Australia: Heart of the Matter- the Role of Split Loans

Last Updated: 8 August 2002
Article by Anton Joseph
This article is part of a series: Click The Last Word on Split Loans? for the previous article.

Tax anti-avoidance provisions came for consideration by the Full Federal Court decision in the case of Hart v. Commissioner of Taxation1 This case was concerned with deductibility of interest on a split loan. The Federal Court decided that there was avoidance but the Full Federal Court reversed that decision in late July this year.

A couple owned a private residence. Subsequently they purchased another property (Property 1) which became their residence. The original residence (Property 2) was rented out. The loan was used to refinance their loan on Property 2 and to purchase property 2, property 1, called "wealth optimiser", allowed two loan accounts to be maintained: home loan account 1 and investment loan account.2

The operative sections of the loan agreement stated as follows:

"While the Loan Amount is split into Loan Accounts:

    1. this agreement applies to each Loan Account as if the balance of each Loan Account was a separate loan made on the same terms and conditions as the loan under the agreement. For example, interest will be calculated on the balance of each Loan Account and debited to each Loan Account; and
    2. We will credit all payments received by us under or in connection with this agreement among the Loan Accounts as requested by you.

Under the heading "Capitalisation of Interest", it was agreed that on each payment date, all interest accrued on the loan balance during the immediately preceding Interest Period will be capitalised by debiting the loan accounts. Interest will be added to the amount on which the interest is accruing and the interest then will accrue on the total amount, compounding interest.

A sum of $ 298,000 was advanced, $ 202,888 was treated as principal in Loan Account 1 and 95,112 in Loan Account 2. The higher amount was the money owed on the new property 1 and the latter on the previous residence (Property 2) which was rented out.

Monthly repayments were nominated to be credited to Loan Account 1. Neither principal nor interest was paid on Loan Account 2.

Loan Account 2 was debited with interest payable on the aggregate of principal and accrued interest, on each payment date.

All monthly payments being credited to the home loan account 1 resulted in no payments being credited to the investment loan account 2. The monthly payments went to reduce the principal in the home loan account 1. This resulted in the home loan account 1 being settled quicker than in normal circumstances. Interest on Acount 1 will not be deductible. The couple claimed deductions for interest on Account 2

No payments were credited to the investment loan account 2 and the interest that arose on the balance in the account was added back to account 2. This resulted in compound interest being levied on the balance in account 2.

Interest deductions would be available only if they was incurred in producing assessable income. Therefore interest arising in the investment account would be deductible against the rental income from property 2.

The revenue authorities argued that monthly payments must be apportioned rateably between the two accounts and credited to them. This would mean that the interest on the investment account 2 would be less than what it turned out to be, resulting in less interest becoming payable on account 2 and therefore less deductions.

In order to establish that there had been tax avoidance, it must be proved that there was a scheme entered into by the taxpayer, a tax benefit to the taxpayer from that scheme and that dominant purpose in entering into the scheme was to gain that tax benefit. Once tax avoidance is established the Commissioner of Taxation could take steps to cancel the tax benefit.

The Federal Court held that the gaining of tax benefit was the dominant purpose of the taxpayers in entering into the loan agreement. Therefore, the court held that tax avoidance was established. In fact it was found that without the taxation benefit the particular form, shape or structure of this transaction made no sense.

However, on appeal the full Federal Court held that obtaining of tax benefit was not the dominant purpose of the taxpayers and that therefore there was no tax avoidance.

Almost certainly the decision will be appealed by the revenue authorities, to the High Court. There has been instances in similar tax avoidance cases where the revenue has been refused leave to appeal. However, the issues involved are of far reaching significance and the high court may address the issues in order to clear the air .

1 [2002] FCAFC 222

This information has been prepared by the firm as a service to our clients. As it is a general guide we recommend that you seek professional advice before taking action. No liability can be accepted by the firm for any action taken as a result of this information.

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This article is part of a series: Click The Last Word on Split Loans? for the previous article.
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