Timing of deductions for prepaid interest on money borrowed to acquire instalment warrants over stapled securities

Will subsection 82KZME(5) of the Income Tax Assessment Act 1936 (ITAA 1936) apply to prepaid interest expenditure incurred in respect of an investment in instalment warrants over stapled securities so that the expenditure is excluded from the tax shelter rules contained in sections 82KZME and 82KZMF of the ITAA 1936?

Yes. Prepaid interest on money borrowed to acquire instalment warrants over stapled securities falls within the exception contained in subsection 82KZME(5) of the ITAA 1936 and is excluded from the operation of sections 82KZME and 82KZMF of the ITAA 1936.

The taxpayer is an individual taxpayer who enters into an agreement to acquire instalment warrants over stapled securities.

The taxpayer is not a trader in financial products and is not treated for taxation purposes as carrying on a business of investing in stapled securities or the underlying shares and units.

Under the terms and conditions of the agreement the taxpayer borrows money to acquire the instalment warrants and is required to pay 12 months interest in advance on 31 May 2004.

At all times during the term of the agreement the taxpayer retains beneficial ownership of the underlying stapled securities.

Each stapled security comprises a share in a company stapled to a unit in a unit trust that has at least 300 beneficiaries and is a widely held unit trust as defined in section 272-105 in Schedule 2F to the ITAA 1936.

The share and the unit that constitute the stapled security are jointly quoted on Australian Securities Exchange Limited (ASX).

The taxpayer either obtains, or can reasonably be expected to obtain, dividends or trust income and no other income under the agreement except for a capital gain.

All aspects of the agreement are conducted at arm's length.

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, except where the outgoings are of a capital, private or domestic nature, or relate to the gaining or producing of exempt income.

The prepaid interest on the money borrowed to acquire the instalment warrants over the stapled securities is an allowable deduction under section 8-1 of the ITAA 1997.

The acquisition of the instalment warrants confer on the taxpayer beneficial ownership of the underlying stapled securities and ultimately the shares and units that constitute the stapled securities. The shares and the units are issued and continue to exist as separate assets and the stapling of the instruments merely reflects restrictions placed on them by ASX. Accordingly, the prepaid interest incurred in acquiring the instalment warrants over the stapled securities is also necessarily incurred by the taxpayer in acquiring the shares and units that constitute the stapled securities.

Sections 82KZME and 82KZMF of the ITAA 1936 (the tax shelter rules) prevent prepaid expenditure made under certain agreements relating to tax shelter arrangements from being immediately deductible under section 8-1 of the ITAA 1997. Instead, prepaid expenditure under these agreements is required to be deducted on a proportional basis over the period to which it relates or 10 years, whichever is less.

The instalment warrant agreement entered into by the taxpayer is considered an arrangement to which the tax shelter rules apply. The taxpayer does not have day to day control over the operation of the agreement and in the income year in which the prepaid expenditure is made the taxpayer's allowable deductions under the agreement exceed the assessable income from it.

Subsections 82KZME(5) to 82KZME(9) of the ITAA 1936 provide certain exceptions to the tax shelter rules. Generally, where any of these exceptions apply, an individual taxpayer who does not incur the expenditure in carrying on a business may be eligible to claim an immediate deduction where the eligible service period is 12 months or less and it ends on or before the last day of the next income year (section 82KZM of the ITAA 1936).

Subsection 82KZME(5) of the ITAA 1936 provides an exception from the tax shelter rules for prepaid expenditure incurred on certain negatively geared investments. The relevant parts of the legislation have the effect of excluding prepaid interest on money borrowed to acquire shares that are listed for quotation in the official list of an approved stock exchange and units in a trust that has at least 300 beneficiaries and is a widely held unit trust as defined in section 272-105 in Schedule 2F to the ITAA 1936.

The shares and units that constitute the stapled securities are quoted jointly on ASX. That is, instead of the two securities being quoted and traded separately on ASX they are quoted and traded jointly.

A requirement for quotation is that the entities whose securities are stapled are admitted to the official list of ASX. Although ASX allows the entities to meet the listing requirements collectively each entity is admitted to the official list. Accordingly, the shares that, in part, constitute the stapled securities are listed for quotation in the official list of ASX.

As the prepaid interest is incurred in acquiring units in a trust that has at least 300 beneficiaries and is a widely held unit trust as defined in section 272-105 in Schedule 2F to the ITAA 1936 and shares that are listed for quotation (albeit jointly) in the official list of ASX the prepaid interest is excluded from the operation of the tax shelter rules.