Income tax - look through companies and interest deductibility

Income tax - Look-through companies and interest deductibility

All legislative references are to the Income Tax Act 2007 unless otherwise stated.

This QWBA considers ss DB 6 and HB 1.

Question

1. We have been asked whether interest will still be deductible where a loss-attributing qualifying company (LAQC) becomes a look-through company (LTC) if:
   • a person had previously sold their family home to a LAQC as a rental asset, to be rented to a third party on an arm’s length basis;
   • the person owned 100% of the shares in the LAQC;
   • the sale was at market value;
   • the LAQC borrowed from a bank to fund the purchase;
   • the person then used the funds raised from the sale to purchase a new family home;
   • the LAQC becomes a LTC.

Answer

2. If all that has changed is that the LAQC has become a LTC, then interest deductions previously allowed will continue to be allowed, subject to the limitations on deductions in ss HB 11 and HB 12 that apply to LTCs.
3. The position would be the same where a person sells their family home at market value directly to a LTC and the LTC holds it as a rental asset and rents it to a third party on an arm’s length basis. (See paragraph 23 and example 2 of this item.)

Explanation

Background

4. The Commissioner has received inquiries from taxpayers asking whether previously allowed interest deductions made by a LAQC will continue to be allowed where a LAQC becomes a LTC./li>
5. The issue has arisen because some taxpayers have interpreted “look-through” to mean that you simply ignore all transactions between the LTC and the owner of an effective look-through interest in the LTC (“the owner”). This would mean that you look through the LTC (essentially ignoring it and disregarding the use to which the LTC put the borrowed funds) to look at the owner’s use of the funds. On the facts outlined in the question above, the owner would be considered to have used the funds to acquire a private asset (the new family home), not for deriving assessable income. The result of this interpretation is that the test for interest deductibility would not be satisfied.
6. The Commissioner considers the above interpretation to be incorrect. The Commissioner’s view is that the owner’s use of the funds received on the sale of the rental asset to the LAQC is not relevant to the issue of interest deductibility on the borrowing by the LAQC (and later the LTC). The correct interpretation is outlined below.

Discussion

Interest deductibility

7. Usually a company would be entitled to an automatic interest deduction under s DB 7. However, neither LAQCs nor LTCs qualify for the deduction under s DB 7.
8. A deduction for interest incurred may be made under s DB 6. Section DB 6 allows a deduction for interest incurred provided the general permission in s DA 1 is satisfied. Section DA 1 allows a deduction for interest incurred by a taxpayer in deriving their assessable income or incurred by them in the course of carrying on a business for the purpose of deriving their assessable income.
9. The Commissioner’s view is that the interest deductibility test is satisfied where a sufficient connection exists between the interest incurred and the assessable income. Where borrowed funds are used to acquire an income-earning asset (such as a rental property) and the property continues to be used as an income-earning asset, then that would establish a sufficient connection.
10. In terms of the LTC regime, s HB 11 operates to limit the deductions that a person with an effective look-through interest can deduct in an income year. This is known as the loss limitation rule and applies to all deductions, including interest. Section HB 12 applies to allow a person with an effective look-through interest to carry forward any limited deductions into future years, subject to the loss limitation rule in s HB 11. Broadly speaking, the loss limitation rule ensures an owner can offset losses only to the extent these reflect their economic losses.

Look-through companies and tax transparency

11. LTCs are generally transparent for income tax purposes. Tax transparency is achieved by s HB 1(4). The effect of s HB 1(4) is that the LTC’s income, expenses, tax credits, gains and losses are passed on to its owners in proportion to their effective look-through interest. Some taxpayers have expressed concern that the effect of these provisions is that interest, in the circumstances set out in the question, will be treated as private and non-deductible. The Commissioner does not agree with this interpretation.
12. Section HB 1(1) states:
    HB 1 Look-through companies are transparent
    When this section applies
    1. This section applies for the purposes of this Act, other than the PAYE rules, the FBT rules, the NRWT rules, the RWT rules, the ESCT rules, and the RSCT rules, for a person in their capacity of owner of an effective look-through interest for a look-through company (the LTC), for an income year, if––
       1. for the LTC, an LTC election described in section HB 13(1) and (2) has been received by the Commissioner under section HB 13(3) and (4) for the income year; and
       2. the LTC meets the requirements in the definition of “look-through company” at all times in the income year; and
       3. the election has not been revoked for the income year by an owner of a look-through interest for the LTC by notice received by the Commissioner before the start of the income year

13. Section HB 1(4) states:
    Look-through for effective look-through interest
    4. For a person, unless the context requires otherwise,—
       1. the person is treated as carrying on an activity carried on by the LTC, and having a status, intention, and purpose of the LTC, and the LTC is treated as not carrying on the activity or having the status, intention, or purpose:
       2. the person is treated as holding property that the LTC holds, in proportion to the person’s effective look-through interest, and the LTC is treated as not holding the property:
       3. the person is treated as being party to an arrangement to which the LTC is a party, in proportion to the person’s effective look-through interest, and the LTC is treated as not being a party to the arrangement:
       4. the person is treated as doing a thing and being entitled to a thing that the LTC does or is entitled to, in proportion to the person’s effective look-through interest, and the LTC is treated as not doing the thing or being entitled to the thing.

14. Section HB 1(4) attributes the actions of the LTC to its owners. This means that the owners are treated as carrying on the activities of the LTC; having the same status, intention and purpose as the LTC; holding property that the LTC holds; being party to any transactions entered into by the LTC; and doing a thing that the LTC does. The LTC is treated as not doing those things or having that status, intention or purpose.
15. The Commissioner is of the view that the use to which the LTC puts the borrowed funds is “a thing” under s HB 1(4)(d).
16. The effect of s HB 1(4) is to treat the LTC’s actions as being those of the owner for income tax purposes. Section HB 1(4) does not work in reverse (ie, the LTC regime does not operate to substitute the owner’s actions for those of the LTC). Legislative support for this position can be found in s HB 1(1), which refers to “a person in their capacity of owner of an effective look-through interest”. This implies that an owner can have more than one capacity. It is the use of the borrowed funds by the LTC, attributed under s HB 1(4)(d) to the person (in their capacity as owner) that is relevant to the issue of interest deductibility, not the use of the funds by the person in their personal capacity.

Application to the question

17. The LAQC borrowed funds to acquire the rental property. The LAQC used this property to derive assessable income. Interest incurred on the borrowed funds was deductible for income tax purposes.
18. When the LAQC becomes a LTC, interest previously deductible will remain so. The rental property becomes an income-earning asset of the LTC. The LTC’s use of the borrowed funds is the same as that of the LAQC – to fund an income-earning asset. It is important to remember that by becoming a LTC the company itself does not change; it remains the same company as before, but it is now taxed differently.
19. Section HB 1(4) then operates to treat the LTC’s actions as being those of the owner, in that person’s capacity as owner of the effective look-through interest. The provision does not apply to treat the owner’s use of the funds in their personal capacity (in this case, to purchase a new family home) as the LTC’s use.
20. Therefore, the interest on the borrowed funds is incurred by the LTC in funding an income-earning asset. The person, in their capacity as owner of an effective look-through interest, is treated as having incurred the interest for the same use. Accordingly, the interest deductibility test will be satisfied and the interest will be deductible under s DB 6, subject to the limitations in ss HB 11 and HB 12
21. The deductibility of interest by the LTC is determined by considering the use made by the LTC of the borrowed funds. The fact the person sold the family home and received a non-taxable amount does not result in the denial of deductibility. The extra amount over and above what the person originally bought the property for reflects an increase in the market value of the property.
22. This interpretation would also apply where a qualifying company becomes a LTC in the same circumstances.
23. Further, the position would be the same where a person sells their family home at market value directly to a LTC, which holds it as a rental asset and rents it to a third party on an arm’s length basis.
24. This answer applies to the facts set out above. The Commissioner is satisfied that in these circumstances, interest would be deductible. If the facts were to vary materially from those in the question, then the Commissioner may need to consider the matter further and a different outcome might apply.

Examples

Example 1

25. The facts of example 1 are as follows:
    • In June 2003, Jamie bought his house, Ivy Cottage, for $400,000 with a loan from the bank for $350,000. The loan was secured by a mortgage over Ivy Cottage. The remainder of the purchase price was funded from his savings.
    • In May 2009, Jamie decided to rent Ivy Cottage and purchase a new family home, Rose Cottage.
    • After taking advice, Jamie sold Ivy Cottage at its fair market value of $500,000 to a LAQC for use as a rental property. Jamie owned 100% of the shares in the LAQC.
    • The bank lent the LAQC $450,000, partially secured by a mortgage over Ivy Cottage. The LAQC contributed the remaining amount of $50,000 from its own funds. Jamie also provided a personal guarantee as further security for the loan.
    • Jamie repaid the balance of the $350,000 mortgage to the bank from the proceeds of the sale of Ivy Cottage to the LAQC. Jamie then borrowed a further $250,000 from the bank to purchase Rose Cottage.
    • Jamie is now living in his new private residence, Rose Cottage. The LAQC owns Ivy Cottage, and it is being used as a rental property, rented to a third party on an arm’s length basis, to derive assessable income.
    • In April 2012, the LAQC becomes a LTC. Is the interest that the LTC pays to the bank deductible for tax purposes?
26. Interest that was previously deductible when Ivy Cottage was owned by the LAQC will remain deductible after the LAQC becomes a LTC, subject to ss HB 11 and HB 12.
27. The LAQC borrowed the funds to acquire Ivy Cottage as a rental property. When the LAQC becomes a LTC the use of the funds does not change. The only thing that changes is how the company is taxed.
28. Under the LTC provisions, Jamie, in his capacity as owner of an effective look-through interest, is treated as doing a thing that the LTC does. The LTC continues to use the amounts borrowed to fund Ivy Cottage as a rental asset to derive assessable income. Section HB 1(4)(d) treats Jamie as using the funds in the same way. As a result, interest incurred by the LTC on the borrowed funds is deductible.
29. It is irrelevant that Jamie used some of the funds that the LAQC paid him on the sale of Ivy Cottage to purchase his private residence, Rose Cottage.
30. The fact the market value price the LAQC paid for Ivy Cottage was higher than the market value price Jamie paid when he first bought the property does not make a difference to the question of interest deductibility.

Example 2

31. Example 2 concerns the situation where a person sells their family home directly to a LTC.
32. The facts in example 2 are as follows:
    • In March 2002, Anne purchased her family home, Seaview Lodge, for $300,000. The bank loaned Anne $200,000, secured by a mortgage over Seaview Lodge, and she funded the remainder of the purchase price from her savings.
    • In August 2011, Anne decided to sell Seaview Lodge directly to a LTC at its fair market value of $400,000 for use as a rental property.
    • Anne is the 100% owner of all the shares in the LTC.
    • Anne purchases a new family home, Mountain Lodge.
    • The bank lends the LTC $350,000 to fund the purchase secured by a mortgage over Seaview Lodge. The remaining purchase price is funded from the LTC’s funds.
    • Anne repays the balance of the $200,000 mortgage to the bank and borrows a further $300,000 to purchase Mountain Lodge.
    • Anne now lives at Mountain Lodge, and the LTC owns Seaview Lodge. Seaview Lodge is being used as a rental property and is rented to a third party on an arm’s length basis. Is the interest the LTC pays to the bank deductible for tax purposes?
33. The fact Anne sold Seaview Lodge directly to the LTC does not affect interest deductibility. The interest incurred by the LTC is deductible, for the same reasons as given in example 1. The LTC has borrowed the funds to acquire a rental property. Anne, in her capacity as owner of an effective look-through interest, is treated as having incurred the interest for the same use. The use to which Anne puts the sales proceeds does not affect the connection with the assessable income. The LTC’s actions are attributed to Anne and not the other way around.

References

Subject references

Look-through companies, interest deductibility

Legislative references

Income Tax Act 2007, ss DA 1, DB 6, DB 7, HB 1, HB 11, HB 12, HB 13