Private ruling: Investment
Published: December 2011
Ruling period: Income Tax Year ended 30 June 2010 | Income Tax Year ended 30 June 2011 | Income Tax Year ending 30 June 2012 | Income Tax Year ending 30 June 2013 | Income Tax Year ending 30 June 2014 | Income Tax Year ending 30 June 2015 | Income Tax Year ending 30 June 2016 | Income Tax Year ending 30 June 2017 | Income Tax Year ending 30 June 2018 | Income Tax Year ending 30 June 2019 | Income Tax Year ending 30 June 2020
Date scheme commenced: 1 July 2009

Ruling: Q1: Is interest incurred by the investor during the years ending 30 June 2010 to 30 June 2020 on monies borrowed to invest in X Limited deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes

Relevant facts and circumstances: The investment The investor ('you') jointly completed and sent a valid Application Form attached to the Prospectus to Y Limited and paid a particular amount to acquire an equivalent number of fully paid voting redeemable shares (Shares) in X Limited. A Contract Note was issued to you by Y Limited on behalf of X Limited confirming your allotment of Shares and that the allotment had been registered on to the relevant share register by the Registrar. You are not a trader in the Shares or carrying on a business of investing in the Shares. You have therefore advised that you are holding your investment on capital account. According to the Prospectus, a portion of the proceeds of Shares issued pursuant to the Prospectus are invested by X Limited as a subscription for redeemable shares in Z Limited, a wholly owned subsidiary of X Limited. X Limited in turn uses the proceeds, on the advice of W Limited as the Investment Manager, to invest using a computerised managed futures program designed to analyse trends and capture opportunities across more than 170 international markets. The balance of the proceeds of Shares issued pursuant to the Prospectus is invested in a Security Deposit held by a bank to secure a Capital Guarantee and a Rising Guarantee, collectively referred to as the Guarantee, in favour of Shareholders on the Maturity Date. The Capital Guarantee provides the Shareholders with protection of their initial investment by ensuring they will receive a minimum amount of $X on or before a specific date in 2020 for each Share held by them on the Maturity Date. The Capital Guarantee will apply if the amount paid to the Shareholders by X Limited on redemption of each Share on the Maturity Date is less than $X per Share. The Rising Guarantee locks in a portion of net new trading profits for each financial year during the term of the investment in which the trading capital of MAN OM-IP 3AHL Trading Limited equals or exceeds 50% of MAN OM-IP 3AHL Limited's aggregate net asset value as at the end of that financial year. When paid into the Security Deposit, any amount locked in will enable the amount guaranteed on the Maturity Date to increase. Shareholders are entitled to receive any dividends declared by the directors of X Limited. As at the date of the Prospectus, X Limited did not intend on declaring any dividends in respect of the Shares or providing any other income through the term of the investment to Shareholders, except for the declaration of a dividend immediately before the Maturity Date equal to the amount by which the net asset value per Share exceeds $X. It is intended that this dividend will be paid as part of the proceeds of redemption on the Maturity Date. Shareholders can sell their Shares to Y Limited or have them redeemed by X Limited at the election of the Shareholders on the first business day of each month at a certain percentage of the net asset value of the Shares (or at 100% of the net asset value of the Shares after 31 December 2012). The Guarantee is not available for Shareholders who sell their Shares or redeem their Share prior to the Maturity Date. Subject to certain restrictions, Shares are also transferable by a standard transfer form signed by both transferor and transferee and registered in X Limited's share register. You have advised that you intend to hold your Shares until the Maturity Date. X Limited will redeem all of the Shares outstanding on the Maturity Date. The amount paid out by X Limited on redemption on or before a specific date in 2020 (including any amount paid as a dividend) will be the net asset value per Share at the time. The Prospectus contains a taxation summary setting out the material income tax issues relevant to Australian resident investors who hold Shares in X Limited as capital assets. The taxation summary advises that where the net asset value of the Shares at maturity are more than $X per Share, the dividend received equal to the amount by which the net asset value of the Shares exceeds $X per Share will be an assessable unfranked dividend in the year of income during which it is paid. No capital gain or loss should arise from the Shares but a capital gain will arise if any payment is made under the Guarantee. The above outcome is said to be subject to the Foreign Investment Fund (FIF) rules set out in Part XI of the Income tax Assessment Act 1936 (ITAA 1936) which apply where the aggregate value of interests in all FIFs (i.e. foreign companies or trusts) held by a natural person Shareholder is not less than $50,000. Where the FIF rules apply, attributable income from holding Shares should ordinarily be calculated annually under the market value method under which increases in the value of the shares during the relevant year are included in assessable income and decreases are allowed as a deduction to the extent of amounts previously assessed and not distributed. For the year ended 30 June 2010, you each: § included an amount as assessable income pursuant to section 529 of the ITAA 1936; and § claimed a deduction for interest incurred on the monies borrowed to fund your investment in X Limited pursuant to section 8-1 of the ITAA 1997. The FIF regime was repealed with effect on 14 July 2010 such that you will not be assessed on any unrealised gains on your investment during the years ending 30 June 2011 to 30 June 2020. The Australian Government announced its intention to repeal this regime on 12 May 2009. You have not made an election under Division 230 to have that Division apply to your investment in X Limited. Your loan transactions Your investment was fully drawn from your loan facility. On a later date, you inadvertently drew a further amount for private purposes from the same loan facility from which your investment in X Limited was funded. In order to separate your investment and private borrowings, you closed your loan during 2010 and opened two new loan facilities. As at 2010, one of those two loans had a balance representing the investment you made in X Limited.

Relevant legislative provisions: Income Tax Assessment Act 1936 Subsection 44(1); | Income Tax Assessment Act 1936 Part XI; | Income Tax Assessment Act 1936 Section 529; | Income Tax Assessment Act 1997 Section 8-1; | Income Tax Assessment Act 1997 Subsection 8-1(1); | Income Tax Assessment Act 1997 Subsection 8-1(2); and | Income Tax Assessment Act 1997 Division 230.

Reasons for decision: Summary: Expenditure, including interest on money borrowed, is deductible under section 8-1 of the ITAA 1997 if its essential character is that of expenditure that has a sufficient connection with the operations or activities which more directly gain or produce a taxpayer's assessable income, provided that the expenditure is not of a capital, private or domestic nature. Interest expenses will have the character of an outgoing incurred in gaining or producing assessable income if they are (wholly or partly) incidental and relevant to the end of gaining or producing assessable income. An outgoing of interest is incidental and relevant to the gaining of assessable income if the borrowed money is laid out for the purpose of gaining that income ( FC of T v Munro (1926) 38 CLR 153). This is a question of fact. As a general rule, interest on money borrowed to acquire shares will be deductible under the first limb of subsection 8-1(1) of the ITAA 1997 where it is expected that dividends or other assessable income will be derived from the investment. Such an expectation will usually exist as shares by their very nature are inherently capable of generating dividends, whether in the short or long term. However, in characterising the whole or part of a voluntary interest outgoing for the purposes of subsection 8-1(1) of the ITAA 1997, the taxpayer's subjective purpose, motive or intention in incurring the outgoing at the time the outgoing was incurred may be relevant, and possibly decisive. Where an outgoing produces an amount of assessable income greater than the outgoing, its characterisation as one wholly incurred in gaining or producing assessable income is not ordinarily affected by considerations of motives and intentions. Where, on the other hand, an outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is wholly deductible. If, after a commonsense or practical weighing of all the circumstances, including the direct and indirect objectives and advantages which the taxpayer sought in making the outgoing, it can be concluded that the expenditure is genuinely, and not colourably, used in an assessable income producing activity, such that it cannot be concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective, a full deduction is allowable for the loss or outgoing within the first limb of subsection 8-1(1) of the ITAA 1997 unless the outgoing satisfies the exclusory provisions within subsection 8-1(2), including outgoings of a private nature ( Fletcher & Ors v FC of T 91 ATC 4950; (1991) 22ATR 613). Where the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective, then the outgoing must be apportioned between the pursuit of assessable income and the other objective. You have procured a loan to fund your investment of Shares in X Limited. You incur a commercial rate of interest on that loan over its term, spanning the term of your investment. If held to maturity as intended, your investment in the Shares of X Limited entitles you to an unfranked dividend during the year ended 30 June 2020 equal to the amount by which the net asset value of the Shares exceeds their issue price, if at all. The receipt of this dividend is assessable to you under subsection 44(1) of the ITAA 1936. The repeal of the FIF regime with effect during the year ended 30 June 2011 means that, other than in the year ended 30 June 2010, there is no prospect of any amounts of assessable income being gained or produced from your investment in X Limited during its term. Aside from the dividend discussed in the preceding paragraph, no other amounts of assessable income, with the exception of any capital gain which may arise in the event that a payment is made in relation to the Guarantee, may be gained or produced from your investment at or following maturity. A practical weighing of all the factors suggests that your outgoing is one which is properly to be characterised as genuinely and not colourably incurred in gaining or producing assessable income. That is, the gaining or production of an assessable dividend which can reasonably be expected to exceed your total interest expense appears to be your only pursuit in making this investment such that any future disproportion between your interest outgoings and relevant assessable income which may arise over the term of the scheme may not be explained by reference to a pursuit of some other objective. With the exception of the initial year of your investment in respect of which you were assessed on an amount of income pursuant to section 529 of the ITAA 1936, the temporal relationship between the incurrence of your interest payments over the proceeding 9 years of the term of your loan/investment and the actual or projected receipt of any income following the Maturity Date (approximately 10 years following your procurement of the loan) may also be a fact relevant to a judgment as to whether the necessary connection between the interest expenditure and the operations or activities gaining or producing your assessable income exists. Despite the deferral of the receipt of income a deduction would still be allowable under the first limb of subsection 8-1(1) of the ITAA 1997 provided there is always an expectation and intention as well as the potential for dividends to be paid to you, albeit in the long term. As recognised by the majority in Steele v FC of T 99 ATC 4242; (1999) 41 ATR 139, contemporaneity is not legally essential. It is well accepted that expenditure can be deductible under section 8-1 of the ITAA 1997 even though it is incurred in a period prior to any expected resultant income, as long as the expenditure is not incurred too soon, is not preliminary to the income earning activities and is not a prelude to those activities. In your case, even though the interest you have and will incur on your loan over the years ended 30 June 2011 to 30 June 2019 is well prior to any anticipated resultant income, your intentions to retain your investment until maturity is commercially driven with one end in view, the gaining or producing of assessable income. The necessary connection between the interest incurred and assessable income is not lost. As such, to the extent that the interest incurred by you on your loan is not of a private nature, it is incidental and relevant to the gaining or producing of your assessable income, and therefore incurred in gaining or producing your assessable income and deductible under section 8-1 of the ITAA 1997 when incurred. As a consequence of your drawing during 2010 for private purposes, your deduction under section 8-1 of the ITAA 1997 for the interest expenses you incurred under your loan during the period between 2010 will, however, need to be apportioned between that incurred for the purposes of your investment in X Limited and that incurred for private purposes.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Does Part IVA apply to this ruling?: Part IVA of the ITAA 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable. | We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part. | If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply. | For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.