Many people are persuaded to enter into investments that they may otherwise regard from a taxation perspective as being somewhat risky. They are often won over by the fact that the particular investment is said to have been fully explained to the Australian Taxation Office (ATO) by its promoter and has been “green lighted” by the ATO, as evidenced by the issue of a related product ruling said to confirm its claimed features and tax benefits.
Care however needs to be exercised. Product rulings are always limited to the precise facts upon which the product was put to the ATO for its consideration. Sometimes, aka more often than not, an investment product is tweaked over its lifetime so at to maintain or increase its market appeal. The next time, will not be the first time that such a tweak has resulted in a product falling outside of the protection of its product ruling.
A case in point is an equity investment product presently being promoted by one of our banks. It has been marketed in one form or another for several years. Let’s call the product a Protected Equity Investment (PEI) and let’s suppose that it is sold to investor clients by advisors on behalf of the Structured Investment Division (SID) of the promoter bank.
The bones of the product are that a client is persuaded to invest in the PEI product. The investment is presented as being virtually self funding with the investor client being invited to borrow the entire required capital sum from the promoter bank on an annual interest only in advance basis for the proposed term of the investment. In fact, the loan of the required capital sum is structured as two equal but separate, annual interest only in advance loans.
The proceeds of the first loan are applied to purchase an equity portfolio selected by the investor client from a pre-approved list of shares and other equities. By the use of related derivatives, written at the time of investment, the capital value of those shares and/or other equities at maturity is fully protected/guaranteed.
The proceeds of the second loan are applied to subscribe for and purchase units in a special purpose cash management trust sponsored by the SID (the SID Cash Trust). The SID Cash Trust is empowered to make but one form of investment, that is, loans back to the promoter bank at an interest rate equal to the current Reserve Bank of Australia (RBA) official cash rate. It is also important to note that while units in the SID Cash Trust may strictly speaking be capital protected/guaranteed by the promoter bank/lender, they offer no opportunity for any capital appreciation to the client investor.
To give the PEI a little more tax “zing”, the promoter bank may, subject to its credit assessment of the client investor, elect to advance to the client investor the full year’s interest payable on both loans for the coming year, thereby permitting an immediate prepayment of such interest and garnering for the client investor a possible timing benefit.
To understand what is behind the split loan structure, it needs to be appreciated that not all the interest payable on a loan in respect of a capital protected/guaranteed investment will necessarily be tax deductible under section 8-1 of the Income Tax Assessment Act 1997.
Since 16 April 2008, the position has been that to the extent that the interest charge on a loan in respect of a capital protected/guaranteed investment exceeds the RBA’s standard variable interest housing loan plus a margin of 1.00% it will not be tax deductible. Any excess interest expense on the loan is treated as being a cost attributable to the capital protection/guarantee of the underlying investment and therefore not tax deductible.
The derivatives associated with providing capital protection/guarantee to an investor client require the payment of upfront premiums, the cost of which must necessarily be recovered over the life of the associated loan and investment from the investor client in the form of interest. It follows that the nominal interest rate payable in respect of such a capital protected/guaranteed investment loan will need to be priced at a substantial margin (e.g. roughly 7.00% for a 5 year loan) above the cost of a comparable standard investment loan. In marketing terms this substantial and potentially non tax deductible interest rate margin is a real and obvious impediment to attracting new investor clients and the writing of new business.
In an apparent attempt to overcome that impediment and notwithstanding the different costs and risks the two forms of underlying investment represent to the promoter bank/lender, the loan in respect of the capital protected/guaranteed equities and the loan in respect of the SID Cash Trust units are ostensibly priced to the investor clients at a single, averaged interest rate. This common interest rate pricing may assist with the cosmetic of there being a single, headline loan but it demonstrably inflates the true interest cost of the first underlying loan in respect of the SID Cash Trust units. However by way of offset, it substantially reduces the true interest cost and more importantly, the otherwise potentially non-tax deductible component of the cost of the second underlying loan in respect of the capital protected/guaranteed investment in shares and other equities.
It is not known whether all the relevant facts of this presently offered structured loan have ever been fully explained to the ATO and for that reason, whether or not the currently marketed version of the PEI remains, as is claimed, within the protection of its related product ruling. However the form over substance structure of the headline loan looks very much like a rather clumsy attempt to make the facts fit the ruling rather than allowing the ruling to reflect the facts. If that is true, it is doubtful whether product ruling even applies.
It is also important to remember that a product ruling is no more than the ATO’s view of the outcome of the current tax law applied to the specific set of facts put to the ATO for its consideration. It is not a general statement of the law and ought not be relied upon as such.
The law in respect of the PEI requires a proper consideration of Division 247 of the Income Tax Assessment Act 1997 (which reversed the result in FCT v Firth [2002] 50 ATR 1), of the more general legal position regarding the tax deductibility of interest – see Ure v FCT (1981) 11 ATR 484, Ilbery v FCT (1981) 12 ATR 563 and of the possible application of Part IVA of the Income Tax Assessment Act 1936 – see Macquarie Finance Limited v FCT (1991) 22 ATR 613.
The important take away for clients from all this is that while the issue of a product ruling may be helpful and provide some degree of comfort, it is really conclusive of nothing. All structured investments need first to be carefully modeled and analysed, in both financial and legal terms, having regard to the client investor’s own circumstances and goals.
Disclaimer: – Please note the comments made in this document do not represent general legal advice and no person should rely upon it/them without seeking advice particular to their own facts and circumstances.
