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Ruling

Subject: Apportionment of interest expense

Question

Are you entitled to claim a deduction for a portion of the interest expense on borrowed funds used for both income-producing and private purposes?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts and circumstances

During the 2011-12 financial year you borrowed money from a financial institution.

Interest was payable in advance for a period of less than 12 months.

The amount borrowed was applied as follows:

Your tax return for the year ended 30 June 2012 contains a deduction for interest and dividend expenses relating to the following uses of the borrowed funds

Interest on funds used to:

  

Purchase of shares

  

On-lend to the Trust

  

Pre-pay interest (income-earning portion)

  

The interest relating to the share purchase and loan to the Trust was calculated using the formula:

The portion of the pre-paid interest included in the calculation was calculated using the formula:

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Paragraph 25-5(2)(c)

Reasons for decision

Summary

You are entitled to a deduction for that portion of interest expense on the loan funds which relate to the purchase of the shares and the loan to the Trust. A portion of the pre-paid interest is also deductible.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income or a provision of the taxation legislation excludes it.

Taxation Ruling TR 95/25 provides that the deductibility of interest is determined by the use to which the borrowed money is intended. The use test is the basic test for the deductibility of interest and looks at the application of the borrowed funds as the main criteria. Where the borrowed funds are used for the purposes of producing assessable income, a deduction will be allowed for the interest on the loan.

Funds used purchase shares

You have some of the borrowed funds to acquire shares.

As these shares are expected to produce dividend income, the interest expense on the borrowed funds used to purchase these shares is deductible.

Funds on-lent to the Trust

You have on-lent some of the borrowed funds to the Trust at a commercial interest rate The Trust has paid you interest which has been shown in your tax return as income.

As this portion of the borrowed funds has been used to generate assessable income, you are entitled to a deduction for the related interest expense.

Payment of outstanding tax debt

Some of the borrowed funds were applied to your tax debt.

Paragraph 25-5(2)(c) of the ITAA 1997 denies a deduction for costs associated with borrowing money to pay tax, general interest charges and shortfall interest charges.

Accordingly, the interest associated with this portion of the borrowed funds is not deductible.

Private use of funds

You used some of the borrowed funds for private purposes. As these funds were not used to gain or produce assessable income, no deduction is allowable for the interest associated with this portion of the borrowed funds.

Pre-paid interest

Some of the borrowed funds were used to pre-pay interest on the loan for a period of less than 12 months.

Tax Determination TD 2008/27 states that the deductibility of compound interest is determined according to the same principles as the deductibility of ordinary interest. That is, a deduction is allowable where the underlying borrowed funds were used to gain or produce assessable income to the extent that it is not of a private, domestic or capital nature. The same principles can also be applied to prepaid interest.

Thus, you are entitled to a deduction for that portion of the pre-paid interest which relates to borrowed funds used for income producing purposes. In this instance, those funds used to purchase shares and on-lent to the Trust.

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