Edited version of private ruling

Authorisation Number: 1011852537948

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Ruling

Subject: Interest expenses

Question

Are you entitled to claim a deduction for interest expenses where an amount equal to 12 months of interest expenses is deposited into the loan account in advance?

Answer

No

This ruling applies for the following period

Year ending 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You and your spouse own rental properties which are rented at arms length at a market rate.

You have an interest only mortgage over the properties. There is no private component of the mortgage.

The loan is an interest only loan with a variable interest rate.

You intend to make a lump sum deposit equal to 12 months of interest payments onto the loan.

You will not be entering into a prepayment agreement with your financial institution.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 82KZL(1),

Income Tax Assessment Act 1936 Section 82KZM and

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

You will not be entitled to a deduction for a lump sum payment to a loan account as the payment does not represent interest incurred on the loan and is considered to be a capital payment.

Detailed 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 or a provision of the taxation legislation excludes it.

Loan interest is an allowable deduction under section 8-1 of the ITAA 1997 where the borrowed funds are used to purchase an income producing asset such as a rental property. However where there is a prepayment of the interest expense the application of section 82KZM of the Income Tax Assessment Act 1936 (ITAA 1936) must be considered.

The effect of section 82KZM of the ITAA 1936 is to evenly spread the deduction for prepaid interest over the years comprising an '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 (subsection 82KZL(1) of the ITAA 1936).

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 an individual

· the expenditure was not incurred in carrying on a business, and

· the eligible service period is 12 months or less.

However excluded expenditure cannot be included in a claim for prepaid interest. The definition of excluded expenditure is located in subparagraph 82KZL(1)(d) of the ITAA 1936. Expenditure of a capital nature is excluded.

It is also relevant to consider when an expense is incurred. Taxation Ruling TR 97/7 provides guidance on when an expense is incurred. There is no statutory definition of the term 'incurred'; however, the ruling outlines general rules, settled by case law, which will assist in most cases in defining when an outgoing is incurred.

Broadly, an expense is incurred at the time that a present money debt is owed and cannot be escaped. Importantly, the taxpayer need not have actually paid any money to have incurred such an outgoing, providing they are definitely committed to it in the year of income. That is, an expense may be incurred where there is a presently existing liability to pay a pecuniary sum.

In your case you are paying interest on a loan taken out to purchase rental properties. This is a deductible purpose as required.

You intend to make a lump sum payment into the loan equivalent to 12 months interest. The loan is an interest only loan with a variable interest rate. You will not enter into a prepayment agreement with your financial institution.

In a prepayment agreement arrangement, the financial institution calculates the amount of interest that will become payable on the loan for the period of the agreement. The financial institution then provides the mortgagee with a formal notification of the interest (the agreement). It is at the time the agreement is signed by the mortgagee, or at the date specified in the agreement, that the interest is considered to be incurred. That is, the mortgagee has a presently existing liability to pay a pecuniary sum.

Without a prepayment agreement, the interest to be paid in the future is an unknown liability. With a variable rate loan the amount of the interest that will become due and payable cannot be calculated with certainty as both the interest rate or loan balance may fluctuate.

Simply calculating an estimate of the next 12 months of interest on the loan and paying that amount to the loan account, is not sufficient for the interest to be considered to have been 'incurred' for tax purposes, even if no other payments are made during the period.

In this situation, the interest that will be incurred is the actual amount of interest charged to the loan account by the financial institution over the next 12 months.

The payment of the lump sum will reduce the balance of the loan which will, in turn, affect the calculation of the actual interest incurred. As such, the payment is considered to be a capital payment.

Therefore you would not be entitled to a deduction for an amount paid as a lump sum under the provisions of section 8-1 of the ITAA 1997 or section 82KZM of the ITAA 1936.