Loans can avoid taxing times for clients

While it may appear complex and out of reach for some investors margin lending for holds some positive tax benefits. David Shirlow examines how planners and investors can use these for local and offshore investments.

Publicity surrounding circumstances in Kalgoorlie recently highlights why clients are moving away from the "traditional" agricultural tax products and looking for more reliable ways to increase their wealth, while minimising their tax.

The residents of Kalgoorlie found themselves out of pocket because the ATO withdrew approval for independently run agricultural schemes they had put money into during the past decade. This left them them not only paying the original tax debt, but also the accumulated 10 years of interest.

While investors are becoming more cautious about agricultural schemes they are still looking for an investment which is going to hold their interest and keep them involved.

One way of dealing with a potential tax debt, while also building a solid share portfolio both on the local and international market, is to gear clients into margin lending, which is also Australia's fastest growing tax effective investment.

The Reserve Bank of Australia reported a 38 per cent increase in margin lending for 1999, lifting the amount lent to invest in shares and managed funds to about $5.2 billion. Although margin lending is less than 2 per cent of total household debt, it accounted for more than one-fifth of the rise in personal lending by banks (excluding credit cards) since 1996. These figures have continued to grow.

When looking at the appropriate people to put into margin lending to increase tax effectiveness many advisers only consider high earning individuals, or high tax rate payers.

However, post tax reform analysis carried out shows gearing through a number of avenues, including margin lending, can be suitable for lower marginal tax rate payers as well as high tax rate payers in the right circumstances.

With many clients it can be important to test the traditional assumption that gearing is purely the domain of high income earners on the grounds that:

- they can afford such a wealth accumulation strategy in the first place and

- they will benefit most from the tax deductible interest cost, particularly where the investment starts off being negatively geared.

If your clients are a couple who are on different tax rates then, depending on their circumstances, it may actually be more effective to gear in the lower income earner's name.

If you only consider the interest cost, the benefit of the tax deduction on it is greater for higher income earners than for lower income earners.And with negatively geared arrangements, the deductible expenses exceed the income in the year, leading to a net tax benefit.

Thus there is a tendency to assume that investments which start out being negatively geared are more tax effective for higher income earners. However, often these arrangements become positively geared over time (ie. annual investment income starts to exceed interest and other expenses) so that the arrangement produces a net tax liability. In these later years it would be better to be on a low marginal tax rate than a high one.

Also, when the investment is sold for a capital gain, part of the gain will be taxable, and again it is better to be taxed on this at a low rate. Of course, if a large taxable gain is realised in one year, it can push a low tax rate investor into a higher tax rate, so the placement of the gearing needs to be carefully worked out.

An extra tax dimension to margin lending for income-producing purposes, such as investing in shares, is the possibility of prepaying the interest cost. That is, if clients pay the interest on their loan for the following financial year before June 30, they can claim this as a deduction in the current financial year.

Clients need to be aware of the triggers for a margin call which would be made if the market value of their shares falls below an agreed level resulting in their level of borrowing exceeding the maximum permitted.

A well diversified managed fund portfolio, with an exposure to international and domestic shares, is an effective way to minimise the risk over the long term and most lenders build in around a five per cent buffer to account for any short term movements in the market.

The opportunities for international investment are increasing, and will continue to do so as Australians gain more direct access to overseas sharemarkets, but many clients seem to believe, wrongly, that gearing and international investment do not mix.

Certainly under current law the deductibility of interest and other borrowing expenses is limited to the extent of the class of foreign income to which the deduction relates in the relevant year. The classes are interest income, modified passive income, offshore banking income, and (often the most relevant, as it includes foreign capital gains) other assessable foreign income.

Where a client has a borrowing cost that relates to a foreign investment, the deduction they can claim in any financial year depends on the actual foreign income they receive in that year. If they gear into a diversified portfolio including both domestic and international investments, the foreign income deduction will be determined by reference to the proportion of foreign sourced income in the total return.

If the foreign-related interest cost exceeds the assessable foreign income of a particular class, the excess interest expense cannot be used as a deduction to offset either foreign income of another class nor domestic income.

To the extent that the interest expense cannot be used in the current financial year, it may be carried forward indefinitely until it is offset against foreign income of the same class in future years.

At first sight, the limits on immediate deductibility of interest costs may constitute a problem in clients' eyes. Depending on the circumstances, though, the problem under the current law may be non-existent or minimal. Further, we anticipate it will disappear altogether from 1 July 2001. That is the date from which the Government proposes that the quarantining provision should no longer apply to an interest expense. However, the proposal has not yet been legislated.

In the meantime, let's look at the situation as it is today. There are three key factors that will determine the level of deductibility:

- The level of gearing undertaken, and therefore the associated interest cost, relative to the level of foreign income received.

- The proportion of international investments to domestic investments in the geared portfolio.

- The composition of the return from the investment, that is the proportion of foreign income relative to the total return.

To some extent, these factors can be managed to minimise any loss of immediate deductibility.

Firstly, you can arrange for the gearing to be positive or neutral. In that case the interest cost will not exceed the return and so will be deductible in full.

Secondly, the problem may be diluted if the client is gearing into a balanced fund as the international component will represent only a small portion of the total investment. Using the apportionment method, the interest cost attributable to the foreign income will typically be relatively small.

Alternatively, where the client's international and Australian investments are held as separate assets, gearing only the Australian asset will eliminate the problem altogether.

Thirdly, Tax Ruling IT 2562 makes it clear that a foreign capital gain is not treated as foreign income and so is not subject to the section 79D quarantining rules. As a result, the interest cost relating to the realised foreign capital gain proportion of a given return is deductible.

This can make a big difference where the return from foreign investments is predominantly realised capital gain, as the foreign income element for section 79D purposes may actually be quite low.

David Shirlow, head of technical services, Macquarie Financial Services.