The Price Of Making A Bundle With Loans
Sydney Morning Herald
Wednesday February 3, 1999
TOWARDS the end of last year, the Australian Taxation Office issued an important ruling relating to linked or split loan facilities and the treatment of resulting interest payment deductions which will affect thousands of taxpayers with combined investment and personal loans.
The investment loan may be used to buy a rental property, trade in shares or run a small business.
Ironically, while life insurance companies are unbundling their policies, banks have moved to mass-market business and personal loans as one product, with the speed of repayment varying between the two elements.
Borrowers are told that bundling the loans in this fashion renders them more tax efficient because any spare cash can be used to pay off the personal loan faster, thus minimising the personal interest cost, while at the same time the interest charges mount more quickly on the business loan. As interest charges on business loans are conventionally tax deductible this has meant that tax deductions emanating from these bundled loans have blown out beyond what the Tax Office regards as fair and reasonable.
The main feature of such loans is that while the lender sets the minimum loan payment at the amount required to pay back the total loan amount on a principal and interest basis, the taxpayer applies the payments first to pay the principal and interest on the private account and when that part of the loan liability is extinguished the payments are made against the investment account.
The ATO has been concerned for some time that all taxpayers may be subsidising what is in effect personal loan interest charges incurred by the borrowers of these split loans through loading the interest deductions attributable to the business portion of the loans. As a result it has stepped up its scrutiny of what is being claimed as a legitimate business interest cost and fees. A suitable case for testing its attitude in the courts is being selected, and will probably make it into the courts this year.
According to Gadens Lawyers, the ruling - TR98/22 - seeks to deny a deduction of two types of interest payments.
The first category includes interest on cap-italised interest, that is interest already accrued on unpaid interest, on the basis that interest on interest is not incurred for business purposes but instead to pay off the private borrowings earlier.
The second is any amount deemed by the Tax Office to be a tax benefit. The ATO argues in its ruling that a tax benefit includes the amount by which the interest claimed on the business loan exceeds the interest cost the taxpayer would have incurred on a conventional principal and interest investment loan.
Where there are two separate loans which involve an interest and principal repayment plan the situation is quite clear; the business loan interest is quite distinct and separate from the personal loan interest. The trouble emerges when the two merge and it seems no-one seems to pay off the business loan first and then the personal loan. It is always the other way round.
The Tax Office says it is ready for challenges to its recalculation of what should have been deductible in these circumstances and is understandably of the view that taxpayers generally should not be subsidising the accelerated extinction of personal loans through split loan arrangements.
What is more, the higher interest bill accumulating on the business loan blows out the cost base for the asset when it is sold, thus reducing capital gains tax liability.
To separate the two loans for tax purposes, the Tax Office will calculate the interest bill it regards should have been allocated to the business loan if it stood alone. It is also scrutinis-ing the allocation of bank fees attaching to such loans - including application, ongoing administration, monitoring, reference and other fees which have become commonplace - between the business and personal elements of the loan.
There will no doubt be dust-ups with taxpayers' accountants arising from these recalculations and one can see a lot of work being created for bean counters in the test case on the best and most acceptable way of calculating the interest.
The ruling has identified common features of all the schemes under scrutiny. They include:
* Both loans are with one lender.
* Acceptance by the lender of capitalisation of interest on the investment account on the basis that the lender receives another predetermined amount in reduction of the private account.
* Application of any payments to the private account including those that would have otherwise been paid against the investment account.
* The consequential incurring of an amount of additional interest (by reason of the process of capitalising interest) on the investment account.
* An understanding or agreement as to how the facility is to operate, including the linking of the private and investment accounts.
The scheme may also include additional characteristics, such as the refinancing of an existing private loan arrangement or the advancing of funds for a private loan. It may include refinancing of an existing business or investment loan or the advancing of funds for a business or investment loan, securing both loans or accounts by the same assets and often the charging of additional fees and interest which happen to get allocated to the business loan.
The ATO has warned that it is also looking at applying the provisions of the anti-avoidance section of the Tax Act, Part IVA, to the deductions claimed from such arrangements.
If it finds that there has been a planned course of conduct designed to produce a tax benefit using split loans, that the bundling is designed to produce additional interest deductions, that it is marketed in a manner that emphasises the associated tax benefits, that it accelerates the repayment of the private account and there are no commercial reasons for capitalising the interest on the business loan or the interest rate charged on the facilities is higher than under a conventional business loan, the taxpayer could find himself or herself facing severe tax penalties under this provision.
The Tax Office has stressed that each case will be considered on its own merits but if it emerges that the dominant purpose of the arrangement was to obtain a tax benefit, the Tax Commissioner has made it clear he may disallow the whole or part of the interest bill claimed as a deduction.
CAPITALISING INTEREST
Adding the unpaid interest to the amount borrowed.
© 1999 Sydney Morning Herald
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