Edited version of private advice

Authorisation Number: 1051921960648

Date of advice: 27 January 2022

Ruling

Subject: Interest deductions

Question

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

Answer

No.

This ruling applies for the following period:

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-occupied home loan (Home Loan) of $XXX which is currently offset by funds of $XXX in a separate offset account (Home Loan Offset).

The Home Loan Offset is linked to the Home Loan.

You are paying an interest rate of XXX% on the Home Loan.

You also have an investment property loan (Investment Loan) of $XXX, which is linked to an offset account (Investment Loan Offset).

You are paying an interest rate of YYY% on the Investment Loan.

You propose to withdraw the funds of $XXX from the Home Loan Offset and deposit the funds directly into the Home Loan, effectively creating an available redraw amount of $XXX in the Home Loan.

You propose to then redraw the $XXX from the Home Loan and deposit it into the Investment Loan Offset.

You advised that the purpose of the arrangement is to effectively reduce the interest on the Investment Loan, whereby you will be paying the lower rate (XXX%) on the Investment Loan.

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.

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, 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 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.

In this ruling the Commissioner considers a redraw from a loan account, is a separate borrowing. Therefore, the deductibility of the interest on that separate borrowing depends on whether the interest is incurred in gaining or producing assessable income regardless of the original purpose of the funds. 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.

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.

In your case, the redraw funds from the Home Loan will be deposited into the Investment Offset to decrease the net interest payable on the Investment Loan. A taxpayer with an acceptable loan account offset arrangement is entitled to claim a deduction for the full amount of interest incurred on the associated loan account, whilst the loan is used wholly for income producing purposes. We note that the Investment Loan Offset is not associated with Home Loan from which the redraw funds will be deposited.

Further, the redraw funds to be deposited into the Investment Offset will not reduce the principal amount owing on the Investment Loan. In effect you are shifting your funds from the Home Loan to the Investment Offset in order to save interest on your Investment Loan. Therefore, we do not consider that the redraw funds will be used to acquire an income producing asset or relates to an income producing activity, but rather it will be solely for the purpose of reducing the payable interest on the Investment Loan.

Having regard to all your circumstances, we do not consider there is a connection between incurring the interest expense on the redraw funds and gaining assessable income. Therefore, the interest expense you will incur on redraw funds from the Home Loan will not be an allowable deduction under section 8-1 of the ITAA 1997.

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