Margin Loans Margin loan: to prepay or capitalise?

Thanks for that Glebe. It's always easier with numbers.

Mark

 

Ditto Glebe - very well explained

I assume you haven't bought those boxer dogs yet ? No one I know who owns boxers would have spare cash at the end of the year ;-)

 

Glebe, you have confused me when you say 'nothing coming out of your wallet'.

You have pre-paid interest from your wallet IN ADVANCE haven't you ?

Would be nice if Steve could contribute his thoughts here. By the way ... anyone heard how he is doing ?

 

Using my example from above, whilst technically I'm "pre-paying", all I'm really doing is promising $37 500 to my margin lender.

The advantage to the margin lender is that they know they have secured $500k lend for the entire 12 months. That's why they're prepared to discount a little.

Pre-paying and capitalising aren't mutually exclusive. I thought they were but Mr Darcy has told us otherwise. It makes sense to me.

 

Glebe, I am not so sure I agree that 'Pre-paying and capitalising aren't mutually exclusive'.

This topic is definitely a grey area. Do a search on the forum and you will find folks discussing pre-paying interest separately to capitalising interest.

Why would you want to pre-pay interest when you can capitalise it ? Defeats the purpose doesn't it ?

 

It doesn't defeat the purpose if you get the tax deduction upfront and if you're given a discount on the standard rate.

I'm happy enough to be told it's mutually exclusive but when you've got people on here saying that's what they're doing I'm inclined to believe them!

 

I would be interested in hearing others opinions. Seems the guru's are all asleep !

I completely agree with your first point. I just don't think you necessarily need to capitalise interest in order to pre-pay interest. I am happy to be proved wrong.

 

You don't necessarily need to capitalise in order to pre-pay

The previous financial year I pre-paid but didn't capitalise. I liked the pre-paying part (cheap interest rate, immediate deduction) but didn't enjoy coughing up all that money.

Perhaps if others want to clarify if what I'm saying is correct that'd be a good thing...

 

OK I am with you now.

I am pretty sure we can however make the pre-paid interest $$$ work harder than the tax savings. Spreadsheet anyone ?

 

Good point, should be considered. But tax, once paid, is gone forever, no amount of investing will make the ATO give it back.

Looking forward to seeing what Mr Navra has to offer tomorrow night. Invest the money AND get the deduction seems to be plan, although I'm sure there are downsides.

 

Is the tax minimisation course on tomorrow ?

 

Details at Navra web site.

 

And I am stuck in China !

Anyways ... will have to wait until I get back. I thought Steve mentioned he would post materials here soon ...

 

Hi ALan
i am not aware of any specific rulings in relation to capitalising interest on margin loans.

Harts case is the most relevant re capitalising interest


NickM

 

Glebe,

I'm in no way qualified to give advice but I'll give you my opinion.

I dont see how the ATO would possibly allow you to claim a deduction in a financial year where the intrest payment has not been physically made or deducted from your loan in that year.

Pre paying to my mind is just that "Paying" or at least having it "deducted" in the relevant FY. How can you claim a deduction on an expense you haven't incurred.

This is a RORT to my way of thinking, creative as it may be. I'd reckon this sort of behavior would make it more likely that the ATO would clamp down on legitimate capitalising.

Actually, after re-reading your example I see that you have said that the lender will charge the interest to your account in the relavent FY. Maybe this brings the concept back into line with what I would consider fair. If this is the case perhaps the above does not apply.

2CFWIW

MJK

 

I have asked my lender if they allow the capitalisation of pre-paid interest (it does sound like a contradiction doesn't it?)

If they say yes, I'll approach my accountant more formally. Thanks everyone for your assistance.

 

Just in case some of us are not confused yet, have a read of a similar thread on Somersoft

 

MJK,

Although the interest is not being physically paid, it is charged and you do need to pay it at some stage. Whether you just do this in perpetuity and then your beneficiaries pay, someone will eventually have to pay it. The lender may expect you to physically pay it within a certain time period, who knows. It's not a rort if it's legal.

Mark

 

Hi Glebe,

Interest can be capitalised on pre-paid and variable.

- Leveraged Equities.

So onto my accountant I go for more information.

 

Guys

1. Are you entitled to claim a deduction for interest accrued on a loan obtained to purchase investments?

2. Are you entitled to claim a deduction for the prepaid interest expenses?

3. Are you entitled to claim a deduction for the interest accrued on a loan obtained to pay part of the prepaid interest expenses

yes yes and yes

i have just found a private ruling decision on the ATO site

Glebe, this should also answer your email query.

http://www.ato.gov.au/rba/content.asp?doc=/rba/content/44746.htm

Full text is here

EDITED VERSION OF NOTICE OF PRIVATE RULING

Authorisation Number: 44746

This Ruling is a 'Private Ruling' for the purposes of Part IVAA of the Taxation Administration Act 1953.

YEAR(S) OF INCOME TO WHICH THIS RULING APPLIES:

Year ended 30 June 2004

TAX LAW:

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1936 Section 82KZM.

WHAT THIS RULING IS ABOUT:

1. Are you entitled to claim a deduction for interest accrued on a loan obtained to purchase investments?

2. Are you entitled to claim a deduction for the prepaid interest expenses?

3. Are you entitled to claim a deduction for the interest accrued on a loan obtained to pay part of the prepaid interest expenses?

THE SUBJECT OF THE RULING:

You obtained a loan to purchase shares and an interest in a managed fund.

Shortly after, you decided to refinance the existing loan and accept a loan from another financial institution. The new loan provided for prepaid interest at a reduced fixed interest rate. The interest that had accrued on the original loan was also rolled over to the new loan.

You made a lump sum payment for prepaid interest on the new loan. The prepaid interest relates to a 12 month period that ends before the 30 June 2005.

The payment for the prepaid interest was made up of a cash component and the balance was paid with the proceeds from another loan you obtained from the financial institution which refinanced your original loan. You have also incurred an amount of accrued interest on this loan.

You wish to claim a deduction for the following interest expenses:

· interest accrued for the initial loan obtained to purchase investments

· prepaid interest for the new loan

· interest accrued on the loan obtained to pay the prepaid interest.


COMMENCEMENT OF ARRANGEMENT:

1 July 2003


RULING:

1. Are you entitled to claim a deduction for interest accrued on a loan obtained to purchase investments?

Yes.

2. Are you entitled to claim a deduction for the prepaid interest expenses?

Yes.

3. Are you entitled to claim a deduction for the interest accrued on a loan obtained to pay part of the prepaid interest?

Yes.

EXPLANATION: (This does not form part of the Notice of Private Ruling)

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, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. TR 95/25 specifies that to determine whether the associated interest expenses are deductible under section 8-1 of the ITAA 1997, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the Federal Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153; (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. Accordingly, it follows that if a loan is used for investment purposes from which income is to be derived, the interest incurred on the loan will be deductible.

Interest expenses on loan obtained to purchase investments

In your case, you borrowed funds to purchase shares and an interest in a managed fund. The loan has been obtained for income producing purposes.

Therefore, consistent with the principles established in TR 95/25, you are entitled to claim a deduction under section 8-1 of the ITAA 1997 for the interest expenses incurred on the loan.


Prepaid interest expenses

The prepayment rules which affect the timing of deductions for prepaid expenses incurred by a taxpayer are specified in section 82KZM of the Income Tax Assessment Act 1936 (ITAA 1936). The effect of the application of the prepayment rules is to apportion the deduction over the years comprising the 'eligible service period'. The eligible service period' is the period to which prepaid expenses relate to, being a period not exceeding 10 years.

Under section 82 KZM of the ITAA 1936, an immediate deduction for prepaid non-business expenditure of an individual (which is otherwise deductible under section 8-1 of the ITAA 1997) is available if the 'eligible service period' does not exceed 12 months and the period ends no later than the last day of the income year following the year in which the payment was incurred.

In your case, you refinanced your existing loan by transferring that loan to another financial institution. The terms of the new loan, provided for a fixed interest rate and enabled you to prepay the accrued interest for a 12 month period.

Your 'eligible service period' is the period to which the prepaid interest relates to. The period does not exceed 12 months and the period ends no later than the 30 of June 2005 (the last day of the income year following the year which the expenditure incurred).

Therefore, the prepaid interest expenses you have incurred for the loan qualify under section 82KZM of the ITAA 1936 to be claimed as an immediate deduction. The interest expense is deductible in the 2003-04 income year.

Interest expenses on loan obtained to pay prepaid interest

TR 95/25 at paragraph 27, provides that to determine the essential character of an interest expense, a tracing of the borrowed funds may be necessary to determine the 'use' to which the borrowed funds have been put.

In your case, you obtained a loan to pay a component of the prepaid interest expenses. The prepaid interest expenses were incurred on a loan used to purchase investments, from which income will be derived. Accordingly, a tracing of the borrowed funds indicates that the loan has been obtained for income producing purposes.

Therefore, you are entitled to claim a deduction under section 8-1 of the ITAA 1997 for the interest expenses incurred on the loan obtained to pay a component of the prepaid interest.

cheers

NickM