Edited version of private ruling

Authorisation Number: 1011642777750

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Ruling

Subject: Interest expenses

Question 1

Are you entitled to a deduction for all interest expenses incurred on loan money deposited in a term deposit?

Answer

No.

Question 2

Are you entitled to a partial deduction for interest expenses incurred on your loan up to the amount of assessable income derived from money deposited in a term deposit?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on

1 July 2010

Relevant facts

You wish to purchase an investment property in a foreign country.

You have opened a loan account with an Australian bank.

You are currently conducting research into the housing market in the foreign country and won't purchase the property immediately.

You have opened a bank account in the foreign country and intend transferring the loan money you will draw down, into that account. You need to have a bank account in the country before purchasing real estate there.

You opened up this account now to reduce the risk that the currently high exchange rate will become less favourable in the future.

You will then take out a term deposit in the foreign country using the transferred loan money, to generate interest income to offset the interest loan expense.

It is unlikely that there will be a net profit in the short term.

You hope that there will be long term financial benefits.

You are an Australian resident for tax purposes.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

You are entitled to a partial deduction for the interest incurred on the funds borrowed and subsequently put in a term deposit. The deduction allowed is up to the amount of assessable income derived.

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 (Lunneys case)), 

· 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).

Where an expense comes at a point in time too early to be regarded as being incurred in gaining assessable income then no deduction is allowed. That is, the expenditure must be related to the production of assessable income and not incurred at a point too soon to be deductible (FC of T v. Maddalena 71 ATC 4161; (1971) 2 ATR 541 (Maddalena's case ).

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 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.

It is generally accepted that interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction. However where a loan is set up some time before the acquisition of an investment property, the full circumstances need to be considered to determine if the interest expenses incurred are fully deductible.

Taxation Ruling TR 95/33 considers the deductibility and apportionment of losses and outgoings where expenses are incurred for dual purposes. TR 95/33 states that if an outgoing produces an amount of assessable income greater than the amount of the outgoing, there would normally be no need to examine the taxpayer's motives and intentions when determining the deductibility of the expenditure.

However, if the outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is wholly deductible. This may, depending on the circumstances of the particular case, include an examination of the taxpayer's subjective purpose, motive or intention in making the outgoing.

If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective (for example, to derive exempt income or the obtaining of a tax deduction), then the outgoing must be apportioned between the pursuit of assessable income and the other objective: see Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 (Fletcher's case).

In your case, you will incur interest expenses on funds that you intend to use to purchase an investment property in the future. As you are still researching various aspects of this investment, you have not actually purchased a property as yet and may not in the immediate future. Therefore, you will incur interest expenses prior to earning assessable rental income. For the period before you purchase an investment property, the connection between the interest expenses and the earning of rental income is too far removed. Your interest expenses will be incurred at a point too soon to be an allowable deduction and the expenses are preliminary to the earning of any rental income.

However, while you are researching the property market, you will deposit the borrowed funds into a term deposit. As the borrowed funds will be used to derive interest income, it can be said that the funds have a purpose other than the single objective of having monies available to purchase an investment property in the future. For this reason, it is considered that your circumstances are consistent with those examined in Fletcher's case.

As the interest derived from the term deposit is assessable income and is attributable to the funds borrowed, a deduction for some amount of interest is therefore appropriate.

Accordingly, as there is a dual purpose in relation to your borrowed funds, a deduction is allowed to the extent of the assessable income received from the term deposit.