Preamble
A capital protected loan facility is a fixed term loan used to purchase shares listed on the Australian Stock Exchange. Typically, a capital protected loan will either be a limited recourse loan or a full recourse loan together with a put option. The capital protection feature means that the investor is effectively protected from the risk of a fall in the price of the shares as the associated put option enables the borrower to require the lender to take the shares in full repayment of the borrowed sum.
Interest is payable on the capital protected loan facility. Typically interest will either be payable annually in advance or monthly in arrears.
Under a capital protected loan facility the investor may have the opportunity to use a ' call option writing feature' . This feature allows an investor to sell call options over the underlying shares with a strike price that is greater than the capital protected amount of the loan. Depending on the particular circumstances of the product, an investor may be restricted to writing call options to the issuer only, or may be able to write call options to unrelated third parties.
If the price of the shares increases above the strike price of the call option the holder of the call option may elect to exercise the option. When this occurs, the investor is obliged to sell the underlying shares to the option holder.
An investor may have various choices with respect to the proceeds from the sale of the shares, although generally they are required to acquire further shares or repay the capital protected loan.
When the capital protected loan is first drawn down and the proceeds are used to acquire shares that are expected to produce dividends, the necessary nexus with the assessable income exists for the Interest outgoings to be deductible under section 8-1 of the Income Tax Assessment Act 1997 .
As selling call options under the option writing feature will not change the occasion of the Interest outgoings on the sum borrowed to acquire the shares, the nexus between the Interest expense and the assessable income will not be broken and Interest outgoings will continue to be deductible under section 8-1.
If an investor subsequently sells the shares as a result of the call option being exercised it is necessary to determine whether the occasion of the Interest outgoing on the borrowed sum continues to be found in an income producing activity. The application of the proceeds of sale in an amount equal to the original loan amount to an income producing purpose maintains the necessary connection between the Interest outgoings on the originally borrowed sum and a relevant income producing activity.
That is, if income producing assets acquired with borrowed funds are sold and the proceeds of sale are used to acquire (a) new income producing asset(s) costing at least as much as the originally borrowed sum, the interest on the loan continues to be an allowable deduction. The funds used to acquire the original assets are now reflected in the new asset(s).
Accordingly, where proceeds equivalent to the loan amount are used to acquire further shares or remain in an income producing security deposit account, Interest outgoings will continue to be deductible under section 8-1.
Where the use of the borrowed funds has changed such that it can no longer be said that there is an income producing purpose, further Interest outgoings will not be deductible.
Should the capital protected loan allow proceeds to be withdrawn from the facility such that the amount reinvested in shares or in a security deposit account is less than the amount borrowed, Interest outgoings in respect of the originally borrowed amount will need to be apportioned.
Where the call option is not exercised, it subsequently lapses and the investor continues to hold the underlying shares, the nexus between the Interest outgoings and income producing activities remains and further Interest outgoings continue to be deductible under section 8-1. Note 1: Acquisition of the shares on capital account will not necessarily mean that a subsequent disposal is on capital account. This will depend on the facts and circumstances relevant to each investor . Disposal of a call option on capital account will not necessarily mean that a subsequent disposal is on capital account. This will depend on the facts and circumstances relevant to each investor . Note 2: Where interest is paid in advance the prepayment provisions in Subdivision H of Division 3 Part III of the Income Tax Assessment Act 1936 will need to be considered . Note 3: Where the sold call option and the capital protection feature have the effect that the investor has materially diminished risks of loss or opportunities for gain in respect of the shares, the investor may not be a qualified person in relation to a distribution received and unless able to satisfy that requirement in another way, will not be entitled to a tax offset under section 207-20 of the ITAA 1997 in respect of the franked distribution .
When the final Determination is issued, it is proposed to apply both before and after its date of issue. However, the Determination will not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Determination (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).
We invite you to comment on this draft Taxation Determination. Please forward your comments to the contact officer by the due date. Due date: 18 February 2005 Contact officer details have been removed following publication of the final ruling.