Edited version of your written advice

Authorisation Number: 1012785423930

Ruling

Subject: Interest expenses

Question

Are you entitled to a deduction for interest expenses incurred on your loan?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2004

Year ended 30 June 2015

The scheme commenced on

1 July 200X

Relevant facts

You purchased an investment property overseas several years ago.

You have declared the rental income from the property on your Australian tax returns since you became an Australian resident.

You were unable to borrow funds from an overseas financial institution against the value of the property or gain access to those funds without disposing of the investment property.

You borrowed funds in Australia for your family home in Australia.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

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, or relate to the earning of exempt income.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

• it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478 (Lunneys case)), 

• there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47 (Ronpibon's case), and

• it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that it is not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances.

Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, regard must be given to all the circumstances including the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. The interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income. That is, it is generally accepted that interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction. However, where the new funds are used for private purposes, no deduction is allowed.

TR 95/25 lists the following general principles to determine whether interest is deductible under section 8-1 ITAA 1997:

• the interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature

• 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 

• a tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity

• interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets, and

• interest on borrowings will not continue to be deductible if the borrowed funds cease to be employed in the borrower's business or income producing activity.

In your case, you borrowed funds to purchase a family home in Australia. The fact that you are also retaining your investment property overseas is not relevant in determining the deductibility of your interest expenses incurred on your Australian loan.

The deductibility of interest on a new loan depends upon the use to which the funds are put. A future borrowing of a similar amount previously repaid on an investment loan cannot be said to be used for the investment property purchase. Any future loan cannot be reclassified into a previous loan. The use of the new funds borrowed determines the deductibility of the associated interest expenses. Where the borrowings are not used for an income producing purpose, a deduction for the associated interest incurred is not deductible under section 8-1 of the ITAA 1997.

The purchase of a family home is private in nature. Therefore as the borrowed funds are used for private purposes, the associated expenses are regarded as being private in nature and therefore not deductible. Furthermore there is insufficient nexus between your Australian loan expenses and the derivation of your assessable rental income from your overseas property.

We acknowledge your specific circumstances, however no deduction is allowed for interest incurred on your Australian loan.

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