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Edited version of your written advice
Authorisation Number: 1012870080229
Date of advice: 8 September 2015
Ruling
Subject: Deductibility of interest
Question
Are you entitled to a deduction for interest in relation to the proposed arrangement?
Answer
No.
This ruling applies for the following periods:
Year ended 30 June 2016
Year ended 30 June 2017
Year ended 30 June 2018
The scheme commenced on
1 July 2015
Relevant facts
You and your spouse have several residential rental properties with a mix of sole ownership and joint ownership.
You have rental properties solely in your name which you solely account for in your tax returns. Although the title to the properties are in your name only the bank has drawn up documents stating that you and your spouse are jointly responsible for the loans.
Your spouse is selling a property which is held in their name as sole owner. As a result surplus funds will be available.
You wish to borrow the surplus funds from your spouse and use the funds to reduce the loans on the rental properties that are owned solely by you.
You will have a written loan agreement between you and your spouse. You will make interest only payments to the loan each month. The loan will be unsecured, as the security is based on your relationship only.
You originally proposed an interest rate with respect to the arrangement with your spouse that was higher than the rate you currently pay to the bank.
You stated that the arrangement will help you and your spouse as they will only receive 2% interest if they deposited the surplus funds in a bank.
When queried why you would incur more interest than you were currently paying, you stated that you could change the rate for the proposed arrangement to the same you were being charged by the bank.
Your spouse is not in the business of lending money.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 8-1.
Reasons for decision
Summary
You are not entitled to a deduction for interest as the arrangement is largely private in nature.
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, 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,
• 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, 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.
Where a person borrows money from a related entity, the deductibility of interest will be dependent on whether the money is borrowed on a commercial basis.
The test that should be considered to show whether the arrangement is at arm's length, is whether a reasonable person with no relationship to either party would enter into this arrangement using exactly the same terms and conditions. If the answer is yes, then it would be an arm's length and commercial arrangement.
In your case you will borrow from your spouse and repay part of the loans on properties solely owned by you. While it is acknowledged that they are income producing properties, consideration must be given to the commerciality of the arrangement between you and your spouse.
Factors which point towards the arrangement being uncommercial in character include:
• The loan is unsecured.
• The security is based on your relationship only.
• The interest rate being proposed is well below the market rate for an unsecured loan.
• The arrangement will benefit your spouse and at the interest rate originally proposed by you would have been to your detriment in terms of interest payable compared to your current loans.
• The payments made to your spouse can be used for household expenses which can also benefit you.
• A genuine liability paid to a third party does not generally generate a benefit to yourself.
• Your spouse is not in the business of lending money.
• The funds you will borrow from your spouse will be used to pay off loans which the bank holds your spouse jointly responsible for. Although you are the sole owner of the rental properties and as such declare all income and expenses from the properties for tax purposes, nevertheless the bank considers that your spouse is jointly responsible for the loans.
• When queried why you would incur more interest than you were currently paying, you stated that you could change the rate for the proposed arrangement to the same rate you were being charged by the bank. This shows that you can change the interest rate at will which is not possible with a commercial loan.
Although you will have a written agreement with your spouse, this does not convert the arrangement into a commercial loan.
It is not considered that you would be able to enter such an arrangement with an unrelated party.
Having regard to all your circumstances, it is not considered that the proposed borrowing from your spouse is on a commercial basis. Rather it is considered that the arrangement with your spouse is largely private in nature and therefore no deduction is allowable under section 8-1 of the ITAA 1997.
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