Claiming a tax deduction on a rental property is reasonably straightforward. The general rule is that any expense you incur on a property available for rent is usually tax-deductible. This is so long as it was for producing rental income and wasn’t capital, private or domestic in nature.
Where it has recently become more complicated is on one of the “big ticket items’ usually claimed by landlords. The Australian Tax Office’s Tax Determination TD 2012/1 is casting some doubt on the deductibility of interest on loans used to buy an investment property under certain, not uncommon, loan arrangements.
The Hart case
This is actually not the first time the tax office has expressed concerns over interest deductions. In 2004, the deductibility of interest on a split loan arrangement was considered by the High Court in FCT v Hart as part of the ATO’s test case program.
The case pertained to a “split loan” or “linked loan”, which was a borrowing facility split into sub-accounts. It was something that a few financial institutions offered at the time.
In a typical split-loan arrangement, one of the sub-accounts is a home loan, the other an investment property loan. As part of the facility, the lender calculates the loan repayments (and interest) on the aggregated loan balances of all the sub-accounts. However, each loan repayment is first applied to the sub-account for the home loan. No repayment is required on the sub-account for the investment loan. The interest expense incurred on the investment loan is capitalised and added to the loan principal.
This arrangement has the effect of compounding the tax-deductible interest on the investment loan while also accelerating the repayment of the home loan.
The High Court sided with the Commissioner of Taxation. Putting aside the complex legal arguments around the application of the general anti-provisions in Part IVA of the tax law, the gist of the High Court decision was that Part IVA applied because it was found that the dominant purpose for the relevant taxpayers to enter into the split-loan arrangement was to obtain a tax benefit.
If the taxpayers hadn’t entered this arrangement, loan repayments (including interest) would need to have been paid on both the home loan and investment loan in the normal manner. This would not have given rise to the tax deduction on the additional interest (incurred on the capitalised interest) and would have avoided principal reductions that were added to the investment loan.
The decision in the Hart case effectively put an end to split loan arrangements as a tax effective strategy. Arguably, other loan arrangements that didn’t share a lot of the same elements of split loan arrangements were not affected.
Latest ruling: TD 2012/1
Fastforward to March 7, 2012, when the Commissioner released TD 2012/1 and we’re now seeing a development that seems to have received limited attention at the moment.
Even though it is implied in its title, the purpose of the Determination is not immediately obvious:
can Part IVA … apply to deny a deduction for some, or all, of the interest expense incurred in respect of an “investment loan interest payment arrangement” of the type described in this Determination?
The more disturbing aspect is that “this Determination applies to years of income commencing both before and after its date of issue”. In other words, the Determination applies retrospectively.
Interestingly, unlike the Hart case, which dealt with a specific loan arrangement, TD 2012/1 specifically, states that “while investment loan interest payment arrangements may vary in the precise loan and security details, they all have familiar financial and purported tax effects”. This means that the Determination takes a “substance over form approach”, which applies to arrangements that substantively exhibit all or a significant number of the following elements:
(a) The taxpayer owns at least one home and one investment property
(b) The taxpayer has an outstanding home loan, investment loan, and a line of credit (or similar borrowing facility) capped at an approved limit, which is typically provided by a single lender
(c) The home loan and investment loan impose a similar interest rate on outstanding loan principal
(d) The investment loan is typically an interest-only loan for some period
(e) The line of credit typically has no minimum monthly repayment obligations or may require minimum monthly repayments equal to the accrued interest
(f) The home loan, investment loan, and line of credit are secured against the taxpayer’s home and/or investment property
(g) The line of credit is drawn down to pay the interest on the investment loan. In some arrangements, no repayments are required to be made on the line of credit, which results in interest being capitalised and compounded on the line of credit account. If interest repayments are required, the taxpayer will make the repayments from their own cash flows
(h) Typically all or a significant proportion of the taxpayer’s cash flows are used to repay the home loan and
(i) If the line of credit reaches its approved limit before the home loan is paid, the taxpayer may apply to increase the limit on the line of credit account in conjunction with a corresponding decrease in the “redraw amount” in the home loan.
The Determination states that the Commissioner may apply Part IVA to this type of arrangement on the basis that:
…if the scheme had not been entered into or carried out, the taxpayer(s) would have met the interest payments on the investment loan out of their own cash flow rather than use the line of credit. Thus, the taxpayer(s) would not have incurred any interest, or would have incurred less interest, on the line of credit.
This approach is reinforced by the Commissioner’s argument that apart from the use of the line of credit account, which effectively results in interest being capitalised on the investment loan, the arrangement appears to make little financial sense and the taxpayer’s financial position is generally no better or worse off. This is especially true when considering that the loans and line of credit are most probably secured by the taxpayer’s home. This makes it difficult to argue that the dominant purpose of the arrangement is for the taxpayer to pay off the home faster.
Where to go from here?
At the outset, it should be remembered that the Taxation Determination only represents the Commissioner’s views and interpretation of the law.
If you have entered into a similar loan arrangement, you need to be aware of the risk that the Commissioner may apply Part IVA to deny your past deduction claims on the capitalised interest if a tax office investigation reveals that you have been involved in such an arrangement. What you need to decide is if you want to take the risk. You could continue to make the claims in future or amend your past claims – remembering that the Commissioner can only amend a limited number of past taxation returns.
It would also appear that the biggest gripe the Commissioner has against these loan arrangements is the tax deduction on the additional interest incurred on the capitalised interest in respect of the investment loan. If the interest on the investment loan has never been capitalized it is arguable that no mischief has been committed and Part IVA does not apply. An example of this would be if you pay the interest out of your own funds, rather than borrow them to pay the interest.
Notwithstanding the Commissioner’s current stance, it may perhaps be argued that, apart from the capitalised interest, another potential mischief inherent in some of these loan arrangements is the direction of the loan repayments to exclusively reduce the home loan principal while the investment loan principal is deliberately left intact.
However, a potential counter-factual to such an argument is the common commercial arrangement under which the lender simply provides a home loan and a separate interest-only investment loan to a borrower without any interest capitalisation feature. In my view, it may be difficult for the Commissioner to attack the interest-only investment loan in this instance. This is because there is a cogent commercial imperative to use this type of loan arrangement to maximize the investor’s return on capital – and isn’t dependent on any tax advantage.
In summary, at this stage, people should be very cautious about any loan arrangement that incorporates a feature that would effectively give rise to the capitalisation of interest on an investment loan, whether the arrangement fits squarely into those described in TR 2012/1 or is different in form but similar in substance to those described in the Determination.
If you think your loan arrangement is a potential risk, perhaps consider reducing your risk by not claiming a tax deduction on the interest incurred on the capitalised interest going forward. This would probably involve some fairly complex apportionment calculations. You’d need the assistance of your tax adviser, who should also tell you how to handle your past tax deduction claims in light of the Taxation Determination.
Eddie Chung is partner, tax & advisory, property & construction at BDO (Qld) Pty Ltd. Contact email@example.com or call (07) 3237 5927
Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. The article is provided for general information only and the other and BDO (Qld) Pty Ltd are not engaged to render professional advice or services through this article.