Edited version of your private ruling

Authorisation Number: 1012521475805

Ruling

Subject: Deduction for Penalty Interest

Question 1

Is the penalty interest payment a deductible expense?

Answer

Yes, to the extent that it relates to producing assessable income.

Question 2

Can the penalty interest expense, incurred in an earlier year, be claimed as a deduction in a later financial year?

Answer

No, an expense must be claimed as a deduction in the year in which the expense was incurred.

This ruling applies for the following period(s)

For the period 1 July 200X to 30 June 20XX

Relevant facts and circumstances

The taxpayer bought the investment property in Year One and sold their investment property in Year Two.

The taxpayer used the property for income producing purposes for a period.

The taxpayer incurred a penalty interest expense for the early exit of a fixed interest loan agreement on the investment property.

The taxpayer lodged an income tax return for Year Two but did not claim a deduction for the penalty interest expense relating to the investment property.

Due to various circumstances the taxpayer commenced their own business.

No taxable income was incurred by the taxpayer for several years.

The business has only started to perform in Year Five.

Relevant legislative provisions

Section 25-30 of the Income Tax Assessment Act 1997

Section 67A of Income Tax Assessment Act 1936

Section 36-15 of the Income Tax Assessment Act 1997

Reasons for decision

Question 1

Is the penalty interest payment incurred in Year One a deductible expense?

Answer

Yes, to the extent that it relates to the purposes of producing assessable income.

Detailed reasoning

Taxation Ruling TR 93/7 states at paragraph 4:

"Where the repayment of a loan moneys borrowed for the purposes of producing assessable income is secured by mortgage, penalty interest payable on an early repayment which effects the discharge of a mortgage will be deductible under section 67A "(of Income Tax Assessment Act 1936 (ITAA36)).

Section 67A of ITAA36 is now covered by section 25-30 of the Income Tax Assessment Act 1997 (ITAA97).

Sub-section 25-30(2) states:

You can deduct expenditure you incur to discharge a mortgage that you gave as security for the payment of the whole or part of the purchase price of property that you bought if you used the property solely for the purpose of producing assessable income.

Sub-section 25-30(3) states;

If you used the money you borrowed, or the property you bought, only partly for the purpose of producing assessable income, you can deduct the expenditure to the extent that you used the money or property for that purpose.

Further Rental Properties 2007-08 NAT 1729 states:

Mortgage discharge expenses are the costs involved in discharging a mortgage other than payments of principal and interest. These costs are deductible in the year they are incurred to the extent that you took out the mortgage as security for the repayment of money you borrowed to use to produce assessable income.

For example, if you used a property to produce rental income for half the time you held it and as a holiday home for the other half of the time, 50% of the costs of discharging the mortgage are deductible.

Mortgage discharge expenses may also include penalty interest payments. Penalty interest payments are amounts paid to a lender, such as a bank, to agree to accept early repayment of a loan - including a loan on a rental property. The amounts are commonly calculated by reference to the number of months that interest payments would have been made had the premature repayment not been made.

Paragraphs 22 and 23 of Taxation Ruling TR 93/7 provide the following example of a prepayment penalty being deductible:

Anne obtains a loan from a financial institution to purchase a rental property. Within the terms of the loan Anne decides to sell the property. This requires her to repay the loan to discharge a mortgage over the property which secures the loan. In paying out the loan early Anne incurs a penalty interest payment.

The repayment of the loan, and the associated incurrence of the penalty payment, is a necessary incident of the sale of the property. A payment so connected with the realisation of a capital asset will be on capital account. The payment is therefore not deductible under subsection 51(1). The payment will, however, qualify for deduction under section 67A as expenditure incurred in discharging a mortgage.

The taxpayer incurred the fixed interest prepayment fee as a necessary incident in discharging the mortgage to sell the property. The expense is therefore deductible under subsection 25-30(2) of ITAA97 to the extent that it was used for purpose of producing assessable income (sub-section 25-30(3)).

The taxpayer has stated that they owned the investment property for a period and used it for income producing purposes for a lesser period. The taxpayer can only claim a deduction for penalty interest payment to the extent that the property was used for income producing purposes.

Question 2

Can the expense be claimed as a deduction in the financial year ending 30 June 2013?

Answer

No, an expense must be claimed as a deduction in the year in which the expense was incurred.

Detailed reasoning

Expenses under section 25-30 of ITAA97 can only be deducted from assessable income in the year the expense was incurred.

The taxpayer incurred the expense in Year One and therefore the expense can only be deducted from assessable income in the Year One.

Note: Under section 36-15 of ITAA97 a tax loss from a previous income year can be used to reduce your assessable income in a later income year.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).