Tax consequences for a borrower being charged an 'Indexed Rate' of interest under a home loan

This Ruling sets out the income tax consequences for borrowers in relation to a scheme involving the application of software licenced to Findexia Limited (Findexia) which, in part, calculates a variable interest rate that is charged by a lender on the home loan of a borrower by reference to movements in the measure of an Index or Indexes.

All legislative references in this Ruling are to the Income Tax Assessment Act 1997, unless otherwise indicated. Terms which are defined in the pro forma terms referred to in paragraph 10 of this Ruling have been capitalised.

This Ruling does not address: • the treatment of any costs, fees and expenses (other than interest) payable by the borrower in respect of their home loan • the deductibility of interest incurred by the borrower under their home loan in respect of any loan funds drawn down for a purpose other than to fund - the acquisition of the borrower's principal place of residence or refinance an existing loan used for that purpose - improvements or renovations to the borrower's principal place of residence - the acquisition of assets for personal use, or - private use expenditure • the borrower's tax obligations and benefits in relation to the acquisition, holding and sale of their principal place of residence or any other personal use asset funded by a home loan, and • whether this scheme constitutes a financial arrangement for the purposes of Division 230 (taxation of financial arrangements).

This Ruling applies to you if you are an individual who, as the borrower, enter into the scheme described in paragraphs 10 to 24 of this Ruling on or after 1 July 2023 and on or before 30 June 2026.

This Ruling does not apply to you if you are an individual who enters into this scheme before 1 July 2023 or after 30 June 2026.

This Ruling applies from 1 July 2023 to the borrowers specified in paragraph 4 of this Ruling who enter into the scheme from 1 July 2023 until 30 June 2026.

However, the Ruling only applies and may be relied on to the extent that there is no change in the scheme or in the entity's involvement in the scheme. If the scheme carried out is materially different from the scheme described at paragraphs 10 to 24 of this Ruling, this Ruling cannot be relied upon and may be withdrawn or modified.

Subject to paragraph 3 of this Ruling and the assumptions in paragraph 9 of this Ruling: (a) Interest will not be deductible under section 8-1 where it is incurred by the borrower at the Base Rate under a home loan procured to fund the acquisition of the borrower's principal place of residence, refinance an existing loan used for that purpose, fund improvements or renovations to the borrower's principal place of residence, fund the acquisition of assets for personal use or fund private use expenditure. (b) The extent to which interest incurred by the borrower at the Indexed Rate under a home loan procured for a purpose referred to in subparagraph 8(a) of this Ruling exceeds the amount of interest which they would have incurred at the Base Rate will not be deductible under section 8-1. (c) The extent to which interest incurred by the borrower at the Indexed Rate under a home loan procured for a purpose referred to in subparagraph 8(a) of this Ruling is less than the amount of interest which they would have incurred at the Base Rate will not be assessable income of the borrower under section 6-5. (d) The application of Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) depends on a careful weighing of all the relevant facts and circumstances of each case. Provided the scheme ruled on is entered into and carried out as described in this Ruling, the anti-avoidance provisions in Part IVA of the ITAA 1936 will not apply to the borrower in connection with the scheme.

This Ruling is made on the basis of the following necessary assumptions: (a) The borrower is an Australian resident for tax purposes. (b) The borrower does not use their principal place of residence, or any other asset funded with their home loan, for business or any other income-producing purpose. (c) The Scheme will be executed in the manner described in the Scheme section of this Ruling. (d) All dealings between the lender and Findexia will be at arm's length.

The scheme that is the subject of this Ruling is identified and described in the following: • application for a product ruling as constituted by documents and information received on 17 May 2023 and 24 May 2023, and • pro forma agreement amending lender's standard terms, received on17 May 2023 (referred to as the 'pro forma terms' for the purposes of this Ruling). Note: Certain information has been provided on a commercial-in-confidence basis and will not be disclosed or released under Freedom of Information legislation.

For the purposes of describing the scheme, and aside from the relevant loan and security documentation to be executed between the borrower and the lender, there are no other agreements (whether formal or informal and whether or not legally enforceable) which the borrower, or any associate of the borrower, will be a party to which are a part of the scheme.

All Australian Securities and Investments Commission requirements are, or will be, complied with for the term of the agreements.

As the exclusive Australian licensee of software that enables the computation of a loan interest rate in the manner described in paragraph 15 of this Ruling, Findexia will administer any variable rate home loan that is: • offered, negotiated, documented, maintained and enforced by a lender on its own Standard Terms, and amended to incorporate clauses in or substantially in the form set out in the pro forma terms, and • used for the purpose of - funding the borrower's acquisition of a principal place of residence or refinancing an existing home loan used for that purpose - funding improvements or renovations to the borrower's principal place of residence - funding the acquisition of assets for personal use, or - funding private use expenditure.

The lender will be an existing mortgage lender or a special purpose trust established to fund loans referred to in paragraph 13 of this Ruling by way of a residential mortgage-backed securities issue.

Pursuant to the pro forma terms and during a Non Index Period over which the rate of interest under the loan will be that defined by, or computed in accordance with, the Standard Terms (the Base Rate), the borrower (an individual) may, but need not, elect via a Link On Request to have the interest under the loan calculated at an Indexed Rate, being a rate computed in part by reference to movements in the measure of an Index or Indexes.

Indexed Rates are defined in the pro forma terms to mean, in respect of an Index Period, a series of rates derived by adjusting the Base Rates by applying a constant discount or premium solved for by Findexia using the Calculation Method. The Calculation Method engaged by Findexia to calculate Indexed Rates incorporates, among other things and in addition to changes in the measure of the relevant Index, Base Rates, Benchmark Rates and Participation Factors.

A Link On Request provided by the borrower to the lender must specify the Index or Indexes by reference to which the borrower wishes the Indexed Rate to be calculated (being any Index or Indexes identified by the lender as available for selection by the borrower for this purpose), and any factors by which movements in the Index or Indexes will be scaled.

The right and obligation of the lender to have changes in the measure of an Index taken into account in the calculation of interest charges under the loan is referred to by Findexia as Linking.

In the course of an Index Period the borrower may vary a Link as between Indexes via a Link Variation Request, or terminate all prevailing links to an Index (and engage Base Rates when calculating interest under the loan) via a Links Off Instruction.

Acceptance (or the extent of acceptance) of a Link On Request or a Link Variation Request is at the discretion of the lender.

Linking involves the calculation of the loan interest rate, the Indexed Rate, according to a series of equations which impute 'sufficiently positive' results to the borrower by way of a reduction in the loan interest rate (that is, a rate of interest below the Base Rate), enabling the loan to be amortised faster than would otherwise be the case. In this context 'sufficiently positive' means the performance of the Index exceeds a Benchmark Rate (for example, the standard mortgage rate) nominated by the lender.

Conversely, if the Index performance isn't 'sufficiently positive' by virtue of it being below the Benchmark Rate nominated by the lender, the Indexed Rate charged to the borrower under the loan will be higher than it would otherwise have been at the Base Rate.

Pursuant to the pro forma terms the borrower acknowledges that: • their right to have the Indexed Rate calculated and applied in the manner contemplated by the pro forma terms (as conferred by Linking) is a contractual right exercisable against the lender personally, and incapable of assignment • Linking does not confer upon the borrower any entitlement to money or property, and • the borrower has no proprietary or other legal or beneficial interest in the assets (if any) that correspond to the Index to which it has Linked.

The borrower's loan will not be part of: • a linked or split loan facility as described in paragraphs 3 to 6 of Taxation Ruling TR 98/22 Income tax: the taxation consequences for taxpayers entering into certain linked or split loan facilities, or • an 'investment loan interest payment arrangement' as described in Taxation Determination TD 2012/1 Income tax: can Part IVA of the Income Tax Assessment Act 1936 apply to deny a deduction for some, or all, of the interest expense incurred in respect of an 'investment loan interest payment arrangement' of the type described in this Determination?

Expenditure, including interest on money borrowed, is deductible under section 8-1 if its essential character is that of expenditure that has a sufficient connection with the operations or activities which more directly gain or produce a taxpayer's assessable income, provided that the expenditure is not of a capital, private or domestic nature.

The essential character of interest on money borrowed is a question of fact to be determined by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower (Federal Commissioner of Taxation v Munro [1926] HCA 58).

Interest paid on a borrowing used to acquire an asset or fund expenditure is generally not treated as deductible under section 8-1 where it is not expected that assessable income would be derived from the asset or the expenditure, or where the funded expenditure is of a private nature.

Interest incurred by a borrower at the Base Rate under a home loan does not have sufficient connection with the gaining of assessable income to be deductible under section 8-1 where the loan is used to fund: • the acquisition of their principal place of residence or some other asset which is not being used for business or any other income-producing purpose, or • expenditure to improve or renovate their principal place of residence which is not being used for business or any other income-producing purpose.

Interest incurred by a borrower at the Base Rate under a home loan used to fund some other form of private expenditure will not have sufficient connection with the gaining of assessable income to be deductible under section 8-1 or, otherwise, cannot be deducted under section 8-1 pursuant to paragraph 8-1(2)(b).

Linking merely confers a right to have the rate of interest under the loan computed in part by reference to relative movements in the measure of an Index (that is, at the Indexed Rate). Any increase or decrease in the interest rate attributable to a change in the measure of that Index in turn results in a relative increase or decrease in interest charged under the loan, but the character of the expenditure incurred by the borrower nevertheless does not change.

Therefore, for the reason set out in paragraph 27 of this Ruling, any increase in the amount of interest incurred by the borrower at the Indexed Rate as compared to that which would have been incurred by them at the Base Rate is also not deductible under section 8-1.

The interest expense on a new loan will be deductible if the new loan is used to repay an existing loan which, at the time of the second borrowing, was being used in an assessable income-producing activity (see paragraph 42 of Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith, referring to Commissioner of Taxation v Roberts, J.D. Commissioner of Taxation v Smith, V.R. [1992] FCA 543).

Alternatively, the interest expense on a new loan will not be deductible if the new loan is used to repay an existing loan which, at the time of the second borrowing, was not being used in an assessable income-producing activity. It follows that interest incurred on any refinanced home loan of the borrower used to repay an existing home loan procured to fund the acquisition of their principal place of residence (irrespective of whether that interest accrues at the Base or Indexed Rate) will also not be deductible under section 8-1.

Section 6-5 includes income according to ordinary concepts (ordinary income) in assessable income. Whether or not a particular amount is income according to ordinary concepts depends on the nature and character of the receipt in the hands of the taxpayer.

Ordinary income may be said to be derived pursuant to subsection 6-5(4) which provides that an amount of ordinary income will be taken to be received as soon as it has been applied or dealt with in any way on behalf of or as directed by the taxpayer.

Any reduction in the amount of interest incurred by the borrower at the Indexed Rate as compared to that which would have been incurred by them at the Base Rate is not an amount paid or credited to the borrower, nor an amount which is applied or dealt with on behalf of the borrower or as the borrower directs.

As an amount represented by the reduction in interest that will otherwise be payable by the borrower on the loan at the Base Rate will not be received by, or credited to the borrower (either directly or as deemed by subsection 6-5(4)), that amount will not be subject to tax pursuant to section 6-5.

Part IVA of the ITAA 1936 is a general anti-avoidance rule which gives the Commissioner the ability to cancel all or part of a tax benefit that has been obtained or would, but for section 177F of the ITAA 1936, be obtained by a taxpayer in connection with a scheme to which Part IVA applies.

In broad terms, Part IVA of the ITAA 1936 will apply where the following requirements are satisfied: • there is a 'scheme' as defined in section 177A of the ITAA 1936 • there is a 'tax benefit' that, in relation to omitted assessable income, is defined in paragraph 177C(1)(a) of the ITAA 1936 as ... an amount not being included in the assessable income of the taxpayer of a year of income where that amount would have been included, or might reasonably be expected to have been included, in the assessable income of the taxpayer of that year of income if the scheme had not been entered into or carried out • having regard to the 8 objective matters identified in subsection 177D(2) of the ITAA 1936, it would be concluded that the person, or one of the persons, who entered into or carried out the scheme (or any part of it) did so for the dominant purpose of enabling the taxpayer to obtain the tax benefit in connection with the scheme, and • the Commissioner makes a determination that the whole or part of the amount of the tax benefit that is referable to the omitted assessable income shall be included (paragraph 177F(1)(a) of the ITAA 1936).

The term 'scheme' is defined very broadly in section 177A of the ITAA 1936 to mean: (a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and (b) any scheme, plan, proposal, action, course of action or course of conduct.

The precise description of a scheme for the purposes of Part IVA of the ITAA 1936 will depend on the facts of the particular case. The circumstances described in paragraphs 10 to 24 of this Ruling constitute a scheme for the purposes of the definition set out in section 177A of the ITAA 1936.

A tax benefit can arise to the borrower in relation to a year of income where their assessable income of a year of income, as a result of not having included an amount equivalent to a reduction in interest which accrues under the loan at the Indexed Rate, is less than that which the borrower would have derived, or might reasonably be expected to have derived, but for entering into a scheme.

While the borrower will not include in their assessable income an amount equivalent to any reduction in interest accrued under their loan at the Indexed Rate, they would not be expected to include an amount in their assessable income but for entering into the scheme described in paragraphs 10 to 24 of this Ruling - that is, in the event they had only incurred interest under the loan at a higher Base Rate. A tax benefit should therefore not arise to the borrower in relation to a year of income in connection with this scheme.