Managing tax uncertainty
Investors should carefully review any materials, such as product disclosure statements, that describe the tax treatment of financial products before deciding whether to invest in the product.
The majority of financial products offered to retail investors are simple and do not concern us. However, we have had concerns with a small number of products that promise to provide investors with tax benefits where those benefits may not be available to some or all investors who invest in the product.
Issues that concern us include advice that:
- suggests investors draw certain conclusions about positive tax outcomes from investing in certain products that most taxpayers would not receive in their individual circumstances – for example, statements like 'generally, deductions will be available, however for certain taxpayers a deduction will not be available'
- includes inappropriate caveats, such as when discussing the possible application of the anti-avoidance provisions to the arrangement, stating that 'no economic alternative to this transaction exists' – simply making this comment does not make it true, as many investments offer economic benefits that could be delivered in a variety of other ways.
We recommend that investors seek independent tax or legal advice about the tax consequences of investing in complex financial products from an adviser who is not involved in selling the product. Such tax advice should be separate from advice from a licensed financial planner about the benefits or risks of making the investment. Advice may include whether we have issued an ATO product ruling that states that a tax benefit is available.
Whether interest and borrowing costs can be claimed as a tax deduction
We have come across issues about the correct treatment of certain financial products and product features. An important question for such products is whether investors can claim tax deductions for interest and borrowing costs that they have incurred in order to fund their investment. Investors should not assume that they will be entitled to claim such expenses, even if the issuer of the product suggests that the costs are deductible for all or some investors – this is especially the case where the arrangement is highly complex and is not covered by an ATO product ruling that would provide certainty about the tax outcomes.
Depending on the investment product, there are several possible tax outcomes which depend upon the relevant product and its features. These tax outcomes include:
- The investment is subject to capital gains tax (CGT) – interest and borrowing expenses will be included in the cost base of the investment and, as a result, the interest incurred cannot be deducted. If that is the outcome then the interest and borrowing expenses will reduce any capital gain that arises when the investment matures.
- The investment is subject to both CGT and income tax under the ordinary rules. Dividends, distributions, coupons or any other income received during the life of the investment are subject to income tax under the ordinary rules, and any gain at maturity is subject to CGT. Deductions for interest or borrowing expenses may be limited to the amount of income received each year, especially where it can be shown that an investor could not reasonably expect to receive income (over the life of their investment) that exceeds the expenses incurred.
- An investment in a longer-term financial product that involves a profit-making scheme should be accounted for at maturity on a net basis as a profit-making scheme or undertaking. Investors in such products do not account for amounts that are received or paid during the life of their investment – instead, these amounts are netted off against one another when the investment ends. If amounts received are greater than amounts paid, then this amount will be reported as taxable income on the investor's tax return. If amounts received are less than amounts paid, then this amount can be deducted on the investor's tax return.
- An investment that generates income in excess of outgoings, or is reasonably expected to do so, means that interest and borrowing costs are fully deductible on revenue account in the relevant income year.
Deferred purchase agreements
A deferred purchase agreement (DPA) is an agreement where an investor agrees to purchase an asset (called the deliverable asset – this is usually shares) at a future point in time. The value of that asset at that future point in time is calculated by reference to another asset (called a reference asset), for example the ASX 200 index.
Certain DPA features may impact on the tax treatment of specific DPA products and arrangements if it is an attempt to exploit the revenue/capital distinction. Such features provide an indication – and may therefore support a conclusion – that an investment in such product will be accounted for as either a:
- capital investment, and subject to CGT
- revenue investment, and taxed accordingly.
Investors in DPAs that contain certain features that concern us may be subject to general anti-avoidance provisions in the tax laws.
Examples of the features in question
CGT
Features that indicate that an investment in a DPA is subject to CGT are:
- the payment of distributions (coupons) where the coupon appears simply to be a return of an investor's initial investment – such as where the investment itself does not appear capable of generating any periodic return, even though coupon payments are guaranteed to be made to the investor
- the remote possibility of investors receiving contingent coupons – especially when coupons are theoretically generated by extremely risky investments that are never likely to be realised – in order to attempt to justify deductions for interest and borrowing costs
- guaranteed coupon payments that are less than the interest that is paid by an investor in order to fund their investment. The question is whether interest on such products can only be deducted up to the amount of coupons that are paid to the investor.
See also:
- TD 2008/22 – that sets out other features indicating a DPA is subject to CGT.
Revenue asset
A feature that indicates that an investment is a DPA should be accounted for as a revenue asset is that the DPA has a term that is equal to or less than 12 months.
Anti-avoidance rules
DPA features of concern that may result in anti-avoidance rules applying to cancel tax benefits for investors are:
- reference assets that are the same as delivery assets (where such assets are shares that are expected to pay dividends) if this feature is designed to support an argument that the investment in the DPA is on revenue account
- coupon payments that appear to be a return of an investor's capital – such as where the underlying investment does not appear capable of generating any income, even though coupon payments are guaranteed. This feature would be a concern when it is concluded that its sole purpose is to support an argument that the investment is held on revenue account
- the possibility of receiving contingent coupons, particularly when coupons are generated by extremely risky investments, and it is concluded that its sole purpose is to support an argument that the investment is held on revenue account
- for compulsory loans (limited or full recourse), whether the interest expense on such products can be deducted, particularly where the DPA in question also contains any of the above features
- whether the tax treatment of a DPA changes depending on the type of reference assets that determine the investor's return – again, on the basis that a change in reference assets is used to support a view that the DPA is held on revenue account. In all such cases, concerns arise when the investor would ordinarily hold a DPA that did not contain the feature, or features of concern, on capital account.
Commoditised products
Another area of focus is certain types of investments that would ordinarily be subject to CGT being bundled up in an investment structure using a trust in order to change the tax treatment of the investment. An example of such arrangements would be an investment in a unit trust where the trust itself invests in options.
For an ordinary investor, an investment in options will be subject to CGT. We have concerns when an issuer bundles up an investment in options into a unit trust and argues that the investment is on revenue account.
These products concern us because an investment in such products is often financed from borrowed funds. This gives rise to questions about whether interest and borrowing costs that an investor incurs to invest in such products are deductible or not, as well as potential application of the anti-avoidance rules of the tax law.
Products designed to circumvent franking credit trading provisions
We have had concerns about a small number of products and product features that appear to be designed to provide investors with the benefit of franking credits. The features of such products indicate that there is more than a merely incidental purpose of enabling the investor to obtain the benefit of franking credits from their investment. Specific concerns include:
- features (and products) that are structured to meet the minimum requirements of the holding period rules, yet otherwise affect (or change) an investor's risk of loss, or opportunity for gain
- features where an investor transfers (including by way of a swap) their return on the equity interest that they hold and which generated the imputation benefit for a return that is based on a different (possibly non-equity) investment.
Investors are entitled to franking credits where they are exposed to a sufficient risk of loss or opportunities for gain when they invest in shares (as franking credits are generated from at-risk investments in equity). When taxpayers have invested in products that are specifically designed to reduce that risk, or when the investor has a more than incidental purpose of gaining the benefit of franking credits when they invest in a financial product, then franking credits may not be available under the law. In such circumstances the Commissioner of Taxation can cancel such franking credits under the anti-avoidance rules.
We have issued Taxpayer Alert TA 2012/3 about these sorts of arrangements.
Tax treatment of early exit or walk away features and product failures
Certain tax issues may arise where a financial product fails, is wound up prematurely, or an investor withdraws their investment before maturity. Many tax benefits that are available to investors in financial products arise because an investor's purpose of investing in such products is to hold their investment until maturity. However, where this purpose is not present, such tax benefits (such as deductions for interest) that investors believe they are entitled to may not be available, such as when:
- a product has been designed with the objective intention of it being wound up before maturity. If an investor did not have a purpose of holding their investment till maturity, then the relevant tax benefits may no longer be available under either the ordinary tax law provisions or the anti-avoidance rules
- an issuer fails to undertake critical steps or transactions in implementing a product. If it is clear that these steps or transactions have not been undertaken, then the relevant tax benefits may not be available under either the ordinary tax law or the anti-avoidance rules.
These situations should be contrasted with those where an investment product fails because of the insolvency of an entity responsible for implementing the product.
Capital protected and capital guaranteed financial products that use notional finance
In some cases advisers and product manufacturers may have encouraged retail investors to claim tax deductions on internally geared products that do not have an ATO product ruling. When the main economic rationale for a product or product feature appears to be tax deductibility, there is a risk that we may view the product as a tax avoidance scheme particularly if investors could achieve a similar benefit (apart from the tax deduction) by purchasing other financial instruments such as call options.
On 1 May 2013, the Australian Securities & Investment Commission (ASIC) released its Report 340 'Capital protected' and 'capital guaranteed' retail structured products. We share the concerns ASIC has raised in this report and state that tax deductions may not be available for investors who invest in certain products referred to in the report.
An example of these concerns is capital guaranteed products that are bundled together with a notional loan where it is argued that the investment is funded from this notional loan. Potential risks arise in products where it appears no actual finance or financial accommodation is provided to investors who invest in these products. In these cases deductions may not be available for the notional interest expense that the investor has incurred in order to invest in such products. Such expenses would form part of the cost base of the investment.
Investors in products that promote the availability of tax benefits of the type referred to above should ask the product issuer, or the entity who is marketing the product, whether the ATO has issued a product ruling that states that the tax benefit in question is available. If no such ruling has been obtained then an investor should consider whether the investment in question is suitable for their needs.
See also:
Implementation issues
We have had concerns about certain financial products that appear to have been implemented in a manner that is inconsistent with relevant documentation, including product disclosure statements where these are required by law. Examples include arrangements:
- where the substance of the transaction differs from its legal form
- that are accounted for in a manner that is inconsistent with transaction documents.
Where arrangements are not implemented in a manner that is consistent with relevant documentation, or are implemented incorrectly, issues that will arise include whether:
- the tax benefits that the product promised to investors are available at law
- all, or part, of the purported arrangements or transactions are a sham
- promoter penalty law applies to entities that promoted the arrangement where the tax benefits are not reasonably arguable under the law
- promoter penalty law applies to entities involved in implementing an arrangement that is marketed on the basis of conformance with an ATO product ruling even though the arrangement is materially different to that described in the product ruling.