Regulatory Roundup – June 2019

EOFY last-minute tax planning tactics for individuals

This financial year is almost over, but there are still tactics you may be able to employ to make sure you pay the right amount of tax for the 2018-19 year. While the best strategies are adopted in July (that is, as early as possible in a financial year and not at the end), it’s worth remembering proper tax planning is more than just sourcing bigger and better deductions. The best tips involve assessing your current circumstances and planning your associated income and deductions.

Not all of the following tips will suit your specific situation, but should provide a list of possibilities that may get you thinking along the right track.

Investment property
Expenses stemming from your rental property can be claimed in full or in part, so it can be helpful to bring forward any expenses that can be undertaken before June 30 and claim them in the current financial year. If you know that your investment property needs some repairs, some gutter clean up or some tree lopping, for example, see if you can bring the maintenance and (deductible) payments into the 2018-19 year. Remember however that travel to inspect an investment property is no longer on the deduction table.

Pre-pay investment loan interest
If you have some spare cash, then see if you can negotiate with your finance provider to pay interest on borrowings upfront for the investment property or margin loan on shares (or other loan types), and allow a deduction this year. Most taxpayers can claim a deduction for up to 12 months ahead. But make sure your lender has allocated funds secured against your property correctly, as a tax deduction is generally only allowed against the finance costs incurred for the purpose of earning assessable income from investments.

Bring forward expenses; defer income
Try to bring forward any other deductions (like the interest payments mentioned above) into the 2018-19 year. If you have planned that next year you will be earning less due to maternity leave or  going part-time, for example, then you will be better of bringing forward any deductible expenses into the current year.

An exception will arise if you expect to earn more next financial year. In that case it may be to your advantage to delay any tax-deductible payments until next financial year, when the financial benefit of deductions could be greater. Tax planning is the key, as your personal circumstances will dictate whether these measures are appropriate.

It’s probably leaving it a bit late to adopt this strategy now, but consider for July a tactic that can take advantage of this sort of timing — and place money into a term deposit that matures after June 30. Then interest accrues to you in the next tax year.

Use the CGT rules to your advantage
If you have made and crystallised any capital gain from your investments this financial year (which will be added to your assessable income), think about selling any investments on which you have made a loss before June 30. Doing so means the gains you made on your successful investments can be offset against the losses from the less successful ones, reducing your overall taxable income.

Keep in mind that for CGT purposes a capital gain generally occurs on the date you sign a contract, not when you settle on a property purchase or share transaction. When you are making a large capital gain toward the end of an income year, knowing which financial year the gain will be attributed to is a great tax planning advantage.

Of course, tread carefully and don’t let mere tax drive your investment decisions. You must determine whether this strategy will suit your circumstances.

Is penalty interest deductible? Yes, and no, and maybe

A new ruling has been released by the ATO on the deductibility or otherwise of penalty interest. Ruling TR 2019/2 replaces an earlier ruling on the same topic that has since been withdrawn (TR 93/7W), and spells out the circumstances when penalty interest is generally deductible and the situations where this is not the case.

The term “penalty interest” refers to an amount payable by a borrower under a loan agreement in consideration for the lender agreeing to an early repayment of a loan. The amount payable is commonly calculated by reference to a number of months of interest payments that would have been received but for the early payment.

The new ruling stresses that the deductibility or otherwise is determined by the relevant circumstances, and also that different provisions of the tax law will also influence the outcomes. Relevant provisions dealt with in the ruling include:

– section 8-1 (general deductions)

– section 25-25 (borrowing expenses)

– section 25-30 (expenses of discharging a mortgage)

– section 25-90 (certain debt deductions relating to foreign non-assessable non-exempt income)

– subsections 110-35(9) and 110-55(2) (incidental costs for CGT asset)

– paragraph 40-190(2)(b) (element of cost of holding a depreciating asset)

– section 40-880 (business related costs).

Yes, deductible

The ruling says that penalty interest is generally deductible under section 8-1 where:

– the borrowings are used for gaining or producing assessable income or in a business carried on for that purpose, and

– it is incurred to rid the taxpayer of a recurring interest liability that would itself have been deductible if incurred.

Also, penalty interest that is incurred to discharge a mortgage is deductible (under section 25-30) to the extent that borrowed funds were used doe producing assessable income. The ATO notes here that unlike the general deduction provisions (section 8-1), there’s no outcome influence from the expenditure being capital or revenue in nature.

Deductibility for penalty interest may also be available under section 40-880 if the amount is not otherwise taken into account, or denied a deduction, under another provision (note that section 40-880 is a provision “of last resort”).

No, not deductible

Penalty interest is not deductible under section 8-1 to the extent that it is a loss or outgoing of capital, or of a capital, private or domestic nature.

Also there is no deduction available as penalty interest is not incurred for borrowing money, so is not deductible under section 25-25.

Note also that penalty interest is not viewed by the ATO as being reasonable attributable to a balancing adjustment event occurring to a depreciating asset, so it is not included in the asset cost base under paragraph 40-190(2)(b).

Also to be considered

Other considerations revolve around capital gains tax and foreign sourced income.

Such outgoings that are incidental costs incurred in relation to a CGT event, or to acquire a CGT asset, is included in the cost base or reduced cost base. And penalty interest incurred in deriving foreign source income may be deductible under section 25-90 if, among other things, it satisfies the definition of debt deduction in paragraph 820-40(1)(a) because it is calculated by reference to the time value of money.

Worked examples

As is frequently the case, which thankfully the ATO realises is the case, some examples can help explain the application of the law. The following examples come from the ruling.

Changing lender

John can refinance his rental property at a lower interest rate. In order to refinance, John pays out the first loan early. He incurs penalty interest calculated on the basis of one month’s interest for each year of the loan period remaining.

The advantage sought in practical terms by repaying the first loan early and incurring penalty interest is future interest savings from a lower interest rate. Penalty interest is of a revenue character and deductible under section 8-1.

Alternatively, where refinancing affects the discharge of a mortgage securing the first loan, the penalty interest is deductible under section 25-30.

Selling up

Sally sells her rental property, repays the loan to discharge the mortgage over the property and incurs penalty interest.

The penalty interest is a necessary incident of the sale of the property. A payment so connected to the realisation of a capital asset will be on capital account and not deductible under section 8-1. As the penalty interest is not a cost of borrowing incurred in establishing the loan, it is not deductible under section 25-25. It is deductible under section 25-30 as an expense of discharging the mortgage.

The beach house

Alex obtained an unsecured loan to purchase a beach house to use solely as a holiday house for his family. Alex and his family move interstate for work. Alex sells the beach house, immediately repays the loan early and incurs penalty interest.

Penalty interest is incurred in connection with selling a private-use asset; the expenditure is private in nature and not deductible under section 8-1. As the loan is unsecured, section 25-30 cannot apply.

The penalty interest is an incidental cost that relates to the sale of the beach house and can be included in the cost base under subsection 110-35(9) or the reduced cost base under subsection 110-55(2). However, if Alex did not repay the loan immediately it would be difficult to demonstrate that the penalty interest is an incidental cost.

Event-based reporting mistakes lead to greater scrutiny of SMSF audits

Since event-based reporting (EBR) started for SMSFs from 1 July 2018, the ATO says an unprecedented number of transfer balance cap reports have required re-reporting.

The transfer balance account report (TBAR) is used to report certain events and is separate from the SMSF annual return (SAR). The TBAR enables the ATO to record and track an individual’s balance for both their transfer balance cap and total superannuation balance.

The ATO says the regulations in place do not provide it with a discretion for “special circumstances” regarding contraventions of the transfer balance cap, and that it is particularly important for all SMSF trustees and members to self-monitor and ensure that members do not exceed the cap.

The re-reporting incidents, says the ATO, has mostly been in response to determinations and commutation authorities it has issued.

It says that in some instances the amended reporting indicates:

– the member was not actually receiving a pension during 2017-18

– the pension was commuted on 1 July 2017 so that the member was never in excess

– the member had commuted the pension before 1 July 2017 to avoid being in excess, and the trustees had incorrectly included the commuted amount in their original reporting

– the member commenced a pension during 2017-18, however the initial value reported to the ATO was amended so that the individual no longer exceeded their transfer balance cap.

The amended reporting usually results in the determination or commutation authority being revoked. ATO records show that approximately 39% of commutation authorities issued to SMSFs in the 12 months since were revoked, including commutation authorities issued to APRA funds after SMSFs had corrected reporting errors.

Specifications for this reporting are found on the Standard Business Reporting site (click here).

What to check during an audit
Due to the large number of amended TBARs the ATO is receiving for SMSFs, it is reminding SMSF auditors that it is important to check the following in the case where a member received a pension during 2017-18:

– that an appropriate condition of release was met

– that the pension is valued correctly in financial statements

– the commencement date of the pension and any commutations have been properly documented

– exempt current pension income (ECPI) has been correctly calculated with respect to the pension and any commutations that occurred during the year have been considered

– the payments from the pension have actually been paid

– the minimum pension payment requirements have been met.

The ATO has also announced that any TBAR re-reporting by SMSF trustees for future income years will be closely monitored, and that it may request evidence of relevant documents and calculations to substantiate the TBAR amendment.

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