ATO versus negative gearing: is a legal showdown coming?

Negative gearing is a controversial tax break that might not survive an ATO court challenge, writes UNSW Business School's Dale Boccabella

Can the Australian Taxation Office (ATO) make a small contribution to solving the problem of the housing crisis and negative gearing? The short answer is that the ATO should seriously consider whether it should take a case to the courts to test the effectiveness of negative gearing. Negative gearing is one aspect of the demand side problem of the housing crisis. Another significant demand-side factor is the discredited capital gains tax (CGT) discount (50 per cent) for the gain on the property sale. However, the CGT discount is a matter exclusively for Parliament.

If the ATO wants to achieve a scale-back of negative gearing, it would have to convince the Full Federal Court (majority of three (or five) judges) and/or perhaps the High Court that the ATO's interpretation and application of the general deduction provision apply in a particular way to negative gearing situations (see below). Negative gearing is where deductions for expenses on a rental property exceed the taxable rental income from the property, thereby allowing the resulting loss to be used against other income (often wages) to reduce overall income tax.

Negative gearing for income tax purposes currently rests on interpreting and applying the general deduction section in the Tax Act. Also, part of the legislative framework supporting negative gearing is that the loss quarantining rules (negative gearing not permitted) in the regime dealing with small marginal businesses do not apply to passive rental income. In addition, back in 1995, the ATO accepted negative gearing in the straightforward situation in a binding public ruling: paras 16 and 42-46 of Taxation Ruling TR 95/33.

The ATO has considerable challenges to succeeding in winding back negative gearing. The first one has little or nothing to do with the operation of the tax law; it is mainly political. That is, if the ATO took a case (test case) to the courts, many in the political class would likely complain to remind those who are negative gearing, "We are on your side."

The complaining class of politicians may even assert the ATO is stepping into the political arena. This would be a baseless claim because the ATO would be testing the scope of the general deduction provision in a situation relating to numerous taxpayers by bringing an issue to the independent courts. The ATO regularly tests the boundaries of deduction provisions and taxing provisions by regularly bringing cases to the courts for an independent ruling, even where political sensitivities are involved. This practice is sound regulator administration.

One suspects that some senior tax practitioners would also raise complaints; their criticism would most likely differ, though. It would be along the lines, "Why didn't you bring this on earlier"? The ATO may not have a ready and credible answer to this question.

Onto the chances of success in front of the court. The general deduction section requires a sufficient connection between an outgoing and the pursuit of income to obtain a deduction. The section contemplates apportionment of expenses into deductible and non-deductible parts where a cost is only partly related to making income (and the other part is related to some other advantage or thing).

Read more: To fix Australia’s housing affordability crisis, negative gearing must go

Negative gearing largely rests on a Full Federal Court case decided in 1987, Janmor Nominees. For various reasons, it is respectfully submitted that Janmor Nominees cannot govern the typical negative gearing situation of today, or for that matter, could not have governed it back in 1987.

Janmor Nominees involved a residential property purchased by a discretionary trust with a large borrowing, in circumstances where the trust rented the property to the male controller (surgeon) of the family trust for his family to live in. The rent was a market rent. The trust also had other income. The rental income was $6900, and the property expenses were $19,000, which included an interest expense of $14,000. The court held all of the interest was deductible.

The deficiency of Janmor Nominees as an authority on negative gearing is partly due to the ATO. The ATO argued that the lease of the dwelling between the trust and the surgeon's family did not give rise to income to the trust because the "rent" was just a familial contribution to costs. There could not have been any deduction if the rent was not income. The ATO made other arguments as well; for example, the interest expense was private or domestic because the trust was just a mechanism to provide the surgeon and his family with a home to live in.

Naturally, the court's focus was directed at responding to the ATO arguments. It held that the rent was a market rate and that the parties were dealing at arm's length. The arm's length aspect of the transaction also meant the private or domestic argument was dismissed. The court also noted that the loan from the lender was at arm's length.

With due respect to the justices in Janmor Nominees, the focus of the general deduction section is not just on the commerciality (arm's length) of an expenditure transaction. The overriding focus of the general deduction section is on the relevance of expenditure to producing income. In the standard negative gearing situation, by incurring the interest expense, the standard taxpayer is seeking: (1) rent (2) capital growth in the property and (3) use of the loss against other taxable income to reduce income tax liability. In other words, the advantage sought is not limited to the rent. These multiple advantages are overwhelmingly the subjective and objectively determined purpose of most negative gearing taxpayers: see Tim Seelig and others for the Australian Housing and Urban Research Institute, Understanding what motivates households to become and remain investors in the private rental market, AHURI Final Report No. 130, March 2009 at pp 3, 31-32 and 34-35.  

The three advantages first (obtain rent) satisfy the deduction test; the second and third do not.

Putting aside taxpayer purpose, the main deduction rule(s) are the "occasion of the expenditure" or whether the expenditure is incidental and relevant to the earning of income. In answering this, objectively viewed, the advantage the expenditure is directed at obtaining is key. Again, the interest expense is only partly directed at getting the rent; the pursuit of a tax deduction and capital growth in the property are also advantages the expense is directed at obtaining. After all, who would spend an amount of money to obtain a smaller amount; some other advantage is being objectively pursued?

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Accordingly, apportioning the interest into its deductible and not deductible parts would seem to follow. It is likely, but not to be assumed in every case, that the deductible portion will be roughly the amount of the income. The non-deductible portion should be included in the property's cost base for CGT purposes.

In conclusion, there is no decided case where the issue of negative gearing is properly tested against the applicable (correct) deduction principles and rules formulated by the courts under the general deduction section. Certainly, Janmor Nominees did not do this, and this author knows of no other case that has.

Dale Boccabella is an Associate Professor in the School of Accounting, Auditing and Taxation at UNSW Business School. This article is partly based on an earlier article by the author and Stephen Lawrence: Negative gearing – Is another judicial view possible? Weekly Tax Bulletin, Thomson Reuters, Issue No 26, 17 June 2016, paragraph 847. For more information please contact A/Prof. Boccabella directly.