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Edited version of private ruling
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Ruling
Subject: Deduction- interest
Question
Are you entitled to a deduction for an interest expense after your investment loan was paid out in error?
Answer: No.
This ruling applies for the following period:
Year ending 30 June 2011
The scheme commenced on:
1 July 2010
Relevant facts
You and your spouse had taken out a loan with financial institution to purchase your main residence.
Later you and your spouse borrowed additional funds under a new loan from this financial institution.
The funds were used to buy income producing assets.
The new investment loan was an interest only loan.
You used your main residence to secure the investment loan.
You have received income from these investments and declared these amounts in your tax returns.
You sold your main residence.
The investment loan was discharged on the sale of your main residence.
You advised the financial institution had discharged the investment loan without your knowledge as you were going to use the funds from the sale of your previous main residence to purchase a new place of residence.
You contacted the financial institution to discuss the settlement of your main residence and to enquire about arranging new borrowings regarding the investment loan prior to the settlement of your main residence. You were advised by the financial institution that there was no option but to discharge the investment loan due to the way the loan was set up.
You approached a number of financial institutions to refinance the loan. The financial institutions advised they could not loan you any funds as you did not have any way of securing a new loan.
You did not undertake any action with the financial institution after the settlement of the property in regards to the discharged investment loan.
You purchased a new main residence at a later date.
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.
Taxation Ruling TR 95/25 provides that the deductibility of interest is determined by the use for which the borrowed money is 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 criteria. Where borrowed funds are used for private purposes, such as the acquisition of a home, the interest will not be deductible even if there is a secondary result that other assets are able to be retained for the purpose of producing assessable income.
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 (FC of T v. Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494).
In your case, the debt owing on your investment loan has already been discharged from the proceeds from the sale of your main residence. We acknowledge that you were not able to re-borrow further funds from any other financial institution. However, the Commissioner is not able to take into account the commercial restrictions on borrowing from financial institutions when determining whether a deduction is allowable. As noted above 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 earning assessable income. In your case you could not secure funds from a new lender.
It is acknowledged that you did not intend for proceeds from the sale of your main residence be used to pay out this loan. However, while it may not have been your intention, it is what occurred. More emphasis is placed on what in fact happened rather than what may have been in mind at some earlier point in time.
Accordingly, as the investment loan has been discharged the connection between the interest expense and the income-producing use of the assets has been broken. You are not entitled to a deduction under section 8-1 of the ITAA 1997 for interest expenses after the investment loan has been discharged.