Most families in business around Perth are aware of the tax benefits of negative gearing in real estate. The tax law surrounding negatively geared share investments is almost the same and differs when looking at the tax effect of capital-protected loans.
When Perth family businesses talk to their tax accountants about the tax benefit of negative gearing into the share market, most investors are naturally concerned about the value of the share portfolio falling below the original loans.
The concept of a capital-protected loan tries to take away this concern. A capital-protected loan is ordinarily a loan into the share market that protects the investor from a fall in the value of the shares. In this instance, the tax benefits of negative gearing and the protection from the falling value of the share portfolio are potentially attractive.
What is a capital-protected loan?
Capital-protected loans are typically structured over several fixed years on an interest-only arrangement. They are commonly used for acquiring a portfolio of shares and are like instalment warrants with a limited recourse by the bank to pursue the assets of the investor. An investor benefits from protection against declining share prices through a capital protection feature embedded in the loan facility. This feature grants the investor the right to transfer the shares back to the lender to repay the loan. The lender ordinarily purchases a put option to mitigate the risk, with the associated cost passed on to the borrower.
The above position has many variants, with different types of financial engineering used to create it.
How are capital-protected loans treated from a tax perspective?
The Australian Taxation Office looks at capital-protected loans as comprising two distinct purposes. The first purpose of the interest incurred on capital-protected loans is to generate future dividend income, so this interest on this cost on capital-protected loans is normally tax-deductible. The second part of the interest cost incurred is purchasing capital protection like a put option. This interest cost is related to protecting the asset’s value and will ultimately form part of the capital gains tax payable on the sale of the shares. That is, part of the interest cost incurred is not tax deductible and is deferred until the shares are sold, as it is a capital cost for capital gains tax purposes.
How do I know the tax portions of a capital-protected loan?
The ATO will normally publish a tax product ruling on capital-protected investment structures. The tax ruling is designed to give investors comfort and clarity on the tax treatment of the capital-protected loan.
Importantly, the presence of a tax ruling does not mean that the ATO endorsed or recommended the capital-protected loan or investment. It simply guides an investor on what could happen. A licensed investment advisor’s advice is essential to understand if the capital-protected loan product is a good investment for you.
If an offshore bank finances the capital-protected loan, you should also consider the interest withholding tax obligations on the monies you remitted.
How do I calculate the tax-deductible portion of a capital-protected loan?
For capital-protected products initiated on or after 1 July 2007, determining the portion reasonably allocated to capital protection (the non-deductible tax portion) involves a three step approach by your Perth tax accountant. Division 247 of the 1997 Tax Act covers the tax law surrounding capital-protected loans.
Step 1 involves calculating the investor’s total costs within the income year for the capital-protected product, excluding amounts unrelated to capital protection or interest.
Step 2 requires applying the Reserve Bank of Australia’s (RBA) indicator variable interest rate for personal unsecured loans to an equivalent amount of borrowing. For fixed-rate borrowings, the indicator variable interest rate at the first occurrence in Step 1 is applied. The average of the indicator rates over the borrowing term is applied for variable-rate borrowings.
Step 3 comes into play if the amount from Step 1 exceeds that from Step 2. In such instances, the surplus is attributed to capital protection for the income year. If the underlying securities acquired through capital-protected borrowing are held as capital assets, the excess is considered a capital expense and is not tax-deductible.
In July 2011, Hailey, an investor, opted to invest in a share portfolio utilising a loan featuring capital protection. The loan carried an interest rate of 15%. The Reserve Bank of Australia’s (RBA) website offered a standard variable housing interest rate of 7.8%. Considering an additional 100 points, the benchmark interest rate was adjusted to 8.8%. This implies that 6.2% of the interest is designated for the put option. When engaging with her Perth tax accountant to prepare the income return, the following steps will be applied:
Step 1: Hailey calculated the total interest expenses incurred for the investment at $1,000.
Step 2: Applying the benchmark rate to the equivalent borrowing yields $560.
Step 3: Since the amount in Step 1 is more than in Step 2, the surplus of $440 is allocated to the cost of capital protection. This portion is not eligible for a tax deduction.
What is the risk of a capital-protected loan?
A licensed investment advisor is best placed to discuss the risk of investing in a capital-protected loan. Ordinarily, the risks of these loans are the loan’s fixed-term nature and the higher interest cost due to the put option. However, each investment is ultimately different, so getting written investment advice from an ASIC-licensed investment advisor is essential.
Can an SMSF invest in a capital-protected investment?
The ultimate question as to whether a Perth tax accountant will allow, for tax purposes, an SMSF to invest in a capital-protected loan product will turn on the investment, the SMSF trust deed, the SMSF investment strategy and the taxation product ruling issued by the ATO.
Recent information from the Australian Taxation Office (ATO) indicates increased scrutiny on Self-Managed Superannuation Funds (SMSFs) investing in unit trusts (UTs). According to Draft Ruling SMSFR 2008/D1, the ATO may view an unpaid present entitlement (UPE) owed to an SMSF unitholder, where payment is not pursued, as a ‘loan’ from the SMSF to the UT. SMSFs with outstanding UPEs should be vigilant and ensure the timely collection of any UPEs.
Taxpayer Alert TA2008/4 raises concerns that income generated by SMSFs from ‘hybrid’ UTs may be classified as ‘non-arm’s length income,’ subjecting it to a higher tax rate of 45% if the income is disproportionate compared to what would be expected in arm’s length transactions. UT deeds should be reviewed for any hybrid or non-fixed components accordingly.
Additionally, SMSFD 2007/1 clarifies the timing of when a distribution from a pre-1999 geared UT is considered ‘received’ by an SMSF, which impacts the ability and timing of reinvestment in the UT before the reinvestment deadline (generally by June 30, 2009).
What other tax aspects are relevant to capital-protected loans?
Much discussion happens among investors with their Perth tax accountants about the tax deductibility of capital-protected loans. However, the capital gains tax effect should not be forgotten. The portion of the loan that is not tax deductible will become part of the tax cost base of the capital-protected investment product. When that investment product is sold, the non-deductible portion will reduce the taxable income from the (hopeful) sale profit.
So, an intelligent Perth tax accountant will also maintain a capital gains tax register for the investment to show the yearly increase in the capital cost base of the investment. This won’t affect the current year’s tax return but will make a significant difference later.
Capital-protected investment product has a place in the Perth business community, and it is essential investment advice is engaged when looking at them. At the same time, separate independent tax advice is also critical. The investment advisor is often unwittingly placed in a conflicted position as a tax advisor when discussing capital-protected loans.
This is where Westcourt becomes a natural choice for smart families in business. Our proven tax knowledge, laser-sharp focus on families in business, forward-looking approach, upfront pricing, deep global connections through GGI, and commitment to independent advice through collaboration make us the natural choice for tax planning and tax strategy – so why not call us today?