Edited version of private ruling

Authorisation Number: 1011619318901

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Ruling

Subject: Rental property - interest

Are you entitled to a deduction for your share of interest expenses paid to a foreign entity before construction of the rental property is completed?

No.

This ruling applies for the following period

Year ended 30 June 2010

The scheme commenced on

1 July 2007

Relevant facts and circumstances

You are an Australian resident.

You and your spouse purchased an investment property overseas in a complex which is still under construction.

Contract for the purchase of the residential apartment was signed in 2007.

You borrowed from an overseas bank.

The term of the loan was for ten years.

You expect to have the property available for rent in 2011.

You have enclosed a summary of the interest rate changes since the start of the loan.

You have not withheld withholding tax from the interest paid to the overseas bank.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 6(1)

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 26-25

Taxation Administration Act 1953 Section Sch 1-12-245.

Reasons for decision

Summary

As you have not complied with the withholding tax requirements, you are not entitled to a deduction for the interest expense that you incurred on your overseas loan.

Detailed reasoning

Deductibility of interest

Interest is deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) to the extent that it is incurred in gaining or producing assessable income or in carrying on a business for that purpose, except to the extent that the expense is of a capital, private or domestic nature or incurred in gaining or producing exempt 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. The 'use' test, established in the Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. Where borrowed funds are used to purchase a property, the interest will be deductible to the extent that the property is used to produce assessable income.

In Steele v. Federal Commissioner of Taxation (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's Case), the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. It follows from Steele's Case 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.

You have incurred interest on a loan used to purchase an overseas investment property off the plan. As the expenses you incurred in relation to the property were incurred solely for income producing purposes, they are not considered to have been incurred at a point 'too soon' prior to the commencement of the income producing activity.

Generally, an Australian resident can claim a deduction for interest expenses incurred on funds borrowed to purchase a property overseas if the property is used for income producing purposes.

However, section 26-25 of the ITAA 1997 specifies that interest is not deductible if the withholding tax requirements have not been met.

Withholding tax

Section 12-245 of Schedule 1 of the Taxation Administration Act 1953 (TAA) provides that an entity must withhold an amount from interest that it pays to another entity if the recipient has an address outside Australia. The rate of tax on interest income, as specified in Regulation 41 of the Taxation Administration Regulations 1976, is 10%.

According to section 960-100 of the ITAA 1997, entity means any of the following:

· an individual

· a body corporate

· a body politic

· a partnership

· any other unincorporated association or body of persons

· a trust

· a superannuation fund.

As you are making a payment to a non-resident entity overseas you are required to deduct and remit the 10% non-resident withholding tax on the payment of interest. If you comply with the withholding requirement, the interest expense that you incur is deductible under section 8-1 of the ITAA 1997, as the interest expense has been incurred in producing your assessable income.

The withholding tax requirements apply to you because you make interest payments to a non-resident.

Note

The 10% non-resident withholding tax is not a tax on your income; rather it is a tax payable on the interest income earned by a non-resident (in this case, the overseas bank) from sources in Australia. However, you as the payer are required to deduct the 10% non-resident withholding tax from the interest payment you make to the non-resident and remit the amount deducted to the Tax Office. For example, if you incur an interest expense of $1,000 in relation to your overseas rental property, you would be required to deduct and remit $100 to the Tax Office, leaving $900 to be paid to the overseas bank. You may wish to contact your overseas bank to discuss this matter with them.

You must be registered for pay as you go (PAYG) withholding before you withhold tax from interest, dividend or royalty payments to non-residents. If you are not already registered, you can register:

· by phoning 13 28 66 between 8am and 6pm Monday to Friday (you will need to have your ABN or tax file number to register over the phone), or

· by completing a Add a new business account form.

You have been paying to the lender the full amount of interest charged to you. However, you have not complied with the withholding tax requirement to remit to the Tax Office 10% of the gross interest. Therefore, you cannot claim a deduction for the interest paid.