Proposed Division 7A changes

What are the changes?

In broad terms, Division 7A is an anti-avoidance provision of the Income Tax Assessment Act 1936 that has the potential to deem loans from private companies to related parties to be unfranked dividends.  On 22 October 2018, Treasury released a consultation paper that proposed radical changes to the way Division 7A would operate from 1 July 2019.

This consultation paper caused quite a stir in the tax and business community – ranging from criticising the proposed overhaul of the Division 7A system as “bad for business” to “stifling innovation and entrepreneurial spirit in Australia”.

A brief overview of the main proposed changes is set out in the table below:

  Proposed change as set out in the consultation paper Which taxpayers will be affected?
1 Division 7A compliant loans should now have a term of 10 years (i.e. no more 7 / 25-year compliant loans). Private companies making loans on or after 1 July 2019
2 Distributable surplus concept (i.e. a measure of a company’s profits according to a Division 7A calculation – not necessarily the same as a company’s retained earnings) will no longer limit the amount of the deemed dividend. Private companies making loans on or after 1 July 2019
3 Unpaid present entitlements or UPEs (i.e. a distribution from a trust to a company that has not yet been paid) existing at 30 June 2019 (excluding UPEs that arose before 16 December 2009) will be treated as loans. Private companies with UPEs at 30 June 2019
4 Transitional rules to convert 7 or 25-year loans existing at 30 June 2019 to 10-year loans. Private companies with 7 or 25-year compliant loans as at 30 June 2019
5 Pre 4 December 1997 loans still in existence at 30 June 2021 will become subject to Division 7A. Private companies that still have pre 4 December 1997 loans at 30 June 2021
6

 

A new benchmark interest rate will apply which as at 1 July 2018 was 8.3% compared to the current Division 7A benchmark rate of 5.2%. Private companies that make loans on or after 1 July 2019 and existing Division 7A loans as at 30 June 2019

We are just over three months away from 30 June 2019 – and we still do not have certainty on whether the proposals will become law before 30 June 2019.  Parliament reconvenes on 2 April 2019 (i.e. the same day as the Federal Budget). We also have an upcoming election that must be held before 19 May 2019.

The odds are stacked against the possibility of passing these proposed measures as law before 1 July 2019 – not just because of the tight timeframe but also because of a possible change of Government. However, even if these proposals only become law after 1 July 2019, there remains the possibility the laws could be applied retrospectively.

How can we help you?

We recommend clients who may be affected by these potential changes to have a conversation with their Adviser about the risks and opportunities that the proposals contain.

In an ideal world, it would be great if legislation would only apply prospectively and had an appropriate lead time to allow taxpayers to prepare for the new rules.  However, this is not always the case.

Through our Tax Advisory team across Australia, we can help you identify your exposure if these proposals were to become law, as well as identify potential steps to take to help manage such exposure.

Our Family Office Model means regardless of the location or service offering of your key relationship manager, we can access the right Tax Advisory expertise for you.

Roelof van der Merwe

National Tax Director – Tax Advisory




Transaction completed, or not?

Selected post-transaction Valuation and Accounting considerations

A successful transaction takes an immense amount of time, effort and skills. The expertise of several advisers and stakeholders are required to collaborate effectively to ensure an optimal outcome from each perspective. Transactions typically have a long duration and when the ‘ink is finally dry’ on the contracts, transaction fatigue is not uncommon for all parties involved.

However, following the completion of any transaction, the next step is to embark on the integration journey. Further, any transaction classified as a Business Combination (in accordance with AASB 3) also involves determining the accounting and valuation implications.

Accounting for a transaction via a Purchase Price Allocation can result in some unexpected practical and financial statement outcomes that should not be underestimated. If possible, these implications should be considered prior to completion of transaction terms. We explore a number of these potential outcomes and their implications below.

Accounting outcome

Description

Implication

Goodwill realisation A large goodwill balance that is unlikely to be supported by future cash flows of a Cash Generating Unit (CGU). Potential impairment of goodwill in future periods.

 

Discount on acquisition Asset values in excess of the purchase price. Recognition of a discount on acquisition, which must be immediately recorded in profit or loss on the date of the acquisition.
Future amortisation impact Recognition of finite life intangibles which require amortisation in future periods. The amortisation adjustment could be significant and will therefore have material impact on earnings per share on an ongoing basis.
Disagreement regarding earn-out calculations Earn out hurdles that are not explicitly explained in the transaction documentation. Variation in the parties’ calculation of the achievement of the earn out and potential disagreement regarding payment of the same.
Earn outs classified as remuneration (expense) Earn out payments that are dependent on key individuals’ continuing employment with the company. The earn out may be classified as remuneration and required to be expensed, rather than being treated as purchase consideration, as the purchaser may have envisaged or intended.
Independent valuation advice A Business Combination requires an independent valuation of all assets acquired and liabilities assumed. Further, where the consideration received is not a fixed cash price, additional valuations may also be required. Additional services from Accounting and Valuation professionals should be factored into the post-transaction timelines, including costs involved for the same.

As highlighted above, there are many important considerations that must be noted during the transaction process. The list above highlights a selected few interesting outcomes and is not exhaustive. The potential outcomes and their flow-on ramifications should not be underestimated. Accordingly, deal-makers (companies and their advisers) should inform themselves of the potential accounting application of any transaction and seek the expert guidance from experienced Valuation and Accounting advisers.

Nicole Vignaroli                                                                                                  

Partner, Corporate Finance – Valuations

Christine Webb

IFRS Technical Specialist




Is your business compliant with customs and excise duties obligations?

The Australian Border Force (ABF) are making trade enforcement one of their key operational priorities with an increase in the penalties payable under the Infringement Notice Scheme (i.e. an “administrative enforcement remedy” that is an alternative to prosecution in Court).

Pursuant to the Infringement Notice Scheme, a person or company does not have to be found guilty of breaching a Customs law before an infringement notice can be issued – all that is required is that a Customs officer should have reasonable grounds for suspecting that the person or company has breached a relevant Customs law.

Early in 2018, a Melbourne based import business was required to pay almost $2 million in penalties and recovered Duty and GST because an ABF investigation revealed that imported pre-galvanised steel products from a number of countries were undervalued.

Is your business compliant with the customs and excise duties obligations?

Currently within your business, what independent assurance do you have to provide you with comfort that you are compliant?

Are you confident that your Customs Brokers / agents are acting in your best interests and paying the correct amount of duty, excise and GST?

It is surely not worth waiting for a visit from the ABF to highlight any weakness and then find yourself subject to possible penalties and infringement notices!

Complimentary Compliance Health Check

To help provide you with the assurance and comfort that your business needs, our Customs and Global Trade team are currently offering a complimentary, no obligation assessment and Compliance Health Check.

The compliance health check will provide you with valuable insight into your trade activities and could provide you with significant cost savings whilst ensuring compliance.

For example, on receiving your signed letter of authorisation, we will use our data analytics tools to provide you with a visual overview of your past four years of import and export data.

We can then review all the key factors (see below) that can affect the custom duty and GST exposure of your cross-border transactions.

Some of the key factors we will look at include:

  • Tariff concessions;
  • Tariff classification for imports and exports;
  • Customs Valuation;
  • Free Trade Agreements; and
  • Country of Origin and Preference.

As part of the review, our Customs and International Trade Experts will consider overpayment as well as past errors and underpayment of duty.  This action will assist in eliminating risks and associated penalties, which have exponentially increased in recent years.

Following the Compliance Health Check, we can design a long-term improvement strategy to help your organisation maintain customs compliance and maximise refund opportunities.

By identifying and mitigating risks, and developing an improved compliance framework for the future, your business has the potential to save on customs duty and related taxes.

As an added benefit, by taking up this complimentary Compliance Health Check offer, you have the opportunity to become more knowledgeable about the various services offered by Crowe Horwath (e.g. international tax services) that may be beneficial for your international business operations.

Ensure peace of mind and book in your complimentary Compliance Health Check with one of our Customs and International Trade Experts today on 02 9619 1661.

As they say, prevention really is better than cure!

Matthew Morgan

Manager – Global Trade and Customs




Labor proposed Super Changes – could the changes affect the way you manage your super?

As you may be aware, the Labor Party have released a number of proposed changes to superannuation should they win the upcoming election.

Whilst this is not an exhaustive list, I have detailed some of the changes below in order to give an overview and provide an insight into how these changes may affect SMSFs.  The proposed changes are:

  • Removal of Franking Credit refunds
  • Reintroduction of the 10% rule whereby anyone who has employer contributions and doesn’t satisfy the 10% rule will be ineligible to top up to $25k concessional contribution cap via member deductible contributions
  • Reduction to the high income super contributions threshold from $250k to $200k
  • Reduction in non-concessional contributions from $100k pa to $75k pa
  • Reduction in bring forward non-concessional contributions from $300k to $225k
  • Removal of the newly introduced carry forward concessional contribution cap

How these changes might affect SMSFs:

  • No longer receive tax refunds in SMSF’s from excess Franking Credits, which may impact on cash flow to the SMSF
  • May restrict contributions made to super for taxpayers who have a mix of employment and self-employed income;
  • Higher tax rate will be paid on super contributions for anyone with income levels of $200k per annum and above (this income level includes superannuation contributions).
  • May reduce the amount of contributions able to be made to super from after tax money.

In order to keep you well informed of the impact election decisions may have on your SMSF, I look forward to providing insights as other parties release their proposed changes.

In the meantime, if you have any questions or concerns in regard to the above proposed super changes, please don’t hesitate to contact your adviser.

Kathy Evans, Senior Partner – SMSF

 




Findex Community Fund Turns One!

The Findex Community Fund was launched as a commitment to give back to the communities we are connected to. February 2019 marks 12 months of operation for the FCF and we are so pleased to celebrate the charitable impact we have been able to make in the areas of Health, Education and Entrepreneurship.

With a vision to create equal access to opportunity for people isolated by location or circumstance we are humbled by the impact we have made so far, and will continue to support the communities of Australia and New Zealand.

Check out this short video, showcasing our first year of operation.




Single Touch Payroll – Are you compliant?

Legislation was passed on 12 February 2019 that requires businesses with less than 20 employees to commence Single Touch Payroll (STP”) reporting from 1 July 2019.  Businesses with 20 or more employees were required to commence reporting from 1 July 2018 unless an exemption or deferral was obtained.

We have seen a number of small businesses proactively commence with STP early, with initial feedback being very positive following the transition.

According to the ATO there are approximately 750,000 small businesses across Australia with 3.8 million employees. Microbusinesses with 4 or less employees account for 60% of this sector. Software provider Xero has estimated that 1 in 5 businesses in Australia still use pen and paper for payroll record keeping purposes. This poses potential risk for these businesses in migrating historical or back of the envelope data if it exists at all.

So why the change to Single Touch Payroll for small business?

The reason for change stems from current problems that exist within the payroll reporting framework. The Federal Government, as part of their review into non-compliance within the superannuation guarantee system, identified three main areas that needed to be addressed:

–          High compliance costs and regulatory burden

–          PAYG Withholding and SG non-compliance

–          Inefficient Government service delivery

High compliance costs and regulatory burden

Under current law, a small business has multiple compliance obligations that contribute to high compliance costs and regulatory burden.  As a small business owner, you will undoubtedly have this experience. A simple example of this is the payment of weekly wages in early January. That one payment results in the following obligations:

–          A payslip is to be generated and provided to the employee at the time of their net salary being paid

–          PAYGW to be reported and paid via an IAS or BAS either by 21 February, 28 April or 28 May, depending on how you lodge the BAS (electronic or paper)

–          Superannuation guarantee attributable to that salary will be required to be paid by 28 April of that year

–          The wage will be required to be included on an end of year Payment Summary that is to be provided to the employee by 14 July of that year

–          That end of year Payment Summary is to be incorporated into end of year Payment Summary Annual Report which the Employer needs to provide to the ATO by 14 August

The above excludes other employee reporting obligations such as Workers Compensation and Payroll Tax.

PAYG Withholding and SG non-compliance

There are some well-known drawbacks that result from the mismatch in timing of making a net salary payment and ultimately the payment of PAYGW and Superannuation Guarantee. These include:

–          Unnecessary reconciliations by the employer

–          Cash flow management difficulties resulting in employers “dipping” into super and PAYGW to settle other liabilities

–          Unfair playing field between compliant and non-compliant small business

–          Loss of retirement savings for employees

–          Future cost to government to support aged pension for these affected employees

–          Little visibility for employees to monitor payments of SG

Often the delay between the non-compliant activity of an employer and recovery action sought by the ATO is well in excess of 12 months. With employees having little visibility of when superannuation payments are made and the ATO’s inability to actively monitor compliance in real time, often non-compliant employers are insolvent by the time an employee makes a complaint or the ATO catches up with them. More often than not there is little to no opportunity to recover these unpaid amounts which ultimately places pressure on future Government spending.

Inefficient Government service delivery

The Federal Government is clearly aware that they need to improve and can improve on their service delivery. In the “Digital Australia – State of the Nation 2014” report, the government ranked as the worst business sector in terms of digital sector experience. Clearly there is a better way in which to improve both employer and individual’s experiences when interacting with the ATO.

Benefits of STP to small business

STP has undergone a rigorous consultation process over the course of the last three years in order to ensure it aligns with the natural business systems of an employer. The primary aim being to work with business in order to not create additional compliance. The benefits of STP are anticipated to be far reaching, including:

–          Help employers streamline their reporting process to the ATO

–          This information will be used to pre-populate the wage and PAYGW sections of the BAS which will eliminate potential errors and double handling

–          Eliminates the need for payment summary processing and end of year reporting obligations

–          Employees will now have real time access to payroll data via their MyGov account

–          Allows the ATO to proactively monitor payments of PAYG and superannuation guarantee earlier and notify employees of non-compliance – complying employers will feel like they are now operating on a level playing field.

The Risk to Small Business

From an Employer’s perspective the major risk is around the accuracy of salary calculations, utilising technology that they previously were not familiar with and the damage to brand for non-compliance. The ATO will now have immediate information regarding PAYGW and superannuation and can act accordingly should they see discrepancies. This can also be compounded by incorrect reporting of payroll tax and workers compensation amounts which may result in an investigation by the relevant governing bodies. We expect government authorities will only continue to improve their information sharing capabilities as further real-time data becomes available.

Fair Work has already taken action and handed down significant fines for businesses and owners that have been found not to be processing salary and superannuation payments correctly. Even minor breaches can result in significant financial cost to the business once on-costs such as payroll tax, workers compensation and the potential for fines and penalties are applied to both the employer and director.

Next Steps

Be proactive in preparing for STP.  If you are processing your payroll in-house, ensure your software is up to date and STP compliant. Alternatively consider what other options are available to you. A good digital payroll solution will not only be STP compliant but will provide other tools such as employee self-service, time and attendance functionality and allow for award interpretation that can be built into the software.

Outsourcing your payroll function can also be a relatively inexpensive option. It provides you with the added comfort of knowing the payroll is compliant, processed by a payroll professional who can also provide advice in relation to various employee related matters. They will use the latest in technology to provide the benefits previously mentioned and provide an overall better experience for your employees

If you have any questions relating to the introduction of STP, please contact your Crowe Horwath business adviser.

For more information, view our STP factsheet here.

About Crowe Horwath Payroll

Crowe Horwath can provide a fully managed outsourced payroll service utilising the latest in payroll technology – fully STP compliant and able to process payrolls from 1 to 5,000 employees. We have a dedicated team of payroll professionals who are specialists in the field and are constantly kept up to date with changes in legislation to ensure that your business is fully compliant.




The dynamic Australian tax landscape

What is the issue?

With an upcoming Federal Budget on 2 April 2019 and Federal Election that must be held before 19 May 2019, we are entering a “perfect storm” situation where various political parties are proposing a variety of tax policies that they hope will give them a better chance of winning the Federal Election.

Make no mistake, tax is complicated and constantly changing (we have numerous volumes of tax legislation, commentaries, case law and ATO documents seeking to interpret that legislation). Constant tax tinkering makes it quite challenging for taxpayers to keep up with the current state of tax laws and understand how they may be affected.

How are taxpayers affected?

To assist taxpayers distil a practical understanding of how tax may affect their current situation, we have set out below a brief overview / snapshot of several key:

  1. recently legislated changes to tax laws;
  2. proposed changes to tax laws that are not yet law (i.e. these proposals are either before Parliament or with Treasury); and
  3. tax policies proposed by the Labor Party (currently, most tax changes proposed by the Liberal Party are either before Parliament or on their way to Parliament).

 How can Findex and Crowe Horwath help you?

If anything in this tax snapshot triggered your interest or if you may be affected by these changes, your Findex or Crowe Horwath Adviser would be pleased to discuss your circumstances in more detail.

Through our specialist Tax Advisory team across Australia, we can help you identify and manage risks and utilise potential opportunities that may be relevant to your situation.

Our Family Office Model means that regardless of the location or service offering of your key relationship manager, we can access the right Tax Advisory expertise for you.

Roelof ven der Merwe

National Tax Director – Tax Advisory




Financial statement disclosure of climate-related and other emerging risks

If you are a director or financial statements preparer in an industry impacted by climate-related risks, guidance has been issued which indicates that climate-related risks are a financial statement consideration, not just a matter of corporate social responsibility.

The Australian Accounting Standards Board has issued a Practice Statement (AASB Practice Statement 2 – Making Materiality Judgements), which whilst not mandatory, represents best practice on determining what climate-related risks are sufficiently material to be disclosed in financial statements.

Determination of the content of financial statements is based on an assessment of what is material to users of the financial statements.  Given investor statements on the importance of climate-related risks to their decision making, directors and preparers need to ensure financial statements are prepared with climate-related risks in mind.

Key recommendations are:

  • Determine whether investors would reasonably expect that climate-related risks have a significant impact on the entity and would that risk qualitatively influence investors decisions?
  • Disclose climate-related risks and adjust balances accordingly, if necessary, in the financial statements.
  • If no climate-related risk impacts have been disclosed, consider disclosing why there has been no impact, if it is believed that investors could have expected climate-related risks to be significant.

For more information on your reporting obligations, talk to your adviser today, and they can introduce you to a financial reporting expert.

Malcolm Matthews – Partner

Malcolm is a Partner in our Tasmanian Audit team.  He has more than  25 years’ experience in financial reporting.  He is a Fellow of Chartered Accountants Australia and New Zealand and a Registered Company Auditor.




ASIC focus areas for December 2018 Financial Reports

No surprises in the release of ASIC’s focus areas for December 2018 with the number one item being the impact of the new accounting standards.

Financial reports for December year-ends and December half-years, are implementing AASB 15 and AASB 9 for the first time.  ASIC Commissioner, John Price said, “We are concerned that some companies may not have adequately prepared for the impact of new accounting standards, that can significantly affect results reported to the market by companies, require changes to systems and processes, and affect businesses. We will monitor these areas closely and will take action where required.”

Preparers should ensure sufficient disclosure is made regarding the impact of both AASB 15 and AASB 9, as well ensuring the new disclosure requirements of AASB 15 and AASB 7 are complied with.  Adequate disclosures will provide comfort to the reader that the new recognition and measurement requirements have been applied appropriately even if there have been no significant changes. Without sufficient disclosure, readers will not know that the new requirements have been adequately considered.

The other focus areas continue to include the usual suspects that we’ve seen for the past few reporting periods, showing that ASIC is still identifying issues with fundamental items such as impairment and revenue recognition. A couple of topics have returned including the Operating and Financial Review (OFR) and Non-IFRS financial information, which serve as a reminder to ensure that the OFR should provide meaningful information and be consistent with the financial report, as well as ensuring that any non-IFRS information is not misleading and is presented appropriately. This also serves as a reminder of regulatory guides RG 247Effective disclosure in an operating and financial review, and RG 230Disclosing non-IFRS financial information.

ASIC focus areas for December 2018 are:

  1. Impact of the new standards
  2. Impairment testing and asset values
  3. Revenue recognition
  4. Expense deferral
  5. Off-balance sheet arrangements
  6. Tax accounting
  7. Operating and financial review
  8. Non-IFRS financial information
  9. Estimates and accounting policy judgements

Read ASIC’s media release 18-364MR for full details on the focus areas for December 2018. The release also includes links to information sheets providing useful information for preparers and directors on financial reporting and impairment of non-financial assets.

Christine Webb

IFRS Specialist




Aspects of Negative Gearing Australian Real Estate

Negative gearing will again be a political issue during the lead-up to the next Federal election.

What is Financial Gearing

A combination of debt and equity is commonly used to fund investment in assets, such as rental properties, shares or business assets.

A leveraged investment refers to the method of using borrowings plus an investor’s own funds to purchase an asset; the higher the leverage, the greater the debt.  Gauging the mix of an investor’s debt to equity is referred to as the gearing ratio.

Leveraged investment is often expressed in terms of being positively or negatively geared.  Positive gearing occurs when net income derived from an asset exceeds borrowing costs (mainly interest).  Conversely, negative gearing arises when the net investment income derived is exceeded by interest outgoings (and other funding costs).

Negative Gearing Real Estate

Negatively geared residential or commercial property occurs when rental (or lease) income, less the costs of owning and managing the investment (such as depreciation, insurances, repairs and maintenance, council rates, land tax, travel costs and agent management fees) is exceeded by mortgage interest costs.

For tax purposes, the resulting rental tax loss can be deducted from an investor’s income derived from other sources, including salary and wages, other net rental income, dividends, interest and/or business income.  Other deductions and considerations come into play where property is located outside Australia.

Is it feasible to Negatively Gear?

Investments in real estate that generate an annual rental loss will be a tax deduction against other income. A tax refund to an individual investor generally arises at the individual’s marginal tax rate(s). The higher the marginal rate, the greater the refund. The tax refund reduces an investor’s net cash outflows from an investment. Notwithstanding the tax refund position, unless the value of the real estate out paces an investment’s cumulative after-tax losses, the investor will not be ahead financially. That is, an investor will lose money over the real estate ownership period.  Of course, if the investment does increase at a rate greater than the after-tax loss position, then an investor will make money.

Key Incentives

(i) Cash flow: For individuals, tax refunds are generated at the relevant marginal tax rates which assists cash flow. For example:

(a) If the top marginal tax rate applies to a salary and wage earner, 47% of the tax rental loss can be refunded by the Australian Taxation Office.  Lower marginal tax rates apply if an individual’s taxable income is less than $180,000.

(b) Rather than wait to lodge an annual income tax return, an individual can apply, to the ATO, to permit their employer to deduct less PAYG throughout the year which boosts monthly after-tax cash flow to better align with loan repayments.

(ii) CGT Discount – Currently, any capital gain on disposal will attract a 50% general discount for resident individuals and trusts (with resident individual beneficiaries) provided the asset is held for more than 12 months.

(iii) Rent Increases – Initially, a negatively geared investment may be justified if the net rental stream is expected to rise or interest costs are expected to reduce.

(iv) The potential ability to claim depreciation on plant and equipment and 2.5% of the construction cost of the building (including alterations and improvements) provide a cash free deduction against rental income each year.

(v)  New Opportunities – The use of internet-based booking platforms such as Airbnb and Stayz has significantly increased an investor’s ability to generate greater financial returns from residential property investments.  In these situations, a question arises as to whether the investment is more of a business operation, especially where there are several rental properties and staff are employed to attend to bookings, cleaning, etc.  If a business does exist, it will be important to consider whether the small business CGT concessions and GST applies.

Key After Tax Outflow Considerations

An important consideration before embarking on a negative geared property investment is to consider the impact that after-tax cash outflows will have on after-tax income.  The after-tax cash flow position differs from the rental loss result.  This is due to non-deductible principal loan repayments and deductions being funded on initial purchase, such as capital works and capital allowance deductions as detailed below.

(i) Deductions for capital costs

A capital allowance deduction may be available on items of plant and equipment that have formed part of the purchase price of a property.  However, since 9 May 2017, this deduction has been restricted on items of plant and equipment forming part of old residential properties (refer below).

Additionally, the construction cost (not purchase price) of the property including any improvements can generally be claimed at 2.5% over a maximum 40-year period.  Therefore, it is important to obtain that information from the vendor, or alternately you can engage a quantity surveyor to provide an estimate of those costs.

(ii) Principal repayments

Importantly, it is necessary to consider the cash flow impact of loan principal repayments to a financier.  Generally, the interest rate associated with principal and interest loan facilities is lower than interest only, as financial institutions perceive the risks of lending to be lower.  However, if an investor is using a principal and interest loan facility, it is necessary to also take into consideration the cash flow impact of principal repayments each year.  Any cash flow shortfalls would need to be met from other funding sources such as after-tax salary.  Currently, there is a definite move away from the provision of interest only loans by Australian banks.

Before embarking on a negatively geared investment, a realistic cash flow analysis should be prepared.

Developments in the Past

Prior to 1985 the Courts provided certain boundaries on acceptable negative gearing scenarios, especially in situations displaying an underlying private or domestic motivation.  For instance, in Ure v. FCT 81 ATC 4101 (FCA), the taxpayer borrowed monies at commercial interest rates of up to 12.5% and on-lent the borrowed money to his wife and family company at 1% interest.  The funds were eventually used to discharge a home mortgage, to purchase a house (that was let to the taxpayer and his wife by a private company) whilst the balance of funds was invested.  The Commissioner of Taxation only allowed an interest deduction to the taxpayer equal to the 1% interest income and the Court confirmed the Commissioner’s stance.

In FCT v. Groser 82 ATC 4478 (S.C.V.) the taxpayer was denied a deduction for part of a rental loss as the rental income charged to his brother was not being levied at a market rate.  Similarly, in FCT v. Kowal 84 ATC 4001 SCG the taxpayer rented a house to his mother at less than a market rate.  He was denied a deduction for part of his rental loss, which reflected the undercharging.

1985 Tax Summit

Following the tax summit in June 1985, the Hawke government introduced anti-negative gearing legislation effective from 17 July 1985.  The law applied to new investments in real estate by individual, company, partnership or trustee investors.  Under these rules, negative gearing interest expenses were quarantined to the extent that they would otherwise create a rental loss (apart from a carve-out for 4% building depreciation deductions).  Rental losses were quarantined so they could not be offset against other income.  Instead, losses were carried forward to future tax years to be offset against property income.  Negatively geared real estate acquired prior to 20 September 1985 continued to fall outside the CGT tax net on disposal but not for property purchased after that date.

After extensive lobbying by the property industry, and possibly for other macro economic reasons, the Hawke government revoked the negative gearing rules during July 1987.  At the same time, the building depreciation rate was dropped from 4% to 2.5% to minimise the impact on revenue collections.

Post Repeal of the 1985 Negative Gearing Legislation

Since the repeal of the negative gearing legislation in 1987, tax cases impacting on negative gearing scenarios have involved split loans.  The use of split loan facilities was the subject of a general anti-avoidance High Court decision in FCT v. Hart (2004) HCA.  The case centred on the level of tax deductible interest that was capitalising on an investment loan at a relatively high rate of interest.

The taxpayers had a debt wrap platform which allowed them to maintain a home loan (non-deductible interest) and an investment account balance (deductible interest).  Security for both loans was the two properties.  All loan repayments were directed towards the home loan.  The tax-deductible interest therefore compounded on the investment loan, which ended up having a balance more than the value of the investment property.  The taxpayer claimed 100% of the investment loan interest as a tax deduction.  The High Court’s order required principal payments to be applied in a pro-rata manner to both loan accounts, whereby reducing the amount of tax deductible interest.

The use of a line of credit facility by an investor is handy for separating borrowings relating to non-income and income producing assets and it is easier to calculate deductible interest. It also provides flexibility to an investor.  However, care needs to be exercised when using split loan funding platforms.

The ATO has issued several tax determinations and rulings concerning the use of these types of financial facilities.  The takeaway message is that deductible compounded interest is fine, provided there is a genuine commercial reason for the compounding.

2017 Legislation Changes

For second-hand residential properties purchased after 9 May 2017, a depreciation deduction is not available for second-hand plant and equipment acquired with such properties.  However, any investor who purchases a brand-new property can claim depreciation on plant and equipment forming part of the investment property.  Non-residential properties are unaffected by the changes.

From 1 July 2017, new legislation provides that travel expenses relating to residential property investment are no longer deductible and cannot be included in a property’s cost base for CGT purposes.  This restriction does not apply to taxpayers carrying on a business of letting rental properties or to certain taxpayers, including companies.

Future Developments

As mentioned, negative gearing will be a leading issue during the lead up to this year’s Federal election.

The coalition’s platform is to leave negative gearing in place, whilst Labor’s position is to apply changes to negative gearing across all new investment asset acquisitions, not just real estate.  Labor is proposing that existing properties are fully grandfathered and therefore unaffected.  That is, tax concessions for negative gearing will cease to be available from a date yet to be determined, although it is proposed that losses from new investments can be used to offset net income from other asset investments and against certain capital gains.

Labor plans to halve the CGT discount rate from 50% to 25% from a date to be determined.  The CGT discount will not, however, change for small business assets.

* * * * * *

Geared investments in a balanced investment plan pre-retirement may be worthwhile pursuing.  However, it must be remembered that there are potential pitfalls and the strategy can end up costing an investor money.

Given the extent of the tax and financial planning issues associated with geared investment strategies, we recommend that you discuss your specific circumstances with your Crowe Horwath tax adviser or financial planner.

Peter Nevell

Partner – Tax