Edited version of private ruling

Authorisation Number: 1011594956065

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Ruling

Subject: deductibility of interest paid to a non-resident

1. Can you claim a deduction for interest paid to a non-resident on a personal loan, where the money is deposited into a mortgage offset account?

No.

2. Can you claim a deduction for interest paid to a non-resident on a personal loan, where the money is used to reduce your investment property loans, and you have not met your pay as you go (PAYG) withholding requirements?

No.

This ruling applies for the following period

Year ended 30 June 2009

The scheme commenced on

1 July 2008

Relevant facts

You and your spouse jointly owned investment properties with loans on the properties.

One of the loans has an offset account attached to it and the credit balances of the offset account are offset against the loan amount to reduce the interest payable.

As interest rates started to rise, you began looking at ways to reduce your interest repayments but could not find a better rate with any Australian lender.

A non-resident friend offered to lend you some money to help reduce your loans in return for an annual interest rate of X% over three years.

You deposited some of the money into an offset account and the balance was used to repay some of the loans.

To date, you have made two interest payments on the borrowed money.

After the three years, you may repay the money borrowed or continue the arrangement for an extended period.

You have not withheld any portion of the interest paid to the non-resident for tax in Australia and have not remitted any amount for tax to the Australian Taxation Office (ATO).

Reasons for decision

Interest deductions

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for losses or outgoings to the extent to which they are incurred in gaining or producing assessable income. However, you cannot deduct a loss or outgoing to the extent that the losses or outgoings are of a capital, private or domestic nature or another provision of the Act prevents you from deducting it.

Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest. An outgoing of interest is incidental and relevant to the gaining of assessable income if the funds were borrowed for the purpose of gaining that income (Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153). The use test is the basic test relied upon to establish the deductibility of interest and looks at the application of the borrowed funds as the main criterion.

Accordingly, where a loan is used for an income-producing purpose the interest on the loan is generally deductible.

In your case, of the money borrowed from a non-resident friend, some was deposited into an offset account attached to one of the investment property loans and the balance has been used to repay part of the loans you have on your investment properties.

Funds deposited into offset account

Taxation Ruling TR 93/6 considers loan account offset arrangements which are used to reduce the interest payable on a customer'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

· no interest is received on the deposit account

· the interest on your loan can only be reduced to the extent of the amount of interest which would have been charged on the loan amount equal to the balance of your deposit account. For example, you have a loan of $250,000 and a credit balance in your deposit account of $50,000. You can only obtain a maximum reduction of interest as if the balance of your loan was $200,000 (reduced by the $50,000 balance of your deposit account).

A taxpayer with an acceptable loan account offset arrangement with dual accounts is entitled to claim a deduction for the interest actually incurred on the loan account whilst the loan is used wholly for income-producing purposes. This will remain the case even if funds are withdrawn from the deposit account and used for non-income-producing purposes. This is because depositing funds into the deposit account will decrease the interest payable on the loan account but will not decrease the balance of the loan account and withdrawing funds from the deposit account will increase the interest payable on the loan account but will not increase the balance of the loan account.

In your case, you have an acceptable loan account offset arrangement. No interest is received on credit balances held in the deposit account. The interest payable on your loan account is reduced by the amount of interest that would have been charged on an amount equal to the balance of your deposit account.

As stated above, for interest payments to be deductible under section 8-1 of the ITAA 1997, they must be incurred in producing assessable income. Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put.

In your case, you have deposited some of the funds borrowed from your non-resident friend into a loan offset deposit account. As already discussed, the balance of this account is offset against the loan account, reducing the interest payable but not the balance owing. These offset accounts are structured so that no interest is derived by the customer and therefore, the customer is not liable to pay income tax in respect of the benefit arising from the account. Therefore, as you have used some of the funds borrowed from your friend only to reduce interest payable on a loan account and not in producing assessable income, you are not entitled to a deduction for the interest payable on this portion of the borrowed money.

Money used to repay loans

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 directed to the production of assessable income (paragraph 42 TR 95/25).

In your case, you have used the balance of the money borrowed from a non-resident friend to repay part of the loans you have on your investment properties. Where the money was used to reduce your investment loans (an income-producing purpose), you will be entitled to a deduction for the interest expenses incurred on the loan unless another provision of the Act prevents you from deducting it.

Under section 26-25 of the ITAA 1997, a deduction for the interest paid to a non-resident is not allowed if the withholding tax requirements have not been met.

You have stated that you have not met your withholding requirements in relation to the interest payments you have made to your non-resident friend. Therefore, pursuant to section 26-25 of the ITAA 1997, you are not entitled to a deduction for the interest expenses under section 8-1 of the ITAA 1997.