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Ruling

Subject: Interest deduction

Question

Is the interest payable on the initial loan to a financial institution (and loan set up and associated expenses) an allowable deduction?

Answer

No

This ruling applies for the following periods

Year ending 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

Year ending 30 June 2017

The scheme commenced on

1 July 2012

Relevant facts

Your (lenders) took out a loan from a financial institution and pay interest regularly from the time of the first drawing.

You will be loaning the full proceeds of that loan to a related party (borrowers).

The proceeds from the loan will not be used for any other purpose.

An agreement was drawn up between the lenders and the borrowers.

Under the agreement the borrowers and the lenders acknowledge that the initial sum and additional sums have been used by the borrowers for, and in connection with, obtaining equity and using their (borrowers) real property as security and agree that the lenders will lodge a caveat against the real property to secure their interest.

The lenders and borrowers will each pay equally for the loan set-up and associated costs.

As outlined in the agreement, if the cash option is taken up, the total amount loaned (principal) plus an additional sum of interest will be paid by the borrowers to the lenders at the end of the agreement period.

The interest is calculated at an interest rate higher than the interest rate charged by the financial institution.

The agreement allows for the total payment to be made via a number of options:

If the loan is repaid early, the exact amount owing will be calculated to the day the monies are repaid.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

The use of the borrowed funds is not considered to be for an income-producing purpose. The method of repayment is also not known with any certainty. You are therefore not entitled to a deduction for the interest or the set up and associated costs irrespective of whether the total amount is repaid in cash or in the form of proportional ownership of the residence.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 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. 

Taxation Ruling TR 95/25 considers the deductibility of interest. Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. The 'use' test, established in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criteria. Where borrowed funds are used to acquire an income producing asset (for example, a rental property), the interest on the borrowed funds is considered to be incurred in gaining or producing assessable income and will be an allowable deduction. Alternatively, where borrowed funds are used for a private or domestic purpose, the interest on the borrowed funds will not be an allowable deduction.

The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower. However, regard must be had to all the circumstances, including the character of the taxpayer's undertaking or business, the objective purpose of the borrowing, and the nature of the transaction or series of transactions of which the borrowing of the funds is an element. In some cases, the taxpayer's subjective purpose, intention or motive may be relevant in deciding the deductibility of the interest.

In your case, you borrowed funds to loan to the borrowers, who you have a close personal relationship with, and you incurred and have paid regular interest payments on a loan with a financial institution. You also incurred some loan set up and other associated costs.

You and the borrowers have an agreement in place which states at the end of the loan term you will be paid the principal amount of the loan and the interest in full:

At the end of the agreement period the principal and total interest amount may be received in cash. However, this outcome is by no means certain as there are many other options available in the agreement. How you will be compensated for providing funds will depend on market conditions and other factors at that time. The fact that there are many possible outcomes at the end of the agreement term, the issue of how you will be paid back the loan funds and any accrued interest cannot be determined with any degree of certainty. Therefore there is no link between the incurring of the interest (and set up and associated expenses) and any assessable income.

If market conditions are not conducive at the end of the agreement term, and the cash option is not exercised, you have agreed to receive a proportion of the ownership of the real property in lieu of cash (equity option). If this option is taken up, the borrowed funds on which interest is being incurred will be used to purchase part of a residence in which the borrowers reside. The borrowed funds have not been used to acquire an income producing asset (for example, a rental property). You will have acquired an interest in a private residence which is not income producing. The interest on the borrowed funds is therefore not considered to be incurred in gaining or producing assessable income and will not be an allowable deduction. This applies equally to loan set up and other associated costs.

Another two options available to both parties at the end of the agreement term are that the loan term may be extended by agreement or that alterations may be made to the loan arrangement to benefit the borrowers.

It is considered that the overarching reason for loaning the funds to the borrowers is to assist them financially given your personal relationship with them. Although there is a possibility of receiving interest in cash at the end of the term at a rate which is slightly higher than current market rates, it is considered that the terms of the agreement are non-commercial. For example no commercial entity would loan money in a business transaction to an unrelated third party to not receive any interest as compensation until the end of a relatively long term unless it is compensated in some significant way and with some certainty.

In addition, the fact that if the circumstances at the time dictate, the terms of the loan will be re-negotiated in favour of the borrowers indicates the non-commercial nature of the agreement.

The interest and loan set up and associated costs are being incurred for a non-income producing purpose therefore you are not entitled to a deduction for those expenses.

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