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Ruling

Subject: Interest incurred before commencement of income earning activity

Question:

Is the interest on the borrowed funds deductible?

Answer:

Yes.

This ruling applies for the following period

Year ended 30 June 2011

Year ended 30 June 2012

Year ending 30 June 2013

The scheme commenced on

1 July 2010

Relevant facts

The entity purchased a unit in a unit trust which is subdividing land.

Each unit held is to be allocated a number of lots of land when the subdivision is finalised.

In order to buy the unit, the entity borrowed money and incurred interest in the 2010-11 and the 2011-12 financial years.

When the project is finished land titles will be issued to unit holders. The entity is expected to receive titles to a number of lots shortly.

Once these land titles have been transferred, the entity intends to commence building residential buildings on its land.

The properties are all expected to be completed in the near future.

When the properties are completed the entity will rent out the properties.

The whole time period from when the money was first borrowed to when rental income will be first received will be between two to three years.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

It is considered that the interest is incurred in gaining or producing assessable income. Therefore, the interest is deductible.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

Taxation Ruling TR 2004/4 is the Commissioner's opinion on how deductions for interest incurred prior to the commencement of, or after the cessation of, relevant income earning activities.

Paragraph 6 states the deductibility of interest is typically determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put (Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613, FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52, and Steele).

Paragraph 7 states ordinarily '...the purpose of the borrowing will be ascertained from the use to which the borrowed funds were put...' (Hill J in Kidston Goldmines Limited v. FC of T 91 ATC 4538 at 4545; (1991) 22 ATR 168 at 176). However, as his Honour later observed in FC of T v. JD Roberts; FC of T v. Smith 92 ATC 4380 at 4388; (1992) 23 ATR 494 at 504, '...a rigid tracing of funds will not always be necessary or appropriate...'.

Paragraph 8 states outgoings of interest are a recurrent expense. The fact that borrowed funds may be used to purchase a capital asset does not mean the interest outgoings are therefore on capital account (see Steele 99 ATC 4242 at 4249; (1999) 41 ATR 139 at 148).

Paragraph 9 states it follows from Steele that interest incurred in a period prior to the derivation of relevant assessable income will be 'incurred in gaining or producing the assessable income' in the following circumstances:

· the interest is not incurred 'too soon', is not preliminary to the income earning activities, and is not a prelude to those activities;

· the interest is not private or domestic;

· the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost;

· the interest is incurred with one end in view, the gaining or producing of assessable income; and

· continuing efforts are undertaken in pursuit of that end.

In application to this case the entity incurred interest expense on a loan which was used to purchase a unit in the unit trust. The subdivision project is expected to finish shortly when land titles will be issued to unit holders. The entity will receive titles to a number of lots, after which it is intending to commence building residential buildings on the lots which are expected to be completed in the near future. When the properties are completed the entity will rent out the properties.

The entity has in effect purchased lots in the subdivision upon which it has plans to build rent-producing properties in the near future.

It has been concluded that the interest is deductible under section 8-1 of the ITAA 1997 after taking the following into account:

· the interest incurred on the loan to purchase the unit is not incurred 'too soon' as the entity is committed to erecting income producing properties in the near future, nor is it considered preliminary to the income earning activities;

· the interest is not private or domestic as the intention of the entity is purely commercial in nature as rent will eventually flow which will be assessable income;

· the period of interest outgoings prior to the derivation of relevant assessable income is not too long; the necessary connection between outgoings and assessable income is not lost as the period is reasonable given the nature of the industry;

· the interest is incurred with one end in view, the gaining or producing of assessable income; and

· continuing efforts have been undertaken in pursuit of that end.

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