Edited version of your written advice

Authorisation Number: 5010048406706

Date of advice: 7 February 2018

Ruling

Subject: Investment loan interest

Question

Are you entitled to a deduction for interest on the part of the loan used to purchase an investment property where the contract did not proceed?

Answer

No.

This ruling applies for the following period

Year ending 30 June 2017

The scheme commenced on

1 July 2016

Relevant facts

You and your spouse borrowed the total amount to jointly purchase an overseas investment property off the plan. The property was always intended to be used for your joint income producing purposes.

There was no intention to use or personally occupy the property.

You had to place a deposit on the purchase, however because you were resident in Australia, you were required to draw the loan in full to ensure funds were available to meet the terms of the contract and settle on completion of construction.

A reservation deposit was paid.

As a result of issues associated with the purchase and construction of the property not being dealt with and resolved, you withdrew from the purchase of the property and the deposit was returned.

The contract was not finalised, and you did not hold title to the property or land on which it was to be built.

You incurred an amount of interest between the time you drew down the loan and the deposit was returned.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

No deduction is allowed for the borrowed funds used to purchase a rental property, as you were not the legal owner of the property. The associated expenses are capital in nature.

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 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 (Munro's case) 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.

Taxation Ruling TR 93/32 states that the income/loss from a rental property must be shared according to the legal interest of the owners except in those very limited circumstances where there is sufficient evidence to establish that the equitable interest is different from the legal title.

Taxation Ruling TR 2004/4 considers deductions for interest expenses incurred prior to the commencement of income earning activities and the implications of the decision of the High Court in Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's case) as well as the decisions in the Full Federal Court.

The deductibility of interest is generally determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put.

In Steeles case, the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. Taxation Ruling TR 2004/4 concludes that interest incurred in a period prior to the derivation of relevant assessable income will be incurred in gaining or producing the assessable income in the following circumstances:

● the interest is not incurred too soon, is not preliminary to the income earning activities, and is not a prelude to those activities,

● the interest is not private or domestic,

● the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost,

● the interest is incurred with one end in view, the gaining or producing of assessable income, and

● continuing efforts are undertaken in pursuit of that end.

In your case, the vendor had not given you possession of the property, that is, you are not the legal owner of the property until the transfer has been completed. There is no other agreement that gives you an equitable interest in the property.

Ormiston v FCT 2005 ATC 2340, is also not relevant to your case, for similar reasons to the above, as the property was not owned.

We acknowledge that you intended to purchase the property to be built for an income producing purpose, however, as you are not the legal or equitable owner of the property, the principles of Steele’s case do not apply. Any interest expenses incurred on the property of which you never became the legal owner are not sufficiently connected to the earning of your assessable income. Furthermore, the expenses are more capital in nature. Therefore no deduction is allowable under section 8-1 of the ITAA 1997.

Accordingly you are not entitled to claim a deduction for the loan interest relating to your intended purchase of the rental property in the 2016-17 financial year.

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