Edited version of private advice

Authorisation Number: 1051882793027

Date of advice: 15 September 2021

Ruling

Subject: Rental deductions for interest expenses

Question 1

When the redrawn funds from my home loan (Loan A) are used to partially repay my investment loan (Loan B), is the interest expense incurred on the redrawn Loan A funds deductible?

Answer

Yes, we accept that the interest expense on the debt incurred in partially refinancing Loan B will be deductible under section 8-1 of the Income Tax Assessment Act 1997. However, the Investment Property must be rented, or genuinely available for rent in the income year for which you claim a deduction.

Loan A will become a mixed purpose loan. The interest on the loan must be apportioned into deductible and non-deductible parts according to the debt incurred to partially refinance Loan B and the portion of debt to finance your Home. You must keep accurate records to enable you to calculate the interest that applies to the income producing portion of Loan A.

If in future the balance of Loan A fluctuates due to a variety of deposits and withdraws, keep accurate records to enable you to calculate and separate the interest that applies to the rental property portion of the loan. A simple example of the necessary calculation for apportionment of interest is in example 16, page 16 of our Rental properties 2021 guide. Taxation Ruling TR 2000/2 provides examples of interest apportionment for moneys drawn down under line of credit facilities and redraw facilities.

Question 2

When the redrawn funds from Loan A are deposited into an offset account linked to Loan B, is the interest expense incurred on the redrawn Loan A funds deducible?

Answer

No, please refer to the Reasons for Decision section of this ruling.

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You have an owner occupier home loan (Loan A). The loan is secured by your home. Loan A has a linked offset account (Offset A) where you deposit funds to reduce the interest payment on Loan A.

You have an investment loan (Loan B) secured against your investment property. Loan B has a linked offset account (Offset B).

You own 100% of your Home.

You own 100% of your Investment Property.

You provided the key terms of your loans. The purpose of Loan A was to acquire your home and the purpose of Loan B.

You propose two schemes (Scheme 1 and Scheme 2) as follows:

•         In Scheme 1, you propose to transfer existing deposit funds held in Offset A to the variable portion of Loan A. You will then redraw those transferred funds from the variable portion of Loan A and deposit the full amount into Loan B in order to make a partial repayment.

•         In Scheme 2, you propose to transfer existing deposit funds held in Offset A to the variable portion of Loan A. You will then redraw those transferred funds from the variable portion of Loan A and deposit them into the Offset B account linked to Loan B.

The purpose of both schemes is to reduce the interest expense incurred on Loan B.

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.

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).

Taxation Ruling TR 95/25 Income tax: deductions for interest under subsection 51(1) of the Income Tax Assessment Act 1936 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, it is necessary to examine 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. Where a borrowing is used to acquire an income producing asset or relates to an income producing activity, the interest on this borrowing is considered to be incurred in the course of producing assessable income.

This remains so even where you change the security for the loan. The deductibility of interest is determined by the use for which the borrowed money is intended and not by the security given for the borrowed money (Taxation Determination TD 93/13). The nature of the security (if any) given for the loan is irrelevant in determining the deductibility of interest (Munro's case). The security is simply a surety to your financier in the case of default of the loan and does not alter the use of the loan funds.

This use is also not altered in the case of a refinance. Paragraph 42 of TR 95/25 addresses borrowings used to repay an existing loan. The paragraph states "Interest on a new loan will be deductible if the new loan is used to repay an existing loan, which, at the time of the second borrowing, was being used in an assessable income producing activity or used in a business activity which is defined to the production of assessable income (Roberts and Smith ATC at 4388; ATR at 504).

Taxation Ruling TR 2000/2 Income tax: deductibility of interest on moneys drawn down under line of credit facilities and redraw facilities considers the deductibility of interest incurred by borrowers on money drawn down under line of credit facilities and loans offering redraw facilities.

The ruling establishes drawing any excess or available funds from a loan account is treated as a new loan. As such the purpose or use of the drawing is relevant. That is, the deductible portion of interest when further borrowings are made depends on the use to which the redrawn funds are put. This is independent of the purpose of the original borrowing. If this is for a non-income producing purpose, then the interest on the redraw amount is not deductible. The redraw facilities referred to in Taxation Ruling TR 2000/2 is where a borrower redraws previous repayments of the loan principal in a loan account.

Taxation Ruling TR 93/6 Income tax and fringe benefits tax: loan account offset arrangements, outlines the Commissioner's view on loan account offset arrangements which are used to reduce the interest payable on a taxpayer's loan account. TR 93/6 provides that an acceptable loan account offset arrangement with dual accounts operates as follows:

•         There are two accounts - a loan account and a deposit account. It is accepted that where the deposit account is a sub-account, it will be treated as a separate account.

•         No interest is received on the deposit account.

•         The reduction of the loan account interest should be achieved by offsetting the balances of the two accounts.

As highlighted in paragraph 6 of TR 93/6, to be an acceptable offset arrangement for tax purposes, it is essential that there be no entitlement, either in law or in equity, to receive interest payment or payments in the nature of interest on the amounts credited to the deposit account. The only benefit arising in the deposit account should be the right to ensure that the interest payable on the loan account is reduced.

A taxpayer with an acceptable loan account offset arrangement is entitled to claim a deduction for the full amount of interest incurred on the loan account, whilst the loan is used wholly for income producing purposes.

Question 1

In your current situation, you have an investment loan (Loan B) with a financial institution used wholly for the purchase of your Investment Property. Loan B is wholly used for income producing purposes and the associated net interest expense on Loan B is an allowable deduction.

When you transfer existing deposit funds from your Offset A account into the variable loan portion of Loan A, this is considered a permanent reduction or repayment to that portion of Loan A. This will reduce the balance owing and will reduce the amount of interest incurred. However, when you then redraw available funds from the variable loan portion of Loan A, the deductibility of the associated interest expense will be determined by the use of these funds.

The redrawn funds from the variable portion of Loan A will be deposited into Loan B and used to partially repay the principal balance owing. We compared this scheme to an arrangement where a new loan borrowing is obtained to refinance an existing investment loan (paragraph 42 of TR 95/25).

When a loan is refinanced, the new loan takes on the same character as the previous loan. The use is not altered in the case of a refinance. Refinancing a loan does not in itself break the nexus between the outgoings of interest under a loan and the income earning activities.

In your case, the funds from Loan B are being used for assessable income producing purposes. The sole purpose of the redrawn amount from Loan A to repay the existing portion of Loan B, will continue to be used for income producing purposes.

Having considered your circumstances, the Commissioner accepts that you are entitled to a deduction for your apportioned interest expense under section 8-1 of the ITAA 1997.

Question 2

Under Scheme 2, the redrawn funds from the variable portion of Loan A will be deposited into the Offset B account linked to Loan B.

In order to determine the deductibility of the associated interest expense, it is necessary to examine the purpose of the borrowing (to reduce interest expense on an investment loan) and where the borrowed funds were put (deposited in an offset account linked to the investment loan). This is best achieved by considering the attributes of an offset account.

An offset account is a separate account and deposits to and withdrawals from the offset account will not change the character of the interest expense on the associated loan. The offset account is only a facility to reduce the amount of interest, being an outgoing, paid on the associated loan account.

Depositing funds into the offset account will decrease the interest payable on the loan account but will not decrease the balance of the loan. The amount deposited is reflected as an increase in savings.

Conversely withdrawing funds from an offset account will increase the interest payable on the loan account but will not increase the balance of the loan and is not a borrowing. The money withdrawn from the offset account is not in the form of borrowings and will not incur any interest. The amount withdrawn is reflected as a reduction in your savings. Any use to which these funds are put (including an income producing purpose) is funded by your savings and not a new loan.

In your case, the redrawn funds will be used to decrease the net interest payable on Loan B but will not reduce the principal amount owing. In effect you are shifting your savings from Offset A to Offset B in order to save interest on your investment loan. The amount deposited is reflected as an increase in savings in Offset B.

Having regard to all your circumstances, we do not consider there is nexus between incurring the interest expense on the redrawn funds to gaining assessable rental income. Incurring the interest expense is considered one step removed from earning rental income. Therefore, the interest expense under Scheme 2 is not an allowable deduction under section 8-1 of the ITAA 1997.

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