Edited version of private ruling

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Ruling

Subject: Interest expense deductibility

Questions and answers:

Is the interest on the part of a line of credit for the purpose of repaying a borrowing used to finance the purchase of land, incurred in the period after the sale of the land deductible?

No.

This ruling applies for the following period:

Year ended 30 June 2010.

Year ended 30 June 2011.

Year ended 30 June 2012.

The scheme commenced on:

1 July 2009.

Relevant facts:

You purchased a block of land with another person.

You intended to build a rental property on the land.

You engaged engineers and designers, with plans prepared.

You collected quotes from various builders.

It became evident that the cost to build the rental property would be higher than expected due to problems with foundations.

The bank was not prepared to loan you or the other person increased funds required to begin building.

You and the other person decided not to continue with the plans of building a rental property and instead sold the land.

The land was sold for a loss.

You and another person refinanced the original loan for the land with a line of credit loan facility in order to pay out the original loan taken out to purchase the land.

The line of credit loan facility has not been used for any private purposes.

The line of credit has been increased due to expenses incurred on two other rental properties owned by you and another person.

Currently approximately X% of the line of credit funds borrowed relate to the other two rental properties, leaving X% solely attributable to the failed development project.

The line of credit facility was opened to fund the repayment of a deposit on the land paid from an account and then used again to pay out the balance of the loan after the sale of the land.

Interest on the line of credit is charged on a variable rate.

There was no contractual obligation to keep paying interest on the original loan once the property was sold.

No other funds were available to repay the loan.

The original loan was not used for any purposes other than the purchase of the land.

The entire proceeds from the sale of the land were applied to the original loan-balance outstanding.

Assumptions:

N/A

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

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.

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 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.

The interest will be deductible to the extent that there is a nexus between the funds and a use which relates to the earning of assessable income for example, rental income.

Line of credit facility

Taxation Ruling TR 2000/2 discusses the deductibility of interest incurred on a line of credit and redraw facilities. Where a line of credit facility loan account is used for a specific purpose, interest is fully deductible where the funds are drawn down and used exclusively for an income producing purpose. Interest is not deductible where funds are drawn down for a non-income producing purpose.

Where a line of credit is applied to a particular use (the relevant use) and an amount is recouped in whole or in part, for example on the sale on an asset (such as land) with the borrowed funds, that part of the outstanding balance of the mixed purpose line of credit debt which had been applied to the relevant use can no longer be regarded as continuing to be applied to that use.

A new draw-down on a line of credit that has not been fully drawn is a new borrowing of funds. A drawn down is considered a separate borrowing. Deductibility of interest on those borrowed funds will be determined by a consideration of the advantages sought from that new use to which those funds are redirected.

Where repayments are made on borrowed funds, the amount paid must be shared between and reduce equally the amount drawn on private and business uses.

Conclusion

For a line of credit, the deductibility of interest depends upon the continued use of the borrowed funds for income producing purposes. After the sale of the land, there are no longer any outstanding funds then used for income producing purposes.

The line of credit was redrawn after the sale of the land and therefore after the relevant use and connection to intentions to produce income was also lost.

After the sale of the land, the outgoing of interest is not for the purpose of retaining the use of those funds for income producing purposes. The interest incurred after the sale relates to financing the capital loss made on the sale of the land. The connection with the previous income producing use of the funds invested in the land does not exist.

Therefore, no deduction will be allowable under section 8-1 of the ITAA 1997 for the interest accruing on the line of credit to the refinanced funds lost on the sale of the intended income producing land.