Tax Man Takes An Interest In Split Loans

Sydney Morning Herald

Friday April 4, 1997

JOCELYN EASTWAY

A spate of split-loan products has hit the market, promising great tax breaks for people with mortgages. However, a Tax Office task force is not far behind. JOCELYN EASTWAY reports.

THE IDEA of turning your home loan into a tax deduction might sound too good to be true.

But that's effectively what's on offer with a spate of "split loans" or "mortgage reduction schemes" being promoted by a range of financial institutions.

In fact, the tax breaks are so attractive that the Australian Taxation Office (ATO) has set up a special task force to investigate such arrangements.

Kathy Dennis, head of the ATO project team, says it's possible people using the schemes are paying less tax than they should be.

The ATO hopes to issue a draft public ruling by July, clarifying the products' status.

Meanwhile, the head of financial planning and investment strategy at Sealcorp, Michael Walsh, is advising financial planners to steer clear of mortgage reduction schemes until the ATO has made up its mind.

"New clients should not be directed to mortgage reduction schemes until their tax position has been clarified," Walsh says.

And for people who are already involved in the schemes, Walsh suggests they restructure their affairs to avoid possible problems with the ATO.

A newsletter from the National Tax & Accountants' Association sounds a similar warning: "Until one of the promoters of these interest deduction products obtains a written opinion from the ATO or until the Commissioner issues a public ruling or statement in respect to these products, a conservative approach should be taken."

The theory behind a mortgage reduction scheme is fairly simple.

The interest on a home loan is not tax-deductible while the interest on an investment or business loan generally is. So if you have both sorts of loans, it makes sense to pay off the home loan first.

The monthly payments on each loan are calculated as usual. But you can choose to direct all your payments to the home loan and none to the business or investment loan.

Interest on the investment loan is "capitalised" or allowed to accrue until the home loan is paid off.

This means you pay off your non-deductible home loan a lot more quickly. Meanwhile, your investment loan gets bigger and bigger - as does your tax-deductible interest bill.

A flood of "split loan" products in the past few months has made implementing the strategy a piece of cake.

Borrowers can establish a home loan and an investment or business loan under the one "split loan" facility and choose to direct all their payments to the home loan portion.

The schemes are generally targeted at people who have built up a reasonable amount of equity in their home, Walsh says. This means they can use their home as security on the investment or business loan (see box).

At first glance, the strategy appears to be little more than a combination of negative gearing and good cash flow management to maximise wealth after tax, he says.

"Hence there is a widespread view amongst tax professionals that the ATO will have a difficult task arguing that bona fide schemes have a dominant purpose to avoid tax (under Part IVA, the general anti-avoidance provisions of the Tax Act) or to disallow a deduction (under Section 51(1) of the Tax Act) where interest is capitalised," Walsh says.

However, since the strategy involves using investment income to reduce the home loan and not to offset interest on the investment loan, the ATO might disallow a tax deduction for the investment loan interest (or for interest on the interest), he says.

For people already involved in these schemes, Walsh suggests they start directing their investment income to the investment loan, rather than the home loan - at least until the ATO has issued its ruling.

"These particular arrangements are of such a magnitude and growing in profile enough that the ATO will fight it," Walsh says.

"If they have to fight it right through, they will ... and I don't want our clients to be exposed to that.

"If you are going into a scheme that someone markets to you where the only benefit is to save tax, that arguably comes under Part IVA since the dominant purpose is to avoid tax."

Some financial planners have chosen to avoid the schemes from day one, long before the ATO put them under the microscope.

"We have always thought it was really pushing the point a bit," says Phil Clinton, manager of asset planning at the Chancellor Group.

"You are deliberately doing something to pay less tax ... we have always thought it was a bit close to the edge."

But if the scheme is properly structured, "you are not doing anything other than paying off your home loan first and keeping your business (or investment) loan going", says Jon Denovan, a banking and finance partner at Gadens Ridgeway lawyers.

However, the scheme can go wrong if the "tax-deductible" debt is not truly tax-deductible or if the personal and business/investment loans are not run as quite separate accounts, he says.

"Some products marketed by some lenders make it one loan with (usually two or three) sub-accounts," he says.

That sounds all right in theory, Denovan says. But by mixing up your deductible and non-deductible debt in that way, the nature of the borrowings is not clear.

"If I was advising a client, I would be encouraging them to make sure that the product was structured so that clearly there are two separate loans."

But promoters of split loan products don't share these concerns.

Glen Spratt, managing director of Wizard Financial Services Group, says the fact that loans are packaged under the one "split loan" facility is not an issue.

It is simply making it easier to implement a strategy of paying off their home loan more quickly than their business or investment loan, he says.

"Provided it's not marketed or promoted as a scheme to reduce or avoid tax, it's OK," Spratt says.

A letter of advice from Arthur Andersen chartered accountants says: "In our opinion the mortgage should be characterised as an arrangement to repay the borrower's private loan more quickly and to decrease payments of interest on the private loan, rather than to obtain income tax deductions."

Spratt strongly doubts the ATO would introduce legislation to stop people from paying off their home loan more quickly than their business or investment loans.

Peter Kidd, general manager of finance at The Locums Group, is also doubtful the ATO could do anything to stop the practice.

However, he thinks it's wrong for promoters to guarantee the tax-deductibility of interest payments to their clients.

"It is not written in legislation," Kidd says.

"It's just an interpretation of the Tax Act."

But there's more to these split loan products than potential tax breaks, says Phillip Cole, group taxation manager at Advance Bank.

Cole is concerned that the proliferation of products in this area has focused too much attention on the tax benefits and not enough on other, more important features.

(Advance launched two such products last year - the Accelerator and Portfolio loans - following verbal advice from the ATO that Part IVA of the Tax Act would not apply.)

"I am concerned there is a perception that these products are considered solely tax-focused and for that reason, everyone is jumping on the bandwagon," Cole says.

All that has happened is that more people have become aware of a strategy that has been accepted for years and, as a result, the ATO is concerned about the impact on revenue.

Cole would be happy for the ATO to clarify the tax position of these products by setting some sort of "speed limit" (a limit on the amount of interest that can be capitalised, for example).

Then people might concentrate more on the other features, such as the ability to control your personal finances.

"It's not appropriate to say the banks are promoting products that are potentially risky for their clients," Cole says.

If they are promoted and used properly, there should be no problem with the Tax Office.

Haydn Park, spokesman for National Australia Bank, says the bank has always had a "split loan" facility which allowed customers to separate their personal and investment borrowings.

But the bank has never promoted it as a tax-saving tool.

"We have tried to push it as a financial management tool which can suit some people," Park says.

"Quite frankly, if you do things the proper way you are not likely to have problems with the ATO or run that sort of risk."

Meanwhile, the Tax Office is continuing to research the vast range of "split loan" products on the market to establish whether or not they can all be dealt with under a single tax ruling.

If the ATO does decide to disallow interest deductions on some of these schemes, it will be looking to amend prior years' tax returns, says the ATO's Dennis.

Interest on underpaid tax would be charged but no penalties would be imposed, she says.

HOW A MORTGAGE REDUCTION SCHEME WORKS

* Promoter identifies people with little or no money to invest apart from the fact that they have equity in their homes.

* Establish investment loan using equity in the home as security. The home mortgage balance remains unchanged at

this stage.

* The new loan proceeds are invested for income and capital growth and the investment income is directed towards reducing the home loan.

* Tax savings from negative gearing also reduce the home loan.

* Allow interest on investment loan to accrue.

* Pay off the mortgage quickly.

* Begin paying off investment loan interest.

* Ultimately realise investments, pay capital gains tax, pay out investment loan and retain the profits.

Source: Sealcorp

© 1997 Sydney Morning Herald

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