These are typically fixed term investment loans (interest only with principal repaid in one lump sum at maturity) used to acquire a portfolio of shares. Similar to instalment warrants, they are limited recourse loans. The investor is protected from a fall in the price of the shares as the loan facility includes a capital protection feature that gives the investor the right to transfer the shares back to the lender as repayment of the loan. The lender in turn covers this risk by buying a put option, the cost of which is passed on to the borrower.
The Australian Tax Office places restrictions on the deductibility of interest expense associated with protected equity loans. The portion of interest expense related to the cost of capital protection is not deductible. It’s instead treated as a capital expense rather than an income expense. While not deductible, this portion is included in the cost base of the investment for Capital Gains Tax purposes. A benchmark is used to determine the portion of a capital protected borrowing’s interest expense that is tax deductible, with the remainder treated as a capital expense. The current benchmark is the Reserve Bank’s standard housing rate plus 100 basis points. Transitional rules apply to capital protected borrowings entered into on or before 13 May 2008. The Australian Tax Office provides instructions on how to calculate deductions for a capital protected borrowing.
In addition to the general benefits of gearing:
the ability to borrow the entire amount i.e. 100% loan to valuation ratio (LVR)
limited recourse with potential loss restricted to borrowing costs prior to exercising the put option.
The primary risk associated with this type of loan is the extra cost due to the embedded put option. This may exceed the future returns generated by dividends and capital gains. Careful assessment of the investment performance should be undertaken before taking on a protected equity loan for an investor to break even or receive a profit.
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