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Edited version of your written advice
Authorisation Number: 1012984938549
Date of advice: 15 March 2016
Ruling
Subject: Timing of interest
Question
Is the accrued interest assessable in the year it is capitalised to the loan?
Answer
Yes.
This ruling applies for the following periods
Year ended 30 June 2014
Year ended 30 June 2015
Year ending 30 June 2016
Year ending 30 June 2017
Year ending 30 June 2018
Year ending 30 June 2019
The scheme commences on
1 July 2013
Relevant facts and circumstances
The taxpayer has provided by way of a secured loan to a borrower.
The taxpayer and the borrower are not related.
The sole purpose of the loan is to provide income for the retirement of the taxpayer.
The transaction has been legally documented by your solicitor via a Deed of Loan agreement (the Deed).
Prime security is a registered mortgage over the borrower's residential property.
The rate of interest charged is consistent with existing loan products offered by commercial lenders. It is reviewed and adjusted annually in accordance with the formula documented in the Deed.
There is no contracted minimum 'repayment' or predetermined duration.
Repayments are optional and there is no obligation for the borrower to make repayments before the due date.
Due date means the earliest of the following dates:
• the date that is six months after the death of the last surviving borrower (loan will be repaid from the borrower's estate)
• the date that is six months after the borrower/s cease to permanently reside in the mortgaged property and
• the date of settlement of any contact for the sale of the mortgaged property.
The deed also details default events. If an event of default as listed in the Deed occurs, the loan money can become immediately due and payable by the borrower upon demand.
Each year the interest is capitalised and added to the balance of the loan. Over the duration of the loan the borrower is charged interest on interest which is included in the balance of the loan owing on the termination of the facility.
The taxpayer is not in the business of lending and this is their only loan investment.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 6-5
Income Tax Assessment Act 1997 Section 6-10
Reasons for decision
Section 6-5 and section 6-10 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident taxpayer includes ordinary and statutory income derived directly or indirectly from all sources, whether in or out of Australia during the income year.
Where income is earned in one year of tax but received in another, the adoption of an appropriate method of determining when income is derived under subsections 6-5(2) and (3) on the Income Tax Assessment Act 1997 (ITAA 1997) in a relevant year of income is an issue of practical concern for taxpayers and their advisers.
Two commonly used methods of determining when income is derived are the receipts method (i.e. cash method) and the earnings method (i.e. accruals method).
In your case, under the Deed there is no obligation for the borrower to make any periodic repayments of principal or interest for the term of the loan. The loan has no predetermined duration and each year the interest is added to the balance of the loan. Over the duration of the loan the borrower is charged interest on the interest which is included in the balance of the loan owing on the termination of the facility
The Commissioner provides guidance in determining the timing of the derivation of interest income in Taxation Ruling 98/1 Income tax: determination of income; receipts versus earnings (TR 98/1). In the case of interest or investment income, the general principle is that it is only derived, or arises, when it is received or credited either actually or constructively. Therefore, income is taken to have been derived by a person although it is not actually paid over, but is dealt with on his/her behalf or as he/she directs.
ATO ID 2002/886: Assessability of compound interest, states that the compound interest is the interest from capitalised interest and is assessable income under section 6-5 of the ITAA 1997.
In your case neither the ordinary interest nor compound interest is paid directly to you but is capitalised as per the Deed. Accordingly, the Commissioner is of the view that you have taken to have received and therefore derived the interest, as soon as it is capitalised. As the compound interest is the interest on the capitalised interest, it retains the character of interest. As such, the compound interest is also assessable under section 6-5 of the ITAA 1997 in the income year it is capitalised.
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