Submission to Capitalise Interest Draft Ruling
Response to TD 2011/D8
Julia Hartman B.Bus CPA CA
Response to TD 2011/D8
PO Box 9977
Albury NSW 2640
I have no doubt that the approach to the construction of Part IVA which has been embraced by the Gleeson High Court will see that provisions employed by the Commissioner will inhibit and disrupt ordinary business and commercial transactions and will lead to uncertainty and unfairness in the administration of income taxation legislation, to the disadvantage of individual taxpayers and the whole community.
A J Myers
It is an arbitrary decision made on an emotional principle that borrowings for interest should be treated differently under Part IVA than borrowings for other rental expenses. The loan arrangement is exactly the same; the only difference is the type of expenditure for which the money is borrowed. It is already conceded by the ATO that capitalised interest is deductible in the same way as other rental expenses. The ATO had to concede this before it could argue Part IVA in the final Hart’s case.
Due to the flawed argument that the loans are a scheme when the borrowing is to pay interest but not a scheme when the borrowings are to pay for rates or repairs, then all that is left of the ATO opinion is a statement that the taxpayer must direct his or her cash flow with priority over personal needs into a LOC even though no payment is required by the bank. The principle that the ATO cannot direct taxpayers in managing their financial affairs was well settled at the beginning of last century and remains a key principle of law today:
Case No, F17 Board of Review No. 1 22nd April, 1955
“However ill-advised and foolish his mode of living may be, he is entitled to conduct his personal affairs and his business as he will and as long as he does not come within any provision of the income tax Acts the Commissioner must accept things as he finds them.”
Tweddle V FCT ATD 1942
“It is not suggested that it is the function of income tax Acts or those who administer them, to dictate to taxpayer in what business they shall engage or how to run their business profitably or economically.
Tooheys Ltd v Commissioner of Taxation NSW 1922
“It is not for the court or the Commissioner to say how much a taxpayer ought to spend in obtaining his income, but only how much he has spent”.
Twisted into some sort of scheme
The words “paying their home loan off sooner” have been twisted into some sort of scheme when in reality that is exactly why home owners run a LOC for their home loan or attach an offset account. That is why these accounts were created and most people use these simply with the dominant purpose of keeping as much money in offset against their home loan for as long as possible reducing the monthly interest charge which over time will allow them to pay their home off sooner. To say that adding a rental property to the mix turns the whole arrangement into a scheme caught by Part IVA is taking the counter factual too far.
I propose another counter factual. The taxpayer has invested in property to provide for his or her retirement. This of course stretches their cash flows but ultimately they see a financial benefit. The taxpayer has a family that maybe dependant on just one income. Accordingly it is only responsible to keep some funds available to meet emergencies. This amount varies depending on the risk aversions of the taxpayer and his or her responsibilities and insurance cover. If this safety net was accumulated in a LOC that is mixed with rental property expenses then should it need to be drawn on to meet an emergency the LOC would become mixed purpose. This would result in every transaction on the account having to be analysed to decide whether it is deductible or not and each daily interest charge being apportioned because the taxpayer, in an emergency would be considered to have borrowed back his or her own funds for private purposes and not be allowed a tax deduction for the interest on that borrowing. A far more sensible choice is to accumulate these funds in the home loan LOC or offset account. Further this is exactly what people do, whether they have a rental property or not. This is not a scheme this is normal banking arrangements and it is not for the ATO to tell people how they should organise their finances. The counter factual attempts to rule that income otherwise earned and available to meet the families living expenses must first be used to meet interest payments on deductible debt, such a statement is absurd and in conflict with case law noted above. The more artificial action would be to take it out of the home loan offset and put it in the rental LOC when a repayment is not required on that LOC.
Points regarding TD 2011/D8I would like to make the following points regarding TD 2011/D8
- The loan arrangements described are normal every day loans used by people even without a rental property to “pay off their home loan sooner”
- The presence of a rental property should not change the above to and evil scheme for Part IVA purposes.
- The LOC used to manage the rental property expenses is also a perfectly normal way of making sure expenses are met on time. And would be entered into by taxpayers who did not have non deductible debt.
- The requirement by the ATO that repayments be made on a LOC when the loan agreement does not call for them, is absurd.
- The statement that a LOC is more expensive is incorrect it is intended to have the same effective interest rate as a normal loan once the way the interest on the loan is calculated is taken into account.
- It is inappropriate to apply this draft ruling retrospectively when the only other statement by the ATO on the matter, namely PBR 94265 ruled that Part IVA did not apply to such arrangements and the fact that the ATO has not answered ruling requests on this topic for over 2 years now so taxpayers have had to self assess based on PBR 94265 as the only information available on the issue.
- It is not for the ATO to tell a taxpayer how to manage their money.
- The draft leaves so many issues unaddressed that it only creates more uncertainty and fear in its wide discretion. “Otherwise reasonably expected” is too vague.
- The counter factual is unrealistic in this day of flexible credit arrangements.
- Many of the points made are irrelevant, simply intended to add emotion to the argument.
- It contradicts the ATOs opinions stated in PBR 94265, PBR 69725 and PBR 81797.
Comments re the Draft Ruling
The following comments are numbered to correspond with the paragraph numbers of the draft ruling. View the Draft Ruling, TD 2011/D8 provided in PDF by the ATO, by following the link above.
The proposal to apply this draft ruling retrospectively is inappropriate because the ATO in the past has issued a Private Binding Ruling (PBR 94265) stating that as the taxpayer’s dominant purpose was to pay their home loan off sooner Part IVA would not apply. Since that ruling was issued 3 years ago hundreds of taxpayers have applied for their own private ruling on the matter and the ATO has refused to answer these rulings. So for the last 2 years, under self assessment, these taxpayers have had to make the decision for themselves as to whether Part IVA applied or not. All they could do was rely on PBR 94265 in the absence of any guidance from the ATO. It is an abuse of power in a self assessment system for the ATO to refuse to answer taxpayers’ questions for over 2 years and then retrospectively apply the law counter to its only public statement on the issue. It may have only been a private ruling but there was no public ruling or case law that contradicted it.
(c) The reason most LOCs have a higher interest rate is to bring them into line with other loans because the interest is calculated differently. The effective rate of interest is the same once timing and frequency are taken into account. Accordingly, a taxpayer is not actually worse off by shifting debt to a LOC.
(h) The statement “the taxpayer(s) cash inflows (including that which the taxpayer(s) otherwise might reasonably be expected to use to pay the interest on the investment loan)”. Requires definition, just what funds might reasonably be expected to be used to pay the interest on the investment loan? Why is this statement so vague? If you are going to tell taxpayers what they are required to do with their money then you need to make it clear. After all it is perfectly normal for mortgagees these days to attach an offset to their home loan or operate their home loan like a LOC. This is simply a way of collecting all the monies in one place to be disbursed as needed and at the same time making the most of this liquidity to temporarily reduce interest. This cannot be done with the investment property LOC because it is tax deductible and using it as a clearing account would render it a mixed purpose loan and a record keeping nightmare. So just what do taxpayers need to do to avoid Part IVA. Is this statement vague because you are well aware from Hart’s case, Case no. F17 dating back as far as 22nd April, 1955 and many other cases and rulings that you cannot actually dictate how a taxpayer manages their finances so instead you are resorting to innuendo of something sinister compared with what you consider “reasonable”. The more artificial action would be to take it out of that account and put it in the LOC when a repayment is not required on the LOC.
It is not satisfactory that the ATO dictate that money must be paid into the investment loan even though the loan agreement does not require a payment to be made. And no consideration is given as to where this money is to come from other than other cash flows. Does this mean the taxpayer is required to use their wages etc to meet a cash shortfall on the rental property rather than use it to meet private needs? Your counterfactual, that a taxpayer would make repayments that are not required by the loan agreement, is flawed and all taxpayers with a home loan and rental property loan are left in fear and confusion as to just how the ATO will reel its big Part IVA stick.
As stated above all cash flows cannot be cleared through the rental property LOC because it will make the LOC a mixed purpose loan and create a record keeping nightmare. It is not just logical to use the private LOC or offset account but a reasonable choice that is available to the taxpayer, not a scheme for a tax benefit. This assertion is based on the fact that most people with a mortgage but no rental property organise their affairs this way. So at this point there is no “real effect …to purportedly make the payment of interest on the capital sum paid in reduction of the home loan tax deductible”. It is only when we move from this to what the ATO considers “might reasonably be expected to use to pay the interest on the investment loan”. Point 4. lacks any validity when you consider that repayments are not required to be made. It amounts to nothing more than the ATO directing taxpayers on how they should manage their money. The ATO failed in this argument way back in 1955 case 17 in the board of review.
People who do not own a rental property also enter into these exact same arrangements; that is, they have an offset attached to their home mortgage or running their home mortgage as an LOC, in order to pay off their home loan sooner. You need to go beyond this simple arrangement. The rental property loans are just as benign, they are simply loans with an LOC to make sure payments are always met on time regardless of cash flow. There no scheme in the actual way the loans are set up because there is no difference in the loan arrangements than what a person would organise on a rental property if they had no mortgage on their home loan. This point is simply innuendo; Part IVA cannot be used to analyse a home loan arrangement which is exactly the same as most home owners and decide it is a scheme with a dominant purpose of a tax benefit. The ruling should try specifying what is unique about the arrangement that means it is caught by Part IVA.
To quote Hart’s case:
“It may mean no more than that, in considering the terms of the borrowing for investment purposes, the taxpayer took into account the deductibility of the interest in negotiating the terms of the loan. How could a borrower, acting rationally fail to take it into account?”
The arrangements described in paragraph 3 are the same as any normal financial arrangement except for the statement that the ATO has some mysterious amount that would “reasonably” be expected to be paid off the rental property LOC when repayments are not actually required. Paragraph 3 attempts to catch as a scheme the loan arrangements most people with a home loan have and rental property have. It heads down the wrong track to try and define the scheme this way.
Gets to the crux of the matter of what would reasonably be expected to be paid from the taxpayers “own cash flow”. It requires that the interest on the loans relating to rental properties be met. This is without consideration as to whether the taxpayer has the means to meet these and it involves the ATO abusing the powers of Part IVA to frighten taxpayers into allowing the ATO to dictate just how they manage their finances, right from how they spend their wages through to how much they keep aside for emergencies. Here is another counter factual. The taxpayer has invested in property to provide for his or her retirement. This of course stretches their cash flows but ultimately they see a financial benefit. The taxpayer has a family that maybe dependant on just one income. Accordingly it is only responsible to keep some funds available to meet emergencies. This amount varies depending on the risk aversions of the taxpayer and his or her responsibilities and insurance cover. If this safety net was accumulated in a LOC that is mixed with rental property expenses then should it need to be drawn on to meet an emergency the LOC would become mixed purpose. This would result in every transaction on the account having to be analysed to decide whether it is deductible or not and interest apportioned because the taxpayer would be considered to have borrowed back his or her own funds for private purposes and not be allowed a tax deduction for that borrowing. A far more sensible choice is to accumulate these funds in the home loan LOC or offset account. Further this is exactly what people do, whether they have a rental property or not. This is not a scheme this is normal banking arrangements and it is not for the ATO to tell people how they should organise their finances. The counter factual attempts to rule that income otherwise earned and available to meet the families living expenses must first be used to meet interest payments on deductible debt, such a statement is absurd and in conflict with case law noted above.
The point made in Spotless is relevant to the counter argument in that there needs to be an examination of what is the dominant purpose of the arrangement. If as stated above the arrangement ie depositing all cash flows into the home loan or offset account is no different to the arrangements of a taxpayer without a rental property, then the ATO must find something more to decide there is a dominant purpose of a tax benefit.
Is a preposterous statement suggesting that the arrangement is not entirely irreproachable and proper, and nothing but a means adopted to achieve these results. Every one of these loan accounts has an entirely proper purpose and would continue to operate no matter how much was paid off the interest. The home loan arrangement is what people use regardless of whether they have a rental property and the LOC used to pay rental property expenses and interest is simply a way of record keeping and ensuring that funds are also available to meet expenses when due regardless of how distracted the taxpayer may be by other things. The loan structures are not in themselves a scheme the only thing in disrepute is that the ATO considers the taxpayer should take funds from their “cash flows” to pay into the rental LOC even though a payment is not required by the bank. Note this payment is not required, because of any arrangement that the home is paid off sooner. The payment is simply not required because when the taxpayer organised their affairs they made sure they had enough available credit to not have to constantly worry about their various account balances.
(a) The manner in which the scheme was entered into is exactly the same as would be organised regardless of how much the taxpayer chooses to pay off the rental LOC each month. The statement that the rental LOC has a higher interest rate is incorrect. Firstly, the same rate would no doubt apply if the clearing account was a LOC. Secondly, not all LOCs have a higher interest rate, for example Suncorp do not charge more for their LOC. Thirdly, the reason most LOCs have a higher interest rate is to effectively bring them into line with other loans. The effective rate is the same, as the banks need to charge a higher rate on an LOC to get the same dollar value return. Accordingly, a taxpayer is not actually worse off by shifting debt to a LOC. The principle behind the higher interest rate charged by most banks proves that LOCs can deliver a lower actual interest charge. To simply apply the set percentage rather than examine the loan arrangements is an attempt to win the argument by deception.
(b) It should be noted here that the counterfactual dictates that the taxpayer use their cash flows to pay the interest on the rental property before considering all other needs that these funds may be required to meet. And that this repayment is made even though the loan agreement does not require it. How on earth could a reasonable person consider this is the most likely alternative considering all the other possibilities?
(c) As stated in (a) even if there was a direct shifting of borrowings the taxpayer is not worse off when effective interest rates are taken into account. Further they have a better method of tracking their deductible expenditure and are not at risk of turning their rental LOC into a mixed purpose loan. So significant are these benefits a reasonable person would conclude that a taxpayer would enter into the arrangement regardless of the tax benefit and in fact they do every day, these are normal banking accounts. LOCs and offset accounts are promoted by the banks for their flexibility not their tax benefit. The very growth of such products over the last decade to borrowers not in a position to organise any tax benefits shows that such a banking arrangement stands on its own merits.
(d) This point misunderstands the statement “to own their own home sooner”. It is the idea of having as much money as possible sitting in the home loan LOC or offset account for as long as possible that reduces the interest charged on the home loan so that more of the repayments are attributed to principle. This is the age old concept of putting all your wages into your home loan and living off a credit card etc for the 55 days interest free or taking advantage of monthly payments of other bills so the annual amount can be sitting in the home loan account for as long as possible. Secondly this ruling includes circumstances where the rental LOC is secured by the rental property. This point should be completely disregarded as emotional innuendo rather than any creditable point.
(e) Your point? This is a discussion about the taxpayer’s purpose not the banks.
If that be the case then why do most taxpayers with a home loan enter into exactly the same loan arrangements? Remember we are not talking about an arrangement with the bank that certain loans had to be paid in a certain way as per Hart’s case. This is simply using everyday products in exactly the same way as they are used by people who do not gain a tax benefit. They use these products so they don’t have to worry about always having funds available to make repayments and so that they can utilise every spare cent for as many days as possible to reduce their interest.
The 30 days allowed to respond to the draft is insufficient considering that the ATO web site’s legal data base as been out of action for most of that period, it certainly has been 80% of the time that I have gone on line during the preparation of this submission.
Yes I most definitely want my comments to be included in the edited version of the compendium.
Most taxpayers with a mortgage
As the arrangement you describe is basically that which is common to most taxpayers with a mortgage, whether they have a rental property or not, the issue appears to be one of what is reasonable for the taxpayers to pay off the rental property LOC when no repayment is actually required. The statement that they should meet the interest payments from their other cash flows is counter to case law and the principle that it is not for the ATO to tell taxpayers how to manage their money.
If the ATO is going to continue to not respond to private ruling request and issue retrospective rulings then this ruling needs to provide far more detail and consider many more cash flow situations. Please do not respond with, each case turns on its own set of facts because taxpayers have to operate under self assessment and the ATO’s history of answering private ruling requests on the topic is that no one will get an answer.
Other issues that need to be addressed
Examples of other issues that need to be addressed:
Just how far does this non acceptability of using your money to pay off you home loan sooner go? Does it go so far to put a taxpayer at risk for simply having an offset account or LOC on their home loan where all their income is deposited? This is a long practiced strategy where taxpayers attempt to have every dollar available each day working for them. What are the requirements to avoid being caught by Part IVA? Assume the taxpayer, has a LOC to ensure that all expenses in relation to an investment are met. Naturally this LOC will be separate from the one where all their income is deposited and their living expenses are drawn from. It has to be that way because if the rental expenses were taken from this account it would become a mixed purpose account and a record keeping nightmare.
Does it catch home owners again with the dominant purpose of paying off their home loan sooner who use a separate LOC to meet the cashflow short fall (ie the rents are paid into this LOC) on their rental property? Freeing up their wages to pay for living expenses and any spare cash being used to reduce the home loan mortgage, so they have a safety net for emergencies.
What if instead of a separate home loan with offset account and LOC the home loan was simply a LOC where all income and private expenses were cleared. This means that just like the LOC for the rental property no repayments are required to be made. What is the ATO’s formula as to which commitments get paid first? Should interest repayments on the rental property LOC take priority even in months that there is no other income? What about if the taxpayer was busy and was late with the interest payment on the rental property loan? Just how far is this ruling intended to reach into normal lives because these days most home loans are the type that allow all possible funds to be used to reduce interest while in the account. This arrangement is clearly, to pay off the home loan sooner.
What if the taxpayer has available credit in their home loan? Again a normal situation to protect against unexpected expenses. Remember that if private unexpected expenses are drawn from the available credit in a deductible LOC this will turn it into a mixed purpose loan and a record keeping nightmare. They may also have an investment that is cash flow negative. Are they not allowed to store up available credit when their cash flow is good, to meet unexpected private expenses? If this is the case what are they to do when they need cash and the only available credit is in the LOC used for the rental property? Must they be forced into a record keeping nightmare? Maybe if they have available credit on their credit card they should use this. But the question is are you saying that they must meet the rental property expenses first and any arrangement to provide for uncertainties will be caught by Part IVA because the very nature of providing for these uncertainties in the only account that they can effectively draw back from, will have the effect of paying off their home loan sooner.
Now what if they are just plain lazy and get all their income paid into the offset account or LOC that is for private purposes and as a safety net get all the rental property expenses and interest paid out of another line of credit with a nice large cap. Obviously they can’t have the rental property expenses paid from the private LOC as this would make it a mixed purpose loan and a record keeping nightmare. Now and again when they turn their mind from their busy life and 4 kids to their finances they may transfer funds to make sure there is still plenty of room for payments not to bounce. Does the ATO now require these people to be more diligent in managing their tax affairs? After all this perfectly logical structure may, in the event of their cash inflows exceeding their cash outflows for the month reduce the interest on their home loan. And that is why they have set up an offset account etc against their home loan, to pay it off sooner by having spare funds sitting against their home loan mortgage. What if this laziness means they are late in transferring money into the rental property LOC? Or is laziness ok it is more the systematic approach that is the problem? Therefore people who are organised by nature cannot capitalise interest but disorganised ones can.
What if the rental property suddenly needs repairs and the taxpayer has been stashing away slowly enough money for a holiday. Of course this is “saved” in the non deductible LOC or offset account so that it does not create a mixed purpose loan when it is withdrawn. Then the rental LOC is used to pay the interest on the rental loans and the repairs. Is there an order this has to happen in to be sure it is the repairs not the interest that is borrowed? Or is it simply that the taxpayer is forced to use this spare holiday cash to pay for the increase in the LOC and then borrow for the holiday?
The ruling only requires the interest to be paid not the other rental property expenses that go through the LOC. How does the deduction for interest differ from the deduction for other expenses, given that the ATO has already issued a ruling based on Hart’s case that capitalised interest takes on the exact same character as the original interest?
What would be the case if a person’s home loan was principle and interest over 10 years so that the repayments were so high that they could not meet the rental property expenses and meet their living costs? What order are they required to meet these commitments and would capitalised interest be deductible in these circumstances?
How does this draft ruling affect the advice given in the following private rulings:
PBR 69725 – An investment in shares where the taxpayer said he or she did not want to use other wages income to prop up the cash shortfall in the investment. They ATO said they could borrow the shortfall instead and that interest on interest would be deductible. No mention was made of the use to which the dividends were put. If the ATO thought they could require the taxpayer to use the dividend to pay off the loan or interest then it certainly would have. There are many case precedents where the ATO has not been allowed to tell a person how they should manage their affairs. PBR 81797 – Accepted dominant purpose was not a tax benefit but simply quarantining a rental property expenses, so Part IVA did not apply. As the draft overrides retrospectively the ATO’s only other stated opinion on the issue in PBR 94265 it is important that taxpayers are informed immediately whether any of these rulings should also not be relied upon.
If you propose to rule that a strategy to pay your home loan off sooner can be caught as a tax scheme under Part IVA then you need to give taxpayers strict guidelines on just how and when and on what they can spend their money. Not just a vague statement that it would be reasonable to expect them to use their money in a certain way. Anything less than strict guidelines will create uncertainty in a self assessment regime. Regime being the operative word because it sounds a lot like a dictatorship to me.
In the event of ambiguity in legislation, the citizen, not the executive government, should have the benefit of that construction of the language of the statute which is most favourable to his or her interests.
– Sir Garfield Barwick