Ruling rejecting debt recycling

[Terryw]

In an August edition of the Bantacs Newsflash there was a small article about an application for a private ruling which concerned a 'method' of borrowing from a LOC to pay the interest and other expenses of a rental property.

The ATO rejected the method and denied the deductibility of this interest.

The ruling wasn't available at the time (i think they only publish them a month or so later), but it is now.

Private Binding Ruling authorisation number 1011345133229
http://www.ato.gov.au/rba/content.asp?doc=/RBA/Content/1011345133229.htm

Worth a look for anyone contemplating borrowing to pay interest - And it doesn't mean this isn't possible, just that it wasn't possible in this case. Structure it different and it may be.

 

[Terryw]

That link didn't work, try this

 

[alexlee]

Terry, one distinctive point seems to be that the LOC is secured by the PPOR. To me, this reads like a variation of the split loan ruling, applicable to a narrow set of circumstances.

Specifically from the conclusion (italics are quotes):
The scheme entered into is considered to be dependant on the inextricable linkage between the home loan and LOC and to allow the home loan limit to fall and the LOC limit to rise and in the provision of the home as security

So the key issue seems to be where one or more loans secured by the PPOR has a deductible and non-deductible portion.

 

[Terryw]

Yes, and the fact that periodically the LOC will need to be increased with a corresponding decrease in the home loan.

Sounds like they didn't have much equity to play with.

 

[BV]

Yes, and the fact that periodically the LOC will need to be increased with a corresponding decrease in the home loan.

Seems to me that they gave to the ATO information they didn't have to give.

 

[Gordon Farkus]

What sort of information do you mean, BV?

 

[BV]

What sort of information do you mean, BV?

The fact that the IP and PPOR loans will be adjusted.

The ATO would try to frame you and to make you admit that you want to enter this scheme to gain a financial benefit and to avoid paying tax.

And when you tell them what they want to hear, they'll send you their rejection letter

 

[Gordon Farkus]

OK, thanks.

But I don't think there's any difference to what is described in Corsa's thread: Interest on Interest and Capitalising Interest - the Facts that the mods deemed gospel enough to designate as a Sticky on this forum, however...

 

[alexlee]

This ruling appears to apply where you have a LOC that you use to pay interest and the LOC is secured by the PPOR.

Were the LOC secured by an IP, it would appear to be outside the scope of this ruling.

While the principle of interest on interest is acceptable under the general rules, the ATO can apply limitations to specific circumstances.

 

[bene313]

This ruling appears to apply where you have a LOC that you use to pay interest and the LOC is secured by the PPOR.

I wonder if the denial of interest deduction is due to:

a) The fact that the LOC is secured by PPOR

b) The fact that the continuation of the scheme relies on the PPOR loan being paid down to allow for LOC limit increases

c) Both of the above.

 

[Mry]

I wonder if the denial of interest deduction is due to:

a) The fact that the LOC is secured by PPOR

b) The fact that the continuation of the scheme relies on the PPOR loan being paid down to allow for LOC limit increases

c) Both of the above.

I would say c only because the PPOR loan is private non deductible debt and the ATO consider the PPOR and LOC to be linked because the increase in the LOC results in a drop of the PPOR maximum loan limit.

As I tell most clients when it comes to debt recycling strategies, they are legal with respect to section 8-1. Whether or not the ATO apply Part IVA is a different matter altogether and its very difficult to advise on that. Getting a private ruling with a valid counterfactual is mandatory. While it looks like the ruling could have gone either way, they decided to apply the principles in Hart's case and denied it.

To me there is still a lot of uncertainty in this area. Will the use of an offset account attract Part IVA on the same reasons as this case for others? Are there people who have applied for a private ruling and did not mention the changes they will be applying to their loan balances suddenly find themselves without the protection of their private ruling since they didn't include everything? What if you don't intend to change the LOC and PPOR balances and then find out 4 years down the track that you don't have the cashflow you once had and have to make an adjustment?

Some of the reasoning used in this ruling could apply to most debt recycling strategies.

 

[Marty McDonald]

"In substance, the home loan and LOC facilities as a whole are operating as one account drawn for multiple or mixed purposes"

That sums it up for me, in essense it turned out to be a manual version of the loan products that were around in the early 2000's which caused the Harts case idecision ie it was specifically designed to allow capping investment interest and reducing o.o. debt.

If they had employed the same methods but weren't so exacting with the implementation I think it would have been OK'ed.....perhaps a regular small repayment into the line of credit every month would make it legit even if less than the monthly interest...?

 

[Rolf Latham]

Harts vs ATO had one big difference.

ALL interest was capped to the IP loan, even interest that was not deductible in nature in the first place...................and that was never going to fly

ta
rolf

 

[Cotchin]

What I don't understand is that why in this case did the borrower plan to reduce their home loan limit by making payments from their offset account and at the same time use this equity to increase their LOC limit. I would have thought that the capital growth in their PPOR would have provided them with enough equity to extend their LOC limit. This way there would not have been this link between the reducing PPOR loan size and the increasiing LOC limit. Once there was enough funds in the offset account they could then pay off the PPOR loan in one hit.
I can only assume that the increase in equity in their PPOR due to capital growth was less than the increase in required funds to be drawn down from their LOC.

 

[Terryw]

Serviceability could be a reason too.

 

[Gordon Farkus]

What I don't understand is that why in this case did the borrower plan to reduce their home loan limit by making payments from their offset account and at the same time use this equity to increase their LOC limit.

Perhaps the PPOR loan was being reduced by all income being applied 'in effect' to the offset a/c, ie. no physical payments being made to the PPOR loan but it getting the benefit of the increasing offset a/c balance.

Anyway, that's not the relevant point. The crux of the ruling is the status of the interest on interest created by not directing rent against IP costs. The ATO is saying that if the rent generated from an IP is not applied against the IP the interest it saves on a PPOR loan (ie. where the rent is directed) is not deductible. And this is bizarre and goes against what multitudes of investors (IPs, margin loans, etc.) and businesses are currently doing.