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Splitting the tax take

May 29, 2004

The taxman has won his case that some split loans may be unfair, reports Anne Lampe.

The tax commissioner's victory this week in a test case relating to a split loan entered into by Canberra taxpayers Richard and Trudy Hart has sent lenders who marketed the loans back to the drawing board and has made borrowers who took advantage of them reassess their repayment schedules.

The company at the forefront of the split loan or Wealth Optimiser concept, Austral Mortgage, said it was disappointed with the decision, but added that not all was lost.

A typical split, or linked, loan is a credit facility under which the borrowing is split into two sub-accounts. One account is usually for investment purposes and the other private. The minimum repayment is worked out for the total borrowing but the whole amount is paid first in reduction of the private part of the loan, usually used to buy the family home.

The total interest paid on the loan is the same, or slightly higher, than for a normal loan. However, interest on the investment sub-account is allowed to remain unpaid and is capitalised. A corresponding amount of capital on the private account is paid off instead.

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The investment account compounds until eventually all the interest accumulates on that account.

In 1997, the Tax Office issued tax ruling TR 97/D7 in response to the burgeoning sale of split loans and that position was confirmed in a subsequent tax ruling, TR 98/22. The ruling set out the Tax Office's view that the extra interest that accrues on capitalised interest was not deductible under the general deduction provisions of income-tax law, or alternatively, that the anti-avoidance provisions of Part IVA would apply to disallow the deduction.

The tax abuse of these loans occurred because there is no tax deductibility on home loan interest payments, but loan costs associated with the investment property are fully deductible against rental income.

The promoters of split loans saw an opportunity and pointed out that borrowers could choose to direct all the loan repayments to paying off the home loan and direct none to the investment property, thereby accruing all the interest against the investment property.

The result delivered was that the home would be paid off in somewhere between four and seven years instead of the conventional 20 or 25 years, while the investment property would become hugely tax effective. It would be sold for a capital gain when the entire loan could be discharged. Effectively the home loan would thereby be interest free.

The tax commissioner, Michael Carmody, has expressed concern about this practice for some time because of its obvious threat to tax revenue. The inflated tax deductions attaching to the investment part of the loan meant taxpayers subsidised acquisition of the investment property for those who participated in this type of split-loan arrangement.

In the Hart case, the court was told that the couple's $$298,000 loan taken out in 1996 would have generated $169,470 in increased income tax deductions as a result of their split loan. It meant their home was paid off faster, but it blew out what was owed on the loan on the investment property from $120,592 to $233,085.

The commissioner disallowed their interest deductions and the Harts took their dispute with the commissioner to the Federal Court, where the court backed the commissioner's view. They appealed that decision to the full Federal Court.

That court, comprising three judges, found for them and against the commissioner.

With so much at stake and the big banks poised to accelerate their marketing of split loans, the commissioner took the matter to the High Court, treating it as a test case for which the Tax Office would pay the legal bills.

The Tax Office successfully argued that the scheme resulted in the borrower's paying less tax than if there were two separate loans with separate repayment schedules, and that would result in more disposable income for the taxpayer. A further effect would be that the amount owing on the investment property would be higher than under a conventional loan arrangement, because interest on both loans would be capitalised and no principal would be paid off the investment part of the loan. As well, the interest charge was marginally higher. All of this delivered higher tax deductions and contributed to a bigger hole in the revenue.

The five High Court judges who heard the case backed the commissioner, ruling the arrangement breached the tax avoidance provision of the Tax Act, Part IVA.

Where does this leave borrowers who have split loans?

It should be pointed out there is nothing intrinsically wrong with split loans and the commissioner is not opposed to them, provided that the repayments are fairly distributed between the two loans so that not all the advantage accrues to the home loan while the interest cost on the investment property loan is inflated. Borrowers who fairly distribute their repayments will not have a problem when they are audited.

However, borrowers who have skewed their payments disproportionately to advantage the home loan may find they will receive an amended assessment following an audit of their tax affairs. In the Hart case the entire monthly loan repayment figure of $2533 went to pay off the home part of their loan.

Justice Ian Callinan of the High Court concluded: "From the matters to which I have referred it is easy to conclude . . . that the respondents [the Harts] entered into a scheme for the [dominant] purpose of obtaining a tax benefit. What other purpose or purposes could have made commercial or other sense?" he asked.

Robert Warnock, the acting president of the National Tax and Accountants' Association, said that the decision dealt the ailing property market another blow because the wealth optimiser loans were a popular way to finance property purchases in the late 1990s.

"The flow-on effect of this decision is that less people will invest in property," Warnock said. "Had Mr and Mrs Hart won the case there would have been a rash of these split-loan facility products on the market, making it cheaper for people to borrow money and buy a property. It would have given the property market a much-needed boost. But that is now not going to happen."

Vicki Edema, chief executive of mortgage manager Austral Mortgage, which marketed the Wealth Optimiser loan to the Harts, said: "The case really turns on its own facts and the judgement has not given the commissioner the green light to attack or question any commercial arrangement that carries a tax benefit, and there was a real concern out there that if the court adopted the ATO's narrow view argument across the board then any structure or commercial transaction that has a tax benefit may have been under scrutiny.

"The decision is largely saying that the loan structure drove the tax benefits and so it doesn't mean that people who are out there capitalising interest on facilities or have different sorts of structures. . .it does not mean they need to be concerned because they are not caught by this judgement."

Edema said while many people took out the Wealth Optimiser loan, when the tax ruling came down in 1997 the product gave the borrower the option of applying the payment to the home loan or the investment loan and it was up to them to choose how they directed repayments.

"At the end of the day, they don't have to unwind anything, because they can redirect their payments."

She thought that in the light of the tax ruling a lot of borrowers might have deducted their simple interest on the loan, but not the capitalised interest.

Carmody, obviously pleased with the decision, pointed out that people who already have these types of loans to finance their investment property purchase will still be able to claim the portion of the interest that directly relates to the investment part of the loan.