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Ruling

Subject: interest expenses

Question 1

Are you entitled to a deduction for the interest expenses incurred on the borrowed funds used in your business?
Answer

Yes.

Question 2

Are you entitled to a deduction for your portion of the interest expenses incurred on borrowed funds used to repair items in your investment property?
Answer

Yes.

Question 3

Are you entitled to a deduction for your portion of the interest expenses incurred on borrowed funds used to pay the loan fees?
Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commenced on

1 July 2006

Relevant facts

You and your spouse borrowed money in 2006.

The loan was secured by a jointly owned property.

The terms of the loan included the following:

· The loan was for no more than two months.

· You will pay interest monthly on the principal sum at the rate of 84% per annum or 7% per month.

· You will be entitled to a lower rate of interest being 60% per annum or 5% per month provided that the lower rate payment is made within seven days of the due date of the monthly payment.

· Any money due and owing under GST legislation incurred by the mortgagee in relation to the mortgage is payable by you. You will also pay government charges on any repayment of principal, including stamp duty upon demand by the mortgagee.

· The interest component of the payout figure will be computed by adding daily interest since the last monthly payment was due.

· In the event the mortgage has been in default, you will execute a deed of release releasing the mortgagee, its solicitors and its mortgage manager from any liability or alternatively provide $5,000 to the mortgagee as security for costs for meeting any later dispute relating to the mortgage. If the circumstances warrant it, a higher amount may be nominated by the mortgagee.

· You irrevocably appoint the mortgagee your attorney after any breach or default of the mortgage to exercise all rights, powers and remedies of the mortgagee expressed or implied and to receive any money's payable to the mortgagee in respect of the land mortgaged.

· In addition you are liable for all mortgage costs and expenses including legal costs incurred by the mortgagee in relation to the loan. The legal work by a solicitor will be charged at $388 per hour.

· The first and second monthly instalments of $1,750 are payable in advance prior to the mortgagee advancing the principal sum.

The money borrowed was used as follows:

· loan expenses of two months interest in advance, legal expenses, stamp duty, valuation fee and application fee,

· repair investment property leaking shower, venetian blinds and strata fees, All these expenses have been claimed as rental deductions.

· buy assets for your business.

The amount for fees and interest were deducted from the principal sum advanced to you.

The investment property was in joint names with your spouse. This property has since been sold. You used the available funds after the sale to reduce your loan.

You were unable to make all the repayments as required under the loan agreement.

You refinanced and borrowed a further sum from the mortgagee in 2008. The security on this loan included your main residence and two other properties.

As the loan was not paid out in July 2008, the mortgagee advised that they intended to exercise a power of sale over your main residence.

You incurred interest on the borrowed funds.

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 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, it is necessary to examine 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.

Accordingly, it follows that if a loan is used for investment purposes from which assessable income is to be derived, the interest incurred on the loan will generally be deductible. 

Business loan

In your case, you used some of the borrowed funds to buy assets for your business. As the funds are used for an income producing purpose, the associated interest expenses are an allowable deduction. The fact that the interest expenses may be high does not change the deductibility of the interest expenses.

Investment property

Some of the borrowed funds were used for repairs to your jointly owned investment property.

Taxation Ruling TR 93/32 states that income or loss from a rental property must be shared according to the legal interest of the owners. As you own the investment property jointly with your spouse, the expenses you have incurred must therefore be apportioned according to your legal ownership. Where you own a 50% share in the property, you are only entitled to 50% of the associated expenses.

This investment property has since been sold, however interest expenses were still being incurred after the sale.

The issue of the deductibility of interest after the cessation of income earning activities has been examined by the courts in FCT v. Brown (1999) 43 ATR 1; 99 ATC 4600 (Brown's case) and Commissioner of Taxation v. Jones (2002) 117 FCR 95; (2002) 49 ATR 188; 2002 ATC 4135 (Jones' case ). In both these cases the taxpayers incurred interest on outstanding loans that were unable to be repaid after the income earning activities of the taxpayers had ceased. In both cases the courts held that the interest expense was deductible despite the interest having been incurred in a year after the year in which the relevant assessable income was earned, and despite the fact that the income earning activities of the taxpayers had ceased prior to the incurring of the interest expense.

In Placer Pacific Management Pty Limited v. FCT (1995) 31 ATR 253; 95 ATC 4459 the full Federal Court held that an expense will not cease to be deductible simply because the assessable income was earned in a year prior to the incurring of the expense. Therefore, the interest expense will be deductible under section 8-1 of the ITAA 1997 if there is a sufficient nexus or connection between the incurring of the interest expense and the assessable income produced.

The Commissioner's view on whether interest deductions are allowable after the cessation of the relevant income producing activity is outlined in Taxation Ruling TR 2004/4. The implications of the decisions in Brown's case and Jones' case were considered.

As some of the borrowed funds were used for an income producing purpose, the associated interest expenses are an allowable deduction, even when incurred after the sale of the property.

Your portion of the interest expenses incurred on these borrowed funds used for your investment property, are therefore an allowable deduction under section 8-1 of the ITAA 1997.

Loan fees

Some of the borrowed funds were used to pay for your loan interest expenses, legal expenses and other loan fees. As these expenses are an allowable deduction the associated interest expenses on these borrowed funds are also allowable. However, as some of these expenses related to fees for your joint investment property, only your portion of the associated interest expenses are allowable.