Edited version of private ruling

Authorisation Number: 1011649304711

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Ruling

Subject: prepaid interest expenses

1. Are you entitled to claim a deduction for an amount debited from your account in error by the bank, and later reinstated, as a prepaid interest expense?

No.

2. Is the reversed bank transaction treated as assessable income?

No.

This ruling applies for the following period

Year ended 30 June 2010

The scheme commenced on

1 July 2009

Relevant facts

The entity has a mixture of investments including shares, other trusts and a rental property and has an aggregated annual turnover of less than $2 Million dollars.

Making up approximately X% of the entity's investments is an investment in a project covered by a product ruling which has been held since before 30 June 2004.

The funds used to purchase the rental property were borrowed from a financial institution.

The entity entered into a five year fixed rate loan with interest to be pre-paid each June for the following 365 days for the period of the loan.

A direct debt authorisation was put in place to have the pre-paid interest amount withdrawn from the nominated account in June of each year.

In June 2010, the interest amount was withdrawn from the nominated account for the pre-paid interest on the investment property loan.

On the following day, a second amount was withdrawn from the nominated account due to a systems error.

Once the error was detected, the second withdrawal was reversed in July 2010.

Reasons for decision

Deductions

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent they are incurred in gaining or producing your assessable income except where they are of a capital, private or domestic nature or they are incurred in gaining or producing exempt income.

Taxation Ruling TR 97/7 considers the meaning of 'incurred' in relation to section 8-1 of the ITAA 1997. As a broad guide, you 'incur' an outgoing at the time you owe a present money debt that you cannot escape (paragraph 5). Similarly, for an outgoing to be incurred, there must be a voluntary movement of resources out of a taxpayer's hands - expenditure.

In your case, you did incur one payment as a pre-paid interest expense in relation to your investment property, as per your agreement with the bank. This was a present money debt and you authorised the bank to debit your nominated account by that amount to meet this debt.

The second amount deducted cannot be said to have been 'incurred' in gaining or producing assessable income within the meanings set out in TR 97/7. The second amount was deducted in error by the bank. It was not part of the arrangement you had with the bank for the second amount to be deducted and once the error was discovered, the transaction was reversed and interest accrued on the additional amount credited to your account, back dated to the date of the error. Therefore, as the second amount was not incurred in gaining or producing assessable income, no deduction is allowable under section 8-1 of the ITAA 1997 for this amount.

The initial amount deducted for pre-paid interest, is an allowable deduction under section 8-1 of the ITAA 1997 as the borrowed funds were used to purchase an income producing asset.

However, as the amount has been debited in advance, the prepayment provisions must be considered. 

The effect of section 82KZM of the Income Tax Assessment Act 1936 (ITAA 1936) is to evenly spread the deduction for prepaid interest over the years comprising the eligible service period. The eligible service period is the period to which the interest relates, not the term of the loan, being a period not exceeding 10 years.

A prepaid expense will not be subject to these timing rules where the following factors exist:

· the interest is otherwise deductible under section 8-1 of the ITAA 1997

· the taxpayer is small business entity and has chosen not to apportion the deduction under section 82KZMD of the ITAA 1936, and

· the eligible service period is 12 months or less.

In your case, the entity holds, as part of its investments, an interest in a project covered by a product ruling which has been held since before 30 June 2004. The product ruling discusses the taxation application of the project investment. Paragraph 65 of this ruling states that, for the purposes of this Ruling, the Growers' afforestation activities in the project will constitute the carrying on of a business.

This Product Ruling was withdrawn and ceased to have effect after 30 June 2004. However, the Ruling continues to apply, in respect of the tax law(s) ruled upon, to all persons within the specified class who entered into the arrangement before this date.

The entity has an aggregated annual turnover of less than $2 Million dollars, and, as stated in the product ruling, is carrying on a small business for the purposes of section 82KZM of the ITAA 1936. The original interest expense is deductible under section 8-1 of the ITAA 1997 and the eligible service period is 12 months or less. Accordingly, the interest is not subject to the timing rules in section 82KZM of the ITAA 1936 and is deductible in the year in which it is incurred. 

Assessable income

Subsection 6-5(1) of the ITAA 1997 provides that the assessable income of an Australian resident includes income according to ordinary concepts. Whether or not a particular amount is income according to ordinary concepts depends on the nature and character of the receipt in the hands of the taxpayer.

Characteristics of what is ordinary income have evolved from case law. Such characteristics include receipts that:

· are earned

· are expected

· are relied upon, and

· have an element of periodicity, recurrence or regularity.

In your case, the second amount was deducted from the entity's account by the bank in error and once the error was discovered, the transaction was reversed. The reinstatement of these funds into the entity's account was not earned or relied upon and it had no element of periodicity, recurrence or regularity. You would have expected the error to be rectified but this is not enough for the amount of the transaction reversal to be considered ordinary income.

Taxation Ruling TR 92/3 discusses situations where profits from an isolated transaction maybe considered income. Paragraph 6 of this ruling states that a profit from an isolated transaction is generally income when both of the following elements are present:

(a) the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain, and

(b) the transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.

In your case, you did not knowingly enter into this transaction and therefore your intention could not have been to make a profit or gain. Therefore, the amount is not assessable as profits from an isolated transaction.

Section 6-10 of the ITAA 1997 provides that your assessable income also includes some amounts that are not ordinary income. These amounts are included in your assessable income by another provision and are called statutory income.

Section 15-2 of the ITAA 1997 states that your assessable income includes the value to you of all allowances, gratuities, compensation, benefits, bonuses and premiums provided to you in respect of, or for or in relation directly or indirectly to, any employment of or services rendered by you.

In your case, you did not receive this money in respect of any employment or services rendered therefore it is not assessable under section 15-2 of the ITAA 1997. 

Subdivision 20-A of the ITAA 1997 includes an amount in assessable income if the amount is received as an assessable recoupment. Section 20-20 of the ITAA 1997 provides that an assessable recoupment will arise if:

· an amount is received as a recoupment, and 

· the recoupment is of a loss or outgoing that you can deduct under a provision listed in section 20-30 of the ITAA 1997.

Recoupment is defined in section 20-25 of the ITAA 1997 to include any kind of reimbursement.

Subsections 20-30(1) and (2) of the ITAA 1997 provides a table of the deductions available in the ITAA for which recoupment's are generally assessable under Subdivision 20-A of the ITAA 1997. If the amount received is not a recoupment within the meaning of that term in section 20-25 of the ITAA 1997, or if the recoupment is not of a loss or outgoing that can be deducted, then the amount cannot be an assessable recoupment for the purposes of Subdivision 20-A of the ITAA 1997.

In your case, the amount reinstated into the entity's bank account could be described as a reimbursement and therefore a recoupment. However, the original debit of this amount is not an expense listed in the tables of deductions contained in subsections 20-30(1) and (2) of the ITAA 1997, and, as discussed above, is not a deductible expense. As you are not entitled to a deduction for this amount, then any reimbursement you receive is not an assessable recoupment.

As a result, there is no provision in the income tax legislation that would include the amount reinstated to the entity's bank account, to rectify an earlier error, in the entity's assessable income.