Private ruling: Rental property and application of Part IVA
Published: September 2014
Ruling period: Year of income ended 30 June 2015
Date scheme commenced: 1 July 2014

Ruling: Q1: Are you entitled to claim a deduction for interest paid on a loan used to purchase a rental property? | A1: Yes | Q2: Will the provisions of Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to deny you a deduction for the interest? | A2: No

Relevant facts and circumstances: Your relative currently is the owner of a residential property (the property). The property was acquired some years ago. The property has been the main residence of your relative since it was acquired until recently. The property is now being rented. There is currently no outstanding mortgage in relation to this property. You are proposing to purchase this property from your relative at market value. You are proposing to obtain a commercial loan from a bank to enable you to purchase the property.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1936 Part IVA

Reasons for decision: Summary: You are entitled to claim a deduction for interest paid on a loan used to purchase a rental property. | Detailed Reasoning - Detailed reasoning: Section 8-1 of the Income Tax Assessment Act 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature. Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put. The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. Accordingly, it follows that if a loan is used for investment purposes from which income is to be derived, the interest incurred on the loan will generally be deductible. In your case, you intend to take out a commercial loan to enable you to purchase a rental property. Therefore the borrowed funds will be used for income producing purposes (derivation of rental income). Accordingly, you are entitled to a deduction for interest incurred on the loan obtained to purchase a rental property from which you will be deriving rental income. | Summary: The provisions of Part IVA of the ITAA 1936 will not apply to deny you a deduction for the interest. | Detailed Reasoning - Detailed reasoning: Part IVA applies to a scheme where, having regard to a number of objective factors or matters, it would be concluded that one of the scheme participants who entered into or carried out the scheme or any part of the scheme did so for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme. A 'scheme' is defined in subsection 177A(1) of the ITAA 1936. That definition is widely drawn and includes any agreement, arrangement, understanding, promise, undertaking, scheme, plan or proposal. The factual arrangement described above will constitute a 'scheme'. Under section 177C of the ITAA 1936 a tax benefit received in relation to a scheme will include an amount for a deduction being allowable where that deduction would not have been allowable, or might reasonably be expected not to have been allowable if the scheme had not been entered into. Part IVA was amended in 2013 to insert section 177CB which applies in relation to schemes entered into after 15 November 2012. Under subsection 177CB(3) when postulating what might reasonably be expected to have occurred in the absence of a scheme, the alternative must represent a reasonable alternative to the scheme in the sense that it could reasonably take the place of the scheme. . In the current case, a reasonable alternative to the proposed scheme would be for your relative, to sell the property to an unrelated third party in an arm's length transaction. You could obtain a commercial loan to purchase another property at arm's length for the purposes of deriving rental income. Under this alternative postulate, you would still be entitled to a deduction for the interest expense on the rental property acquired, (and your relative would still be in receipt of funds, being the proceeds from the sale of the property that they currently hold). Therefore, there is no tax benefit under the scheme. Accordingly Part IVA of the ITAA 1936 will not apply.