Dissenting report by Coalition Senators


Dissenting report by Coalition Senators

Background

1.1        Division 247 of the Income Tax Assessment Act 1997 requires that limited recourse loans are divided for tax purposes into a component of underlying loan and a component that is capital protected.

1.2        Capital protected borrowings are generally associated with the purchase and holding of shares, units in a unit trust or stapled securities such as instalment warrants.

1.3        These financial products allow an investor to borrow money to purchase shares, units or stapled securities. These then become security for the loan. These products are used almost exclusively by individuals to access the equity (mainly Australian) or unit trust market in a relatively prudent way.

1.4        An investor could take a similar financial position by purchasing shares with a full-recourse loan, and purchasing separate insurance (a put option, for example) for the value of the securities.

1.5        In the Australian context they were first developed and marketed in the early 1990s.

1.6        Originally, all the interest on these products was tax deductible.

1.7        In the late 1990s the Treasury and ATO limited the fraction of interest that could be claimed as a tax deduction. Part of the interest was allocated as an investment expense (deductible) and the other a capital expense (not deductible).

1.8        This practice was challenged successfully in the courts. In 2002 the full bench of the Federal Court ruled that the component of `interest' applicable to the cost of capital protection is deductible. The High Court later refused any appeal from the Tax Commissioner.

1.9        This required a legislative solution. In early 2003 the Treasurer and Assistant Treasurer issued media releases that introduced an 'interim methodology' for apportioning deductibility for capital protected borrowings, and opened a consultation process to determine a longer term methodology.

1.10      The new methodology was introduced from 1 July 2007. Any interest paid in excess of the Reserve Bank's Indicator Rate for personal unsecured loans would not be deductible (would be considered to be payment for capital protection). Government and industry were content although Treasury had argued for a lower rate.

Government Looks for More Money

1.11      In May 2008, as part of the Budget, the Labor government lowered the benchmark interest rate to the Indicator Lending rate for Standard Variable Housing Loans. Housing lending rates are significantly lower than personal unsecured lending rates. This measure was forecast to raise $70 million in the 2008 budget.

1.12      The Treasurer's press release claimed the change:

was a more appropriate basis for apportioning the expense in capital protected borrowings between interest on a borrowing without capital protection and the cost of capital protection.

1.13      Industry had not been consulted about the change and lobbied the government to change its decision. The government delayed proposing legislation to implement the change.

1.14      In the May 2010 budget the government undertook to amend its proposal. Its preferred benchmark rate would be increased 100 basis points. At current interest rate levels, this is about 9%, about six percentage points below the personal unsecured lending rate. This measure 'cost' the government $28 million.

1.15      Schedule 2 of this bill amends the Income Tax Assessment Act 1997 and the Income Tax (Transitional Provisions) Act 1997 to adjust the benchmark interest rate used to determine the cost of capital protection on a capital protected borrowing.

1.16             The benchmark rate is to be the RBA’s Indicator Lending Rate for Standard Variable Housing Loans plus 100 basis points. The change will be effective for capital protected borrowings entered into from 13 May 2008.

This Is Yet Another Tax Grab

1.17      This is another tax grab from a government addicted to spending.

1.18      This measure will increase revenue by $170 million. This revenue includes both the gain to revenue from the initial decrease in the benchmark rate, and the subsequent 'cost' to revenue from increasing the benchmark rate by 100 basis points.

2010-11

2011-12

2012-13

2013-14

$30m

$40m

$50m

$50m

1.19      The 2008 budget decision has had a dramatically negative impact on this financial product. According to Mr Duncan Fairweather, Executive Director of the Australian Financial Markets Association, "capital protected loans have fallen by over 45 per cent since the May 2008 budget announcement".[1]

1.20      This is a dramatic reduction in a short period and reveals that the government's policy decision is directly responsible for the negative impact.

Measure Penalises Cautious Investors

1.21      The Australian Financial Markets Association makes the argument in its submission to the inquiry that whilst interest on a margin loan or personal loan to purchase shares is deductible, only a portion of the interest of a capital protected product is deductible.[2] This is a clear disadvantage to cautious investors seeking to reduce their risk.

1.22      Whilst it is clearly the Coalition's position that it is correct that only the capital protection component of the borrowings should be tax deductible, making sure we set this threshold appropriately so as not to discourage risk minimising investment decisions.

1.23      These products are used by many ordinary Australian families to protect their investment – the average size of one category, instalment warrants, is only $10-20,000.[3]

1.24      These are a sensible financial product that should not be excessively priced by a government desperate for money.

What should the Benchmark Rate Be?

1.25      It is clear that the benchmark rate will be set at an arbitrary threshold.

1.26      The government's 2008 Budget decision was clearly wrong and they subsequently walked away from it.

1.27      The 100 basis point change contained in this legislation has little to recommend it in terms of a clearly justified threshold – and is said by stakeholders to be set too low to reflect the economics of the market.

1.28        The Tax Institute in its submission to the inquiry argued that the government's approach could "produce inequitable and distortive outcomes".[4]

1.29      More persuasive is the establishment of a benchmark rate at the midpoint between the indicator rates for standard variable rate housing loans and personal unsecured variable rate loans, as recommended by the Australian Financial Markets Association.

1.30      This is an attempt to set a level that equates the cost of the component required for capital protection equivalent to the cost of acquiring separate protection. Given that this was the original goal of the legislation in establishing a threshold, it would seem to the Coalition to be the more sensible approach.

Recommendation

That Tax Law Amendment (21010 Measures No.5) Bill 2010 be amended to establish the benchmark interest rate for capital protected borrowings at the midpoint between the indicator rates for standard variable rate housing loans and personal unsecured variable rate loans as published by the Reserve Bank.

Senator Alan Eggleston

Deputy Chair

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