Deductibility of interest

Gday folks
On a recent thread I mentioned buying shares the day before they went ex-div and then selling them the next day, in order to get the dividend to pay down non-deductible debt (then when the non-deductible debt was paid off redraw it for investment purposes so you were back to where you were originally but with deductible instead of non-deductible debt).
The shares would be purchased through a margin loan facility.
It was suggested by someone that the interest on the margin loan would cease to be deductible after disposing of the asset.
Personally I dont think this is the case, as deductibility is determined by the original loan purpose of the loan, which doesnt change just because you sold the asset for a capital loss (of course the proceeds of sale would be deposited back to the margin loan, only the dividend income would go to the non-deductible debt).
The closest guidance I could find on the ATO website was:
ATO ID 2003/841 - Deduction for interest expenses on borrowed funds used to purchase shares: no assessable income derived - company liquidated - taxpayer's subjective intention to derive assessable income

Does anyone have an opinion on this, and perhaps any other guidance either way from the ATO through atoids, rulings or cases?
Cheers!

 

Hi Coopranos,

I've never heard of anyone actually doing this but that doesn't mean it can't be done. I think the main reason is that they won't pickup the franking credits.

ITAA s160APHO requires shares or interests in shares to be held at risk for 45 days (90 days for preference shares) to pick up franking credits.

If your not in it for the franking credits you won't have an issue here obviously.

Usually when a stock moves from cum div to ex div the stock price will drop by approximately the dividend amount (this isn't that wonderful as you are getting income vs potential capital gains as gains held for over 12 months are concessionally taxed).

If the shares are purchased through a margin lender (ML), the capital loss will reduce your LVR and depending on how close you get to your buffer the ML may ask you for extra cash.

After you dispose of an asset, the loan technically won't exist as the ML will settle Delivery versus Payment (DvP) with your stockbroker. Three days after you sell at 10:30am Sydney time settlement will occur with your broker sending the proceeds electronically to your ML and the ML send the stock to your broker.

If you sell at a loss, your net position would be a negative dollar figure.

Most MLs will send out a statement at the end of the financial year saying $x dollars is how much you paid to them in interest and you claim that amount in your tax return as a deduction. It's a bit hard to vary it after your transactions have all been done and dusted.

Not sure about that ATO ID, it says non-assessable income. Dividends are assessable income.

Hope this helps,

Dan

This is not a professional opinion! Speak to your Accountant or Tax Adviser before doing anything that effects your tax position!

 

Yep,

There is a presumption that investors buy shares to derive dividend income so the interest expense is deductible under section 8-1 ITAA97.

This means you suffer a capital loss on sale while you pay tax on the dividend (without franking credits caimed).

This looks like a negative sum game to me.

Like Dan says, at least waiting 45 days will give you franking credits. But even then you have bought somebody else's concessional capital gain by deriving a non-concessional income receipt.

Cheers,

Rob

 

it was me who said it wasnt deductible

Dan & Rob, as long as you earn more than 5k of credits (around 16k of dividends) you dont need to worry about the 45 day rule

If the loss can be used to set against other less than 12 month gains, the exercise may become more attractive (effective tax rate= marginal tax rate -30% FC) instead of just your marginal tax rate for the capital gain...

however by ur answers im still not sure if im right or wrong (re the deductability of a loss)

 

I think you distracted us by your example ??

I think you are asking about recycling non-deductible debt by making it mixed use. This is generally bad.

Deductibility depends on the ACTUAL use of the funds, not the ORIGINAL use. Also, repaying a mixed use loan requires apportioning.

e.g. #1 Mixed use loan - bad idea (e.g. Domjan)

1. Private loan $100k.
2. Draw a further $100k to buy shares, this is the income producing portion.
3. Shares pay $100k dividend (I wish !!) which is repaid into loan account. ATO deems 50% pays down the private portion, so now the income loan is only $50k on which deductions can be claimed.

Keeping a loan outstanding is not enough !! Look at the reason the loan is still on hand, not the original purpose.

e.g. #2 Lose deductibility because the use has changed (use test: e.g. FCT v Munro).

1. Borrow $10k to buy shares.
2. Sell shares for a gain.
3. Divert the proceeds to a private purpose. Interest is now not deductible, the loan only exists for a private purpose.

e.g. #3 Keep deductibility based on original purpose (e.g. FCT v Brown)

1. Borrow $100k to buy shares.
2. Shares delisted and declared worthless (CGT loss).
3. Cannot afford to repay loan principle, so keep paying interest although there is no income producing assets or activity. Interest will remain deductible, although beware of refinancing if for another purpose.

My interpretations, of course.

Cheers,

Rob

 

I think this is the main one where focused on. Or #2 were you sell them for a loss not a gain.

It would be the afford to repay part which would be questionable, as you will have the cash from the dividend the ato will argue you can afford to (or hit u with part 4a)

 

Was possibly a little confusing, I will outline again using example numbers hopefully more concisely:
Non-deductible loan: $20,000
LOC against property: $50k (this is drawn as cash and put into margin facility)
Margin available: $50k (ignore LVR and margin call requirement for our example for clarity) (deductible)

buy $100k worth of XXXX Pty Ltd which goes ex-div tomorrow (using cash+ margin loan). they pay 10% div (for easy numbers, obviously will be less). Sell tomorrow, you have div income of $10k which is diverted to non-deductible debt, proceeds of $90k deposited to margin account. Now we have $10k non-deductible debt, $40k cash, and $50k of margin loan available (now at higher LVR)

The next day we buy $90k YYYY Pty Ltd which goes ex-div the day after. They pay 11% div. Sell on ex-div day, $10k div goes to non-deductible, $80k proceeds goes to margin loan. Now we have $30k cash, $50k margin loan available (higher LVR again), and non-deductible loan balance of zero.

Now we are in a position to invest into our buy and hold portfolio:
Redraw our previously non-deductible $20k loan, put cash into margin facility
Back up to $50k cash, $50k margin loan available, back to our original 50% LVR.
The difference is now we have $70k of deductible debt (the original $50k + the new $20k redrawn from the loan), and also $20k of taxable income, fully franked so at 30% marginal no tax on that (hold a few shares for 45 days if required). At 7.5% we have an extra $1500 deduction on the interest on the now-deductible loan, and that is every year from now on. We also have $20k of capital losses to offset against future gains, so that is a further $6,000 benefit in the future (at 30% marginal rate). Plus now we can reinvest all our future dividends/distributions. This is all done over the course of about a week or so.
Hopefully this gets the concept across?!

 

Hi Dave,

Generally, for small investors the activity is incremental to and mixed with other activities. Therefore the mere fact that some of the dividends were use for living expenses and not to pay down debt is not a problem.

I think the ATO would look to subjective purpose where the investor capitalises interest expenses, whilst using ALL dividends for private expenses. This might be viewed as a redraw for private purposes ??

Part IVA was invoked in Hart's case principally due to there being a mass marketed tax avoidance scheme by the banks (surely not the big name banks !!) to divert proceeds to paying down private debt whilst capitalising interest on linked deductible debt.

Cheers,

Rob

 

Coopranos,

Keeping separate accounts will allow you to divert income proceeds to pay down private debt.

Its only mixed purpose loan accounts, or capitalising interest on the investment loan account purely for private purposes where you need to be careful.

Providing loan principle is used for an income producing purpose - no problem.

I just don't like your particular financial plan, but you must have your reasons to derive income as quick as possible, even if not in the most tax-effective way.

Cheers,

Rob

 

Don't forget your medicare levy of 1.5%, so technically your franked dividend won't pay for the 30% marginal tax rate. Though the $ difference is quite small.

 

not really about getting income as quick as possible, more about if you are going to recycle your debt anyway, rather than do it slowly you may as well just get it done asap to maximise your tax benefits. Obviously there are only specific circumstances where this would be effective, but I think it is more effective and efficient than say investing in navra or something and paying your distributions into non-ded debt

 

Yeah but at least Navra units are not guaranteed to devalue over time.

Your buying then selling at a loss causes loss of capital.

With your plan, you are taking a capital sum and turning it into an income stream on which you pay tax whilst your capital dwindles and loss claims are deferred until you have other capital gains.

Effectively you are bringing forward tax on income and deferring deductions on losses.

This may well offset any interest deduction advantages.

Cheers,

Rob

 

Not really
When Navra goes ex-distribution your capital amount still drops by your income amount. Just because you dont actually crystalize your loss doesnt mean you dont have a loss. Sure, your units may (or may not) ratchet up in price between distributions so you arent actually taking a capital loss, but that still takes 3 months to do.
Doing it with dividends achieves the same thing in a week as navra might in 2 years (debt recycle). Yes you take a capital loss, but your capital is now available to put into a more growth oriented fund, and reinvest any income, instead of going income, 3 months ratchet up, income, 3 months ratchet up, etc. The difference between them is that at the end of 2 years the Navra method (using our figures) would be total available of $120k (original 100k + non-ded loan, ignoring income tax although it would be less attractive because navra income isnt fully franked), using dividends it is $100k + 2 years growth (possibly in a higher growth fund) + 2 years of extra deductions ($3000) + your capital losses available.

(not trying to sell this to anyone, just working through it - i appreciate the discussion in order to find anything i may have missed)

 

i too think it is a reasonable idea. However you need to have an investment base to start with. Otherwise something like a portfolio loan might be a good idea when you can "steal" income from the other side. Wouldnt be as good if you were using an offset (which everyone recommends) but a portfolio loan will solve this issue.

Additionally i think gearing to a 50% would be a bit of a waste. If you are going to be true, you mass well gear to 70%, once the price drops, you will be forced to sell (which would of been your game plan anyway). This only works if your 100% true to your objectives and dont stray leaving the amount invested.

If your getting FF divs and are on a 30% tax rate, i dont really see a tax down side. (Providing the price drops exactly the same as the div).You dont pay tax on what you get, you accumulate capital losses and you bring non deductible debt down. Yes higher paper trail, maybe higher accounting fees.

Remember dividend stripping was once a common occurance. The 45 day franking credit rule came in to stop this, however doesnt mean you cant do it on a small scale...

 

But you are losing some capital each time you trade.

You draw out some of that capital as immediate income, pay tax on it and use the net to pay down non-deductible debt.

Your capital base is being eroded by realising assets each time and paying unecessary tax on the 'capital' that is returned ex-dividend as income. Not to mention that if you sell immediately for a capital loss then it is trapped until you realise a capital gain. Even worse, if that other gain uses the discount method you lose half the value of your tax loss.

At least if you hold for a while you will get some capital gains, that does not usually happen over a couple of days around distribution time.

Hey, why not just purchase an annuity. At least you don't get taxed on your return of capital ???

Cheers,

Rob

 

I think you may be mistaking an income fund with an annuity - now that I mentioned it.

The fundamental difference is that the fund will be trying to realise assets in a way that does not erode the capital base.

It will do this by a mixture of distribution income and trading for a (capital) gain to draw out profit on appreciated or over-valued assets.

Your plan is not to draw out profit, only draw out distributions.

Cheers,

Rob

 

Rob - you arent using any more capital than you would be in something like Navra for example, the next day you are down the amount of the distribution whether you sell or not. A paper decline is still a decline, whether you crystalize it or not.
And I am definitely not referring to an annuity, the focus is not on the income as such, the only reason you need income is to keep your original loan interest deductible.
The whole purpose of the exercise is to recycle debt as quickly as possible, then put your capital to work on growing asap.
I am putting together a spreadsheet showing what I am referring to, hopefully that clarify it.

 

Hi Coopranos

Look forward to seeing what you mean.

Accounting for Investments 101, (ignoring franking credits)

1. Buy $100 equity in entity A: asset = $100, wealth = $100.

2 Entity A pays $10 distributions from retained profits earned BEFORE you held an interest = return of capital (NOT INCOME). asset (ex dividend) = $90, your returned capital after tax = $7 (30% marginal tax rate, taxman has taken your $3): wealth = $97.

3. Immediately sell for $90 (ex dividend) then buy $90 equity cum dividend in Entity B, use the $7 net distribution to pay down private debt.

4 Entity B makes a $10 distribution from retained profits earned before you bought. asset (ex dividend) = $80, your returned capital after tax is $7. Wealth = $87.

5. Immediately sell ex dividend for $80, and use the $7 distribution to pay down debt.

Result of churning without profits on trades or any capital gains: $80 cash, $20 capital loss, $14 of private debt paid down.

You have lost $20 of capital to pay down $14 of private debt, the Taxman is $6 better off.

I have ignored any franking credits, but that is just witholding tax. And of course I have ignored the interest expense - which is still an additional expense even after your wonderful tax deduction.

The more you trade cum/ex dividend without gains/profits the more you go broke. You are just paying tax on getting your own money back.

Cheers,

Rob

 

Rob
I think you may be missing what I am trying to explain...

Given your example, you are absolutely correct it would be insane, however you are ignoring the fact that there is a loan as well. If it was just cash there would be absolutely no point doing it, you would just bang your cash onto your non-deductible debt then redraw immediately without the hassle.
Also: it is not a return of capital, it is income. a return of capital is a cost base reduction and not taxable, income is obviously taxable.
Also in your example you deduct tax immediately as the div is paid, this is obviously not going to happen, probably more appropriate to calculate results then do tax at the end.

have a look at the attached spreadsheet. Quick explanation:
Top section is assumptions, all should be changeable and follow through (except marginal rate, i think there are a couple where i just typed instead of linked!). Middle section - the more traditional buy income fund, use distributions to pay off non-deductible debt, at the end redraw and invest the now deductible debt. Bottom section - the div debt recycle idea. See the 2nd worksheet for the first month as this is when the div recycle happens. Basically as I said previously, buy day before ex-div, get div entitlement, sell ex-div the next day, whack the div on non-deductible debt, cop a capital loss. Once debt is zero, invest the lot into a growth oriented fund.
A few assumptions I have put in there: the growth fund has growth of 12%, income fund has income of 10%. As far as I can tell growth funds are probably more likely to outperform by about 50% rather than 20%.
Also, I have calculated tax after 2 years rather than year by year - this would only hinder the income based fund more because of the net taxable income.
It is entirely possible I have missed something so please critique where you can, or i can explain further where necessary. If my calcs are correct, the outperformance of getting the non-deductible debt recycled asap is quite massive. Again, there could be mistakes so please let me know!

 

Hi coopranos,

Bit busy at the moment - hopefully I will get a chance to look closer tonight.

Question: Why don't you draw more on your investment loan as you pay down your private loan, keeping total borrowings similar ??

Cheers,

Rob