The ‘most common’ investment strategy recommended by brokers and advisers has been slammed by the ATO as bad practice and a potential breach of tax law.

Following Australian Broker’s revelations that many brokers are unaware they may be prosecuted as ‘scheme promoters’ for suggesting certain investment strategies, a number of readers came forward with their understanding of the legislation.

The article related to arrangements such as those described in Tax Determination 2012/1 – a determination based on the Hart case.

The arrangement involves a borrower using a line of credit to pay interest on an investment loan, then, as the line of credit can be claimed as a tax deduction, allowing the debt to capitalise and compound while all of the client’s available cash is used to pay the debt on their home of primary residence.

A number of readers responded that there are some notable exceptions to this rule. A Victoria-based broker, speaking with Australian Broker claimed the practice of ‘snowballing’ is one of these. 

“Snowballing is the most common strategy being used in the industry at the moment. You don’t have to trust me on that; you can ring the tax department. Snowballing is something they don’t even have to worry about.

“We have the rent going into the line of credit, so the line of credit is compounding but it’s only going up by the loss on property. So in other words they’re not putting after tax income or wages towards the shortfall - and the tax department are quite happy with that.”

But Australian Broker did contact the ATO, and assistant commissioner Wayne Barford says the tax department is in fact very worried about these types of arrangements.

“Such arrangements capitalise the investment loan interest whilst freeing up funds for use elsewhere, often in order to meet private expenses. This increases the overall level of tax deductions."

Any borrower capitalising on interest and claiming extra tax benefits leaves themselves exposed to consideration as participating in a tax avoidance scheme, says Barford. 

Whether or not this is a breach of tax law is then determined by other factors, such as the dominant purpose for entering the arrangement. 

Barford refutes claims that borrowers can use the extra funds to meet other expenses, and that these other expenses would then constitute the borrower's dominant purpose.

“These arrangements may be subject to the general anti-avoidance provisions (Part IVA) of the Tax Act (see Taxation Determination 2012/1), even where an arrangement advances a wider objective.

“It’s a two-step process. You can say you did the arrangement to help you afford private school expenses for your kids, but your primary purpose is to get a tax benefit and you’re using that benefit to meet extra expenses. This is simply not allowable."

Arguments from readers that banks, accountants or advisers are the ones who should be responsible for such arrangements were also clarified by Barford.

“Banks provide products but it is how the products are used by the clients that is important. There’s nothing wrong with line of credits and accounts being provided by those banks, it would only be an issue if the banks were the ones providing the advice and we have no evidence that this is the case.

“If brokers give such advice they are responsible. If brokers give tax advice they’re exposed and may be subject to civil penalties under the Promoter Penalty Laws.

“We encourage taxpayers and advisors who may be concerned that they have entered into arrangements of this type to lodge a ruling request with the ATO.”