ATO focuses on dodgy financial products

The ATO has released a guide on its areas of focus in relation to various financial products. It says while a majority of financial products are simple, it is concerned with a small number of products that promise to provide investors with tax benefits where those benefits may not be available to some or all investors who invest in the product. In particular, the ATO said issues of concern include advice that:

• suggests investors draw certain conclusions in relation to certain products about positive tax outcomes that most taxpayers would not achieve in their individual circumstances (eg statements such as "generally, deductions will be available; however, for certain taxpayers a deduction will not be available"); and

• includes inappropriate caveats (eg when discussing the possible application of the anti-avoidance provisions to the arrangement, by stating that "no economic alternative to this transaction exists", which may or may not be true).

The ATO has also outlined its concerns about some specific products, as detailed below.

Deferred purchase agreements

The ATO says it is examining certain deferred purchase agreement (DPA) features that may impact the tax treatment of the product (ie by attempting to exploit the revenue/capital distinction). It says such features provide an indication as to whether the investment will be accounted for either as a capital investment, or a revenue investment. According to the ATO, anti-avoidance rules may apply to investors in DPAs that exhibit the following features of concern:

• reference assets that are the same as delivery assets (where such assets are shares that are expected to pay dividends) if this feature is designed to support an argument that the investment in the DPA is on revenue account;

• coupon payments that appear to be a return of an investor's capital (eg where the underlying investment does not appear capable of generating any income, even though coupon payments are guaranteed);

• the remote possibility of investors receiving contingent coupons, especially when coupons are theoretically generated by extremely risky investments that are never likely to be realised, in order to attempt to justify deductions for interest and borrowing costs;

• guaranteed coupon payments that are less than the interest that is paid by the investor in order to fund their investment;

• in respect of compulsory loans (limited or full recourse), whether the interest expense on such products can be deducted; and

• whether the tax treatment changes depending on the type of reference assets that determine the investor's return.

Commoditised products

The ATO is concerned about certain types of investments that would ordinarily be subject to CGT and that are bundled up in an investment structure using a trust in order to change the tax treatment of the investment (eg an investment in a unit trust where the trust itself invests in options). It says these products are of concern as they are often financed from borrowing funds, raising further questions as to whether the interest and borrowing costs incurred are deductible, as well as the potential application of anti-avoidance provisions.

Products designed to circumvent franking credit trading provisions

Specifically, the ATO says features of concern of a small number of products that appear to be designed to provide investors with the benefits of franking credits include:

• features (and products) that are structured to meet the minimum requirements of the holding period rules, yet otherwise affect (or change) an investor's risk of loss, or opportunity for gain; and

• features where an investor transfers (including by way of a swap) their return on the equity interest that they hold and that generated the imputation benefit for a return that is based on a different (possibly non-equity) investment.

Tax treatment of early exit or walk away-features and product failures

Where investors do not hold their investment until maturity, the ATO says certain tax benefits, such as deductions for interest, may also not be available. The ATO says this could occur in situations where the product is designed with the objective intention of being wound up before maturity, where an investor does not have a purpose of holding their investment until maturity, or where an issuer fails to undertake critical steps or transactions in implementing a product.

Capital protected and capital guaranteed financial products that use notional finance

The ATO says it is examining capital guaranteed products that are bundled together with a notional loan where it is argued that the investment is funded from the notional loan. It says in cases where it appears that no actual finance or financial accommodation is provided to investors who invest in the products, deductions may not be available for the notional interest expense incurred by the investor (rather, the expenses would form part of the cost base of the investment).

Implementation issues

The ATO is also examining certain financial products that appear to have been implemented in a manner that is inconsistent with relevant documentation, including product disclosure statements. It says this includes arrangements where the substance of the transaction differs from its legal form, and arrangements that are accounted for in a manner that is inconsistent with transaction documents.

Where arrangements are inconsistently or incorrectly implemented, the ATO says tax benefits may not be available, the transactions may be a sham, and the promoter penalty law may apply to the entities involved.

Source: ATO publication, "Areas of focus – financial products", 18 September 2013, http://ato.gov.au/General/Tax-planning/In-detail/Compliance-updates/Areas-of-focus---Financial-products/.