The ATO has issued Taxation Determination TD 2012/1 in relation to ‘investment loan interest payment’ arrangements (commonly called split loans).
The Determination states that Part IVA of the Income Tax Assessment Act 1936 can apply to deny a deduction for some, or all, of the interest expense incurred in respect of an ‘investment loan interest payment arrangement’.
What is an investment loan interest payment arrangement?
An investment loan interest payment arrangement will exhibit all or a significant number of the features set out as follows:
(a) The taxpayer(s) own at least two properties: one property is the taxpayer(s)’ residence and the other is used to derive rent (‘investment property’).
(b) The taxpayer(s) have an outstanding loan which was used to acquire the residence (or refinance an earlier loan used to acquire the residence) (‘home loan’), an outstanding loan which was used to acquire the investment property (or refinance an earlier loan used to acquire the investment property) (‘investment loan’) and a line of credit or similar borrowing facility with an approved limit (‘line of credit’). All three loan products are typically (but not always) provided by a single financial institution.
(c) The respective interest rates on the home loan and investment loan are typically at or about the same rate. The interest rate on the line of credit is typically (but not always) higher by a small margin (for example, 0.15%).
(d) The investment loan is typically an interest-only loan for a specified period with principal and interest repayments required thereafter, or the interest-only period may be extendable.
(e) The line of credit typically has no minimum monthly repayment obligations provided the balance remains below the approved limit. Alternatively, it may require minimum monthly repayments equal to the accrued interest.
(f) The home loan, investment loan and the line of credit are each secured against the taxpayer(s)’ residence and/or investment property.
(g) The line of credit is drawn down to pay the interest on the investment loan as it falls due. Where no repayments are required on the line of credit, the taxpayer(s) will generally not make any repayments, which results in interest on the line of credit being capitalised and compounded. Where monthly interest repayments are required on the line of credit, the taxpayer(s) meet such repayments from their cash flows.
(h) Typically all or a significant proportion of the taxpayer(s)’ available cash inflows (including that which the taxpayer(s) otherwise might reasonably be expected to use to pay the interest on the investment loan) are deposited into their home loan or an ‘acceptable loan account offset account’, which has the effect of reducing the interest otherwise payable on the home loan.
(i) If the line of credit reaches its approved limit before the home loan has been repaid, the taxpayer(s) may apply to increase the limit on the line of credit in conjunction with a corresponding decrease in the available ‘redraw’ amount in the home loan.
A key feature of the investment loan interest payment arrangement is the use of the line of credit to pay the interest on the investment loan. This results in all or most of the interest on the investment loan, in effect, being capitalised. That is, the payment of the investment loan interest is deferred. This deferral has the economic effect of allowing the taxpayer(s) to repay the home loan at a faster rate than would otherwise be possible: the taxpayer(s) are able to pay an amount equivalent to the deferred investment loan interest on the home loan.
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.
The ATO has determined that it would be open for a reasonable person to conclude that one or more of the parties that entered into or carried out the scheme did so for the dominant purpose of enabling the taxpayer(s) to obtain a tax benefit in connection with the scheme. If a reasonable person would reach such a conclusion then Part IVA applies to the scheme and the Commissioner would be entitled to cancel under paragraph 177F(1)(b) the tax benefit. That is, the relevant interest incurred on the line of credit would not be deductible to the taxpayer(s).
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Posted 22nd March 2012 by David Jacobson in Financial Services, Tax