PORTFOLIO POINT: With tax-effective products back in vogue this financial year, it’s important to make sure you’re covered by an ATO ruling – if not, get some independent advice.
It’s that time of the year again – the countdown to the end of the tax year on June 30. Remarkably, though millions of investors had losses in the GFC compounded by poorly structured – and sometimes entirely inappropriate – gearing arrangements, the race is on again.
Perhaps it’s the sight of the ASX lifting by nearly 8% in the first quarter of calendar 2012, or maybe it’s the passing of time since the scandals surrounding collapsed groups such as Storm Financial, but either way 'creative’ pre-June 30 tax planning is back in vogue. You might have thought too that investors had enough tax losses built up over recent years, but it seems hope springs eternal in this area.
Borrowing to buy other assets like real estate has been a common practice for many Australians, and of course gearing into “alternative” assets like timber and agribusiness was a large part of investment planning during the 1990s and 2000s. Meeting the concerns of risk averse investors, wave after wave of innovative gearing and capital protected investments have been marketed, many claiming a range of enhanced tax benefits to entice investors. It’s not hard to understand how this new style of financial products can capture the imagination of investors who are wary of traditional forms of gearing (such as margin lending), after the losses triggered by the GFC – typified by the Storm Financial debacle. So it’s timely to consider how the ATO reacts to some of these complex financial arrangements, many of which are widely promoted by financial advisers and accountants in the lead up to “tax time”.
New ATO taskforce
Following the proliferation of complex financial products since the GFC, the ATO has ramped up its investigation of taxpayers using gearing arrangements to generate tax deductions or franking credits, often using these complex products as the underlying asset. Following the formation in 2011 of a “Financial Products Taskforce” led by Assistant Deputy Commissioner Bruce Collins, wide-ranging investigations commenced last year, with specific targeting of these arrangements this year.
The problem for taxpayers is that some of these schemes being targeted look very similar to more orthodox investments, using technology like instalment warrants or capital protected products that will be commonplace for many taxpayers. As any taxpayer who has been audited or suffered an amended assessment for participation in a tax scheme will readily attest, life becomes very unpleasant when the ATO takes a dislike to your tax affairs.
Collins was pointed when asked to comment: “The ATO is looking at widely offered financial products that promise tax benefits that aren’t properly available under current tax laws. Often these products promise tax benefits that are disproportionate to the real financial returns on the product.”
What Collins describes are transactions where, for $1 spent by an investor, tax benefits worth more than $1 are claimed. We’ll work through some of the aspects of these “nirvana” products in this article.
Complex financial products under the spotlight
Highlighting the ATO focus on product complexity, Collins pointed out that: “The ATO is concerned about some complex products where some parts of the return are claimed to be on capital account but other parts of the return are claimed to be ordinary assessable income, as these types of products raise questions about the tax deductibility of interest and borrowing costs where loans have been used to finance the investment. An example of such complex products are certain “deferred purchase agreements” with novel or unusual features that promise deductible expenses along the way and capital gains at the end."
Most of the capital protected or leveraged investments promoted by major banks and brokers in Australia use this “deferred purchase” technology, where investors receive their final return through the delivery of shares at maturity of the investment. The ATO sees these deferred purchase agreements (DPAs) as CGT assets, with concessional CGT payable when the shares are delivered (even if the investor elects to sell the shares to receive cash instead). The tax problem arises when these DPAs are morphed into products which pay annual income or “coupons”, which are argued to be normal assessable income. The tax sleight of hand comes about when this income is designed to support negative gearing strategies, generating tax deductions for interest-paying investors.
Overview of negative gearing rules
To understand the problem, we need to step back for a minute. Our tax system provides tax deductions for expenses incurred in the production of assessable income. The most commonly accessed deductions for retail investors arise from so-called negative gearing, where finance is used to buy an income-producing asset (property or shares are the most common), with the rent or dividends being taxable and the costs involved in earning that income (including the cost of finance) normally being deductible. The common myth that these deductions arise because of the potential for capital gain on the ultimate sale of the property is just that: for normal investors, the gain on disposal will be a capital gain (unless the taxpayer is in business, such as a share trader, in which case the gain on disposal will be normal assessable income). Our tax system only permits income tax deductions, which are matched by ordinary assessable income.
It’s around these complexities that most tax schemes are arranged. If a taxpayer can claim deductions for interest costs, but pay tax on final gains at concessional CGT rates, tax planning opportunities arise; and if the income produced during the life of the investment is tax-enhanced (e.g. dividends with franking credits, which reduce the annual tax payable), the tax planning opportunities are magnified.
Limited recourse finance and capital protection
Sometimes tax schemes involve limited recourse finance (where the purchased asset is the only security for the loan), as well as capital protected products (where 100% finance is available). These ingredients combine to generate what is known by tax professionals as “leverage” – where for a very small initial outlay, tax benefits are created with a value in excess of the cost. The icing on the cake for tax scheme promoters and investors arises where the promoter can provide finance to cover the investors’ interest costs. So-called “interest assistance loans” allow investors to create large tax benefits for very little upfront cost.
Protected loans and instalments
But as you read this checklist, you may be wondering how the ATO views some of the more orthodox investment arrangements that are widely used by many taxpayers. Wary sharemarket investors like to invest where their risk is minimised, and many investors in the wealth accumulation phase use borrowings to help build wealth. Protected loans and instalment warrants abound in the retail market – so how do taxpayers assess the tax risk when they borrow to invest and/or protect their investment’s capital value?
ATO Product Rulings
Collins advocates that taxpayers should buy products where the ATO has provided the comfort of a ruling, confirming and explaining the tax result for investors: “The ATO encourages investors to look for financial products where an ATO Product Ruling has been issued. Where an investment in a complex product without an ATO Product Ruling is contemplated, the ATO encourages investors to seek independent tax advice from a qualified tax professional who isn’t selling the investment or to seek a private ruling from the ATO (which would normally take around 2 months to provide).”
As Collins suggests, if a product doesn’t have a ruling, then the investor should take independent advice (from an adviser not related to the scheme promoter) and, if needed, apply for a private ruling which will cover the individual circumstances of the investor.
The ATO has green-lighted some new-age gearing products where 100% finance is available, and where investors’ risk is effectively limited to their interest costs. Products like Macquarie “Flexi 100” paved the way for this result, with the comfort of an ATO Product Ruling (PR 2011/19) which confirms that the investor’s interest cost is tax deductible. Flexi is an example of a “synthetic” product, created using complex derivatives instead of real shares.
'Synthetic deduction' products – not so tax effective, after all
Read this ruling closely though, because it contains a couple of surprises: although the underlying investments offered by Flexi are all linked to shares or sharemarket indices, all of the returns from the investment (including the final gain, if any, from movements in the shares or indices) are taxed as ordinary assessable income – far less attractive than the normal concessional CGT treatment for simpler share-based investments.
Further, although Flexi 100 is marketed as a flexible investment which allows the investor to “walk away” part-way through the life of the product (and in doing so, cease any liability to make any further interest payments), the ATO ruling insists that taxpayers should expect to stay in the product for its full term, and explicitly states that using the 'walk away’ feature can put at risk any of the interest deductions claimed up to that point.
Adopting Collins’ approach, investors looking at some of the Flexi-style clones now being promoted by other banks should only consider investing if the clone product comes with an ATO ruling. Many of these clones don’t have ATO rulings – a signal that they may be more tax-risky.
In comparison with these complex arrangements, more traditional protected share loan products stand out as simpler and less tax aggressive. The ATO has for many years administered these protected loans in line with tax laws which recognise that gains on the disposal of the underlying shares are taxed under concessional CGT rules, and which clearly permit tax deductions for interest costs – with the level of the deduction capped at 1% above the RBA secured home mortgage rate.
Instalment warrants are also now viewed by the ATO as permissible forms of gearing, with interest costs deductible and with the security trust arrangements (which contain the underlying shares) being ignored for tax purposes. Investors can see the ATO view on instalments here. SMSFs are attracted to instalment warrants, something noted with skepticism in the Cooper Review of superannuation.
Collins also noted that there are some even more complex style of products that the ATO are now seeing marketed, where franking credits are generated but investors don’t really receive normal dividend income. Collins noted that in these products: “the investor buys an investment in underlying shares, but then uses a derivative instrument (like a swap) to trade away the net dividend income in return for a notional capital exposure, while attempting to retain entitlement to franking credits. This may mean that economically the investor is just buying the franking credits.”
Where to from here
So the message is simple – the ATO is looking closely at complex investments and gearing arrangements. If you are looking to invest in the market, do so where you have the comfort of an ATO Product Ruling or where, at a minimum, you get clear advice from a truly independent tax professional (not just your local financial planner or accountant if they are promoting the product to you), or where you get ATO sign-off through a binding private ruling. The market may well be starting to recover, and may provide good returns over time – but don’t let these be destroyed through buying into an aggressive tax scheme that looks too good to be true.
Tony Rumble is the founder of the ASX-listed products course LPAC Online. He provides asset consulting and financial product services with Alpha Invest but does not receive any benefit in relation to the product reviewed.