaelway]

Capitalized interest

My understanding is that as long as you don't try to claim any interest on interest, and just claim the normal interest portion you would have claimed under a normal negative gearing arrangement, then the ATO shouldn't have any issue.

Where you park the income from your investment is your choice. Just don't try and claim the interest on the interest - the ATO will probably classify this arrangement as a "tax minimisation scheme"

See also Federal Commissioner of Taxation v Hart in relation to claiming capitalised interest (in this case on an investment property).

Cheers

Michael

 

[talbashan]

thanks michael,
i thought that may be the case. in the Hart case, the ATO was refering to a split loan, however i think the principle is very much the same.
thanks again,
Tal

 

[Andrew]

This has been discussed many times, try doing a search. The short answer is that
many experts say you can deduct interest on capitalised interest.

andy

 

[talbashan]

mmm

my problem is that my accountant is not sure that i can (not sure that i can't either but leaning towards 'i can't') while my financial adviser is adament that i can...

 

[GIDDO]

Another win for the overly complex Aussie Tax System!

 

[Simon]

My understanding is that it is different for property and for share borrowings.

My accountant tells me the former is not allowed whilst capitalising interest for shares is.

Be great to see what the ATO say and I will try to call them.

Cheers,

 

[D.T.]

lol Simon, call the ATO? You're brave

I dropped into the ATO office in the city whilst walking into work the other morning. I asked about obtaining an ABN for my trust. Or at least for the appropiate forms.

And the young lady responded "What's a discretionary trust?"

 

[Simon]

You are right Dave, i just gave up after spending ages on hold.

 

[Mry]

I refer to my previous post -

http://www.somersoft.com/forums/showpost.php?p=201332&postcount=9

Read paragraph 30 in particular.

 

[Simon]

I refer to my previous post -

http://www.somersoft.com/forums/showpost.php?p=201332&postcount=9

Read paragraph 30 in particular.

Thanks MRY - does that apply to a share portfolio as well?

Seems further on in the thread you have just quoted people are asserting (a long held assertion too) that share interest can be capitalised and claimed.

Perhaps we want this to be true but my acountant and some other well known forum identites have always maintained it to be the case.

No luck speaking to the ATO today - maybe I should write them a letter?

Cheers,

 

[talbashan]

mrY

this is interesting. although what you write and the quotes from the ATO are valid, this case (TR 98/22) relates to linked or split loans facilities.

read paragraphs 4 & 5 of the following link and let me know what you think

http://law.ato.gov.au/atolaw/view.ht...2&pn=RDB:::RDB

4. There are many different loan facilities available that could be described as linked or split loan facilities. This Ruling applies only to linked or split loan facilities as described in paragraphs 5 and 6 below. In this Ruling we refer to these loans as 'the facility'.

5. The facility has a number of broad features. There may be one or more borrowers within that facility. A taxpayer borrows an amount or amounts of money ('the loan amount'). The contract/s between the taxpayer and the lender provides that the loan amount is allocated between two or more accounts or loans.

with a margin loan, there is no allocation of the funds between two accounts and it is NOT a linked/split loan. so as i understand it this particular case does not apply to my case where i capitalise my margin loan and therefore can claim the interest AND the interest on the interest as a tax deductability.

am I dreaming?

yours
tal

 

[Tasman]

I refer to my previous post -

http://www.somersoft.com/forums/showpost.php?p=201332&postcount=9

Read paragraph 30 in particular.

Hello MRY,
Your quote from the ATO is in relation to linked or split loan facilities, quoting from ruling:
"This Ruling applies only to linked or split loan facilities as described in paragraphs 5 and 6 below. In this Ruling we refer to these loans as 'the facility".

The ruling it is not about claiming deductions on capitalised interest under other business circumstances. Same comments apply to anyone who quotes the Harts case as prof of non deductibility of capitalised interest. The Harts case was about split loans as a 'mechanism' to maximise tax deductions, ie; with the 'mechanism' seen as mainly contrived for tax benefits.

In other rulings from ATO, capitialised interest is considered as no different to normal interest expense, the nature/category of the expense being unchanged by the capitalisation, and is accepted as a valid deduction.

 

[Mry]

Tasman - On the contrary, I believe that TR 98/22 gives the ATO's view on capitalised interest. The scheme itself was all about capitalising interest.

In order to claim capitalised interest you have to pass two tests - The Section 8-1 Test and the Part 4A Test

Section 8-1

The ATO's view on S8-1 interest deductions is put succintly in Paragraph 8.

8. Where the funds advanced under the investment loan are used to purchase an income producing asset, interest that accrues on the original principal sum is deductible under section 8-1 for the period in which the property is used solely for income producing purposes.

Hmm, interest accruing on principal sum. Why don't they say "interest that accrues on the loan"? A question to all - Do you think that 'principal sum' here means the original sum used to acquire the income producing asset or the loan, even if the loan balance exceeds the purchase price by having interest capitalised?

11. The incurring by the taxpayer of a liability or liabilities comprising the further interest amount is a direct consequence of the capitalisation of interest on the investment account. The character of such liabilities is determined by reference to the advantages arising out of such capitalisation.

12. The advantage arising to the taxpayer on capitalisation of interest on the investment account is the reduction of the principal amount outstanding under the private account. Having regard to this advantage, we take the view the further interest amount does not have the necessary character required for it to be deductible under section 8-1.
.......
14. On this basis, an apportionment of the interest incurred on the investment account in the relevant year is warranted. A fair and reasonable apportionment would be to allow as a deduction under section 8-1 the interest to the extent to which the interest incurred on the investment account in that year exceeds the further interest amount.

(emphasis added)

Note - We haven't even hit Part 4A here. This is just Section 8-1 stuff, the general deduction provision.

So in short - Sure, you can claim a deduction for capitalised interest - as long as you don't get an advantage from doing so and have a perfectly reasonable commercial explanation.

The ATO spends some more time in paragraphs 35-48 knocking back almost any proper explanation for capitalising interest. It seems that if you even get a whiff of a tax advantage from capitalising interest without any overriding commercial explanation, no claim is available. Have a read of that and let me know your thoughts.

Don't think the ATO won't apply the 'logic' of this ruling unless you fit a classic split loan facility - the same arguments apply to capitalising interest and directing payments to private loans.

I'll leave the Part4A test out for now since this post is getting a bit too long.

 

[Tasman]

Mry, in regards to Section 8-1 of the Income Tax Assessment Act 1997, I refer to two private rulings 20834 and 52211.
http://www.ato.gov.au/rba/content.asp?doc=/rba/content/20834.htm

http://www.ato.gov.au/rba/content.asp?doc=/rba/content/52211.htm

52211 reads in part:

WHAT THIS RULING IS about:
Are you entitled to claim a deduction for the capitalised interest on loans obtained to fund a share portfolio?
THE SUBJECT OF THE RULING:
You have several loans secured against the property that is your principal place of residence. The accounts are all held with the same financial institution.
A couple of the loans relate to a personal mortgage and the others are used exclusively to fund a share portfolio.
One of the loans used to fund the share portfolio is a flexible line of credit and the other is a variable loan with a redraw facility.
The accounts for your personal mortgage are not linked to the accounts used to fund the share portfolio.
You do not intend to make repayments towards the principal on the loans used for investment purposes unless you make a disposal of shares.
You wish to claim a deduction on the interest capitalised on the loans used to fund the share portfolio.
The shares are all ASX listed ordinary shares. You intend to increase the portfolio over the coming years.
COMMENCEMENT OF ARRANGEMENT:
1 July 2004
RULING:
Are you entitled to claim a deduction for the capitalised interest on loans obtained to fund a share portfolio?
Yes.
EXPLANATION: (This does not form part of the Notice of Private Ruling)
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, or relate to the earning of exempt income.
Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. TR 95/25 states that to determine the deductibility of interest expenses under section 8-1 of the ITAA 1997, it is necessary to look at the use to which the borrowings are put.
The 'use' test, established in 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 income is to be derived, the interest incurred on the loan will be deductible.
The character of interest on capitalised interest is not necessarily determined in accordance with the use of the original borrowed funds. This is because interest, even when capitalised and added to the overall indebtedness of the borrower for the purpose of calculating future interest, continues to retain the character of interest.
In your case, you have some loans which are used exclusively to fund a share portfolio. You wish to capitalise the interest incurred on these loans. As the loans are used solely for income producing purposes, the capitalised interest incurred on the loans is deductible under section 8-1 of the ITAA 1997.


For your consideration

 

[Mry]

Look at these two similar parts - the second last paragraph of Private Ruling 52211 and Paragraph 41 of the ruling

The character of interest on capitalised interest is not necessarily determined in accordance with the use of the original borrowed funds. This is because interest, even when capitalised and added to the overall indebtedness of the borrower for the purpose of calculating future interest, continues to retain the character of interest.

So in other words, in determining whether or not 'interest on interest' is deductible, you can look at the use of the original borrowing funds but that isn't the real decider. What is the real test? Damned if I know.

In your case, you have some loans which are used exclusively to fund a share portfolio. You wish to capitalise the interest incurred on these loans. As the loans are used solely for income producing purposes, the capitalised interest incurred on the loans is deductible under section 8-1 of the ITAA 1997.

The ATO here looks at the loans themselves and the intentions of the taxpayer to determine deductibility and the purpose of the loan.

42. The further interest amount is incurred on the additional liability that arises when interest is capitalised under the facility. The advantage obtained by the taxpayer when interest is capitalised under this facility is the reduction, by an equivalent sum, of the principal amount outstanding on the private account. In the absence of any commercial explanation for capitalising the interest on the investment loan, the further interest amount does not have the necessary character required under section 8-1.

This is the tax office refuses to look at the loan, but looks at the advantages given. Same as the private ruling situation it would seem. The ATO states that because of the lack of a commercial explanation and the advantages given, the interest is not deductible. That ruling didn't seem to have much of a commercial explanation either, unless it was edited out.

I think that I have a contradiction here. If you don't mind, I'd like to call up the ATO on Wednesday and ask them how they reconcile the two together, and if there is a difference between shares and property in their view.

 

[Simon]

I hope you have more luck than me!

I appreciate the effort you are taking MRY - Thanks

 

[Mry]

5 people later I speak to someone who seems to know what they are talking about. The guy I spoke to stated the position from what ATO auditors do.

The ATO's position is that if you divert income from an income producing asset to a private sources and allow the interest to capitalise on the investment loan, they treat the profit earned from the property before interest as a private withdrawal from the loan.

I don't think that statement is clear enough so lets give a practical example. You buy a rental property for $100,000 and have a loan for $100,000. The interest charged on the loan is $10,000 and the rental property generated $6,000 in income after operating expenses and before interest deductions. The loan is now at $110,000 since the interest was capitalised. The ATO treats that loan as a $104,000 deductible loan with $6,000 (the profit) as a non deductible (same as if it was a private withdrawal under ID 2001/37).

The ATO believe that income received from the investment should be diverted towards the costs of that property, such as a loan and that any diversion of that amount for private purposes while capitalizing the unpaid costs is financing for private purposes.

Here is something that people with interest only loans will find funny - I talked about the above example except with the profit before interest of the IP being $11,000. The guy said that the loan is only $99,000 deductible ($100,000 loan + $10,000 interest - $11,000 profit = $99,000) even though the loan is at $110,000. I said "Wait a sec, there are people out there with interest only loans claiming the interest only on the principal (and haven't performed the adjustment as mentioned) and you are saying that they can't claim interest on the say $100,000 because the entire profit should have theoretically gone towards paying off their loans?" He said yes.

My two thoughts on this are -
1 - It seems to be logical for when the profit does not exceed the interest claim, but once the profit does exceed the interest claim, it doesn't make sense. The interpretation may be in error.
2 - There are no statements on capitalised interest from the ATO that you can rely on. There is a private ruling (binding on the individual who applied only), a tax ruling (based on a decision that was decided upon using Part 4A, not section 8-1) and this advice from an ATO officer, none of which can be relied on.

I'll make a private binding ruling application later.

EDIT - Application made. See you again in 28 days. And sorry for my poor english in post 16. Ewww.

 

[michaelway]

MRY - your post #18.

This just shows how incongruous the ATO's stance on capitalised interest deductions on property investment is in the face of the two Private Rulings quoted by Tasman.

I wonder what the ATO auditors would do if the share dividends/income in the Private Rulings were used to reduce the mortgage on the family home?

Methinks their left hand doesn't know what their right hand is doing.

I look forward to the result of your application for a Private Ruling MRY.

 

[talbashan]

MRy,

first, thanks for all the work that you've done/doing in this matter.
there are a number of things that i'm unclear about from your last answer (#18):

1. the ATO's answer to you talked about 'property', i am led to understand that property and shares are treated differently when it comes to capitalising. do you think that when they mentioned property they meant any investment or property in particular?

2. what do you mean by 'private deductions'? ie in your examples, how would i calculate the income on which i am taxed (after the interest deductions)

thanks again,
tal