Tax Tip 46: Want to Pay IO on a PI loan?

I think Lcg is just borrowing from a $50k split to make the repayments on the investment loan

in scenario 1 there is nothing else paid
in scenario 2 the interest on the $50k is paid.

This is exactly what this thread is about. I think in scenario 2 there is no capitalising of interest and you have an arguable case for deductibility of interest. I would recommend a private ruling.

 

Yes I would recommend one. Its not straight forward.

If borrowed funds are used to make loan repayments you cant specific that the repayment is just interest or just capital in its elements. So you cant say that $$$$ from the offset is the interest and the $$$ from a new loan is a refinance as its just principal. If it acts to compound (as the split is IO) and / or could be argued to be a element of and form of refinance. However if there was a specific reason (eg maternity leave, cashflow preservation) and a interest rate differential there could be arguments that suggest the predominant reason is not tax driven at all but cashflow driven.

The key issue may be that if debt is increased it reduces equity which is a poor investment choice and more easy to argue a scheme benefit relates to tax then the scheme element could further arise if a consequential debt reduction of non-d debt occurs. This may happen over one or more tax periods and accumulate the benefit. Its possibly no different to the choice to use the new split to pay outgoings. But it is different. The tax benefit could be exchange of non-d debt for deductible. All the elements of the scheme need to be known and that would be required for a BPR request.

 

no you can't do this directly, but if you were to immediate pay into the $50k split the interest that is charged this is almost the same thing.

 

Scenario 1:
A LOC account: On the 10th day of the month a transaction appears on the statement labeled "interest" and amount -$99. Two days later the borrower pays $99 into the LOC from their offset.

Scenario 2:
A P&I term loan: On the 10th day of the month a transaction appears on the statement labeled "interest" and amount -$99. Two days later the borrower pays $99 into the term loan from their offset.

How are these scenarios different? Is the borrower in #1 paying interest? Or principal? How is this determined?

In scenario 2 later on the same day the borrower pays $30 into the term loan to reduce the outstanding balance. The source account of this transfer is a LOC.

 

All the above are a debt repayment. None are specific to a specified borrowing purpose. All are apportioned to each borrowing purpose to reduce the balance. You cannot prescribe capital or interest. A % of each as the loan is positioned at that point

 

If in scenario 1 it's not the temporarily capitalised (due to the technicalities of how the bank chose to set up the product) that is repaid by the first repayment it would mean that over its life the loan would contain a significant portion of capitalised interest.
Credit card accounts (used for investment purposes) that are not repaid in full every month would have the same issue.
I haven't seen examples of the ATO targetting such capitalisation of interest.

 

Here is similar question answered by Julia at Bantacs
Borrowing to afford P&I repayments – Ask Ban Tacs

 

Thanks. The article discusses full, purposeful capitalisation of interest and there is the added risk of parking borrowed money in an offset account. However then they go on to state:

"Paying the interest straight into the loan account from accounts other than the offset account, being careful that the only transaction through the offset account is the repayment of principle, is a safe option."

That's some confident language, and a counter-opinion to Paul above.

 

Also if you remember the PBR in Can a loan be unmixed through a two step split? and e.g. TR 2000/2 paragraph 17 the ATO is often happy to take a pragmatic approach and accept that monies paid into a loan account apply to (and/or refinance) only a specific portion of the monies, rather than always assuming strict equal apportioning across every dollar of the entire balance.

 

Yes. There can be a refinance / repayment / discharge of a specific portion. The taxpayer would need to be capable of reasonable demonstration how this was calculated. Para 17 is important as it also guides taxpayer NOT to overpay the blended purpose.

eg Fred has a blended loan he diligently tracks. It comprises two residual uses IP1 deposit $86,500 and IP2 deposit $98,000 and the loan is a total of $184500. Fred sells IP1. His choices are:
1. Repay just $86500 leaving the loan unblended for IP2;
2. Repay less than $86,500 leaving a blende dloan of $98K for IP2 and a private non-deductible balance re the former IP1. (Assumption : He chose not to repay IP1 in full but could have);
3. Repay more than $86500 reducing interest deductions (but enhancing equity) on IP2 for the term of the remaining loan.

 

Borrowing to pay interest may fall foul of Part IVA. The ATO dont generally accept that capitalisation of interest or repayments is acceptable. There can be exceptions eg during a period of maternity leave, unemployment etc. The tax benefit is not the dominant purpose.

A systematic process to farm enhanced tax deductions by new borrowing of repayments is likely contrary and should be supported by a binding private ruling. Attempts to specify a interest element alone would be a higher risk or being considered a scheme and contrary to their capitalisation view as it doesnt meet the period of affected cashflow exception and is seemingly a purposeful arrangement. I wouldnt read any permission due to the views in TR 2000/2 esp para 17.

 

Under this strategy there would be no borrowings to pay interest. Just borrowing to pay the principal. The loan level overall would be flat - the PI loan reducing but the other loan to pay the principal increasing at the same rate.

 

And it's the opposite of Part IVA because the interest rate on the P&I repayments is less than if the borrower chose to keep the account in IO mode, and this translates to comparably less overall interest paid and hence LESS deductions, i.e. the opposite of tax benefit.

 

The tax advantage could be the prevention of the loan being reduced.

 

A tax benefit is anything that would not have occurred had the scheme not been implemented. The test contains two limbs. 1. A scheme and 2. The benefit test.

Scheme ? The definition of a scheme is very broad. It encompasses not only a series of steps which together constitute a scheme or ‘plan’, but also (by reference to ‘action’) the taking of just one step. Repetition does not serve this test well.

 

But also consider the alternate test.if they had not entered into such a scheme what could they have done instead. In this case it would be an interest only loan at a higher rate

 

To arrive at a principal loan amount reduction at which point the resulting interest payment saving/deduction size (vs original loan amount) would start equalising with the saving from the immediately reduced interest from switching to P&I (5%pa to 4%pa = 20% difference) would likely take around a decade.

 

Question about implementation of what Terry is talking about here (borrowing to pay the capital component on P&I).

You have an investment P&I loan. Say monthly payment is $3k. You set up another IO loan. You set up DD from the IO loan to make repayments on the P&I loan. Problem - these repayments comprise both capital & interest. Say of the $3k, $2k was interest, $1k was principal. So, on the same day, you manually deposit the interest component, $2k, back into the IO loan. Now the IO loan is $1k drawn, and your argument is, the IO loan has been used to pay principal (as per a refinancing). Is that right?

Would the ATO see it this way, or would they see the IO loan as mixed? You actually drew it down by $3k, of which $1k was effectively a refinancing. So it is 33% investment. Then you repaid $2k of the IO loan. However, the 33% split still applies, so on the $1k drawn balance that remains, you can only claim 33% of the interest?

Would an alternative be, don't bother repaying the $2k interest component. Just keep letting it draw down the full $3k payment from the IO loan each month. At the end of the year, determine the deductible % split, and just tax deduct that % of interest on the IO loan. Or to be really neat, split the IO loan up into the portion that was used to pay principal (and deduct that interest) and the portion used to pay interest.

 

The alternative doesn't really overcome this problem.

As of yet no one has asked the ATO for a private ruling on this question - to my knowledge.

 

I don't think the mixing would necessarily be an issue either as with normal loans the interest is added and then deducted with a payment.

If you are worried perhaps the interest could be paid in advance so the loan is in credit. before the repayment is taken out.