Edited version of your private ruling

Authorisation Number: 1012008593639

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Ruling

Subject: Interest expenses

Question

Are you entitled to a deduction under 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for your share of the interest you incur on your new rental loans?

Answer: No, however you are entitled to a deduction for the net loss of your tax law partnership as described in the Reasons for Decision.

This ruling applies for the following period

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commenced on

1 July 2010

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 own three properties you use as rental properties (your rental properties). One rental property is held as tenants in common with a 90% share held by you and the remaining 10% share held by your spouse. The other two rental properties are held with a 10% share held by you and the remaining 90% held by your spouse.

You have three joint borrowings with your spouse referable to each rental property respectively (your current rental loans).

You will refinance your current rental loans into a new loan, held jointly with your spouse (your new rental loan).

In addition to the amount directed to refinancing the current loans, you will obtain additional borrowings under the new rental loan. You will place these additional funds into an offset account, which is fully offset against the new rental loan.

This offset account will only be used as follows:

§ initial credit funds only sourced from additional borrowing

§ to fund future rental property acquisition

§ to meet repair and maintenance, rates, agent fees and capital works expenses incurred in respect of your rental properties

§ to meet the interest incurred on your new rental loans.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1936 Division 5 of Part III

Income Tax Assessment Act 1997 Subsection 995-1(1)

Income Tax Assessment Act 1936 Section 90

Income Tax Assessment Act 1936 Subsection 92(1)

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Division 5 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) sets out rules for the treatment of partnership net income and partnership loss.

A 'partnership' is defined in subsection 995-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) as 'an association of persons carrying on business as partners or in receipt of ordinary or statutory income jointly'). Co-owners of a rental property come within the definition of 'partnership' for income tax purposes, not because they are necessarily partners at general law, but because they are in receipt of income jointly: paragraph 3 of TR 93/32.

Section 90 of the ITAA 1936 defines the 'net income' of the partnership broadly as all the assessable income less all the allowable deductions of the partnership, calculated as if it were a resident taxpayer. Similarly, the 'partnership loss' of a partnership is defined as the excess of all the allowable deductions over all the assessable income of the partnership, calculated as if it were a resident taxpayer.

Subsection 92(1) of the ITAA 1936 then includes in the assessable income of each partner their interest in the net income of the partnership. Where a partnership loss has been incurred, subsection 92(2) of the ITAA 1936 provides that there is an allowable deduction to each partner for their interest in that partnership loss.

However, where co-ownership of property is a partnership for income tax purposes only, the income/loss from rental property is derived from co-ownership of the property and not from the distribution of partnership profit/losses: paragraph 4 of the TR 93/32.

The effect of the above provisions of Division 5 of ITAA 1936 as explained in the TR 93/32 is that a co-owner of a rental property will not directly derive income or incur expenses in respect of that rental property. Instead, they will either have an amount included in their assessable income or allowed as a deduction in respect of their share in the net income/loss of a tax law partnership, determined by the legal or equitable interests they hold in the rental property.

In your situation, you are in receipt of the rental income from the rental properties jointly with your spouse. Therefore it is your tax law partnership which is directly assessable on the income from your rental properties and is entitled to a deduction for the deductible rental expenses of the properties. Your assessable income will include any net income from your tax law partnership and you are entitled to a deduction for any net loss of your tax law partnership, in accordance with your legal shares of the properties.

Interest expenses

Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing that is incurred in gaining or producing assessable income, to the extent that it is not of a private, capital or domestic nature.

Whether interest has been incurred in the course of gaining or producing assessable income generally depends on the purpose of the borrowing and the use to which the borrowed funds are put.

Where a borrowing is used to acquire an assessable income producing asset, or relates to expenses of an assessable income producing activity, the interest on this borrowing is considered to be incurred in the course of gaining or producing assessable income. The character of a new loan which refinances a previous loan follows from that previous loan: Taxation Ruling TR 95/25

Compound (or capitalised) interest, as with ordinary interest, derives its character from the use of the original borrowings: Taxation Determination TD 2008/27.

In addition to refinancing the loans referable to each property into a single loan, the purpose and use of an additional amount of the borrowing was to apply the borrowed funds to a deposit account, being an acceptable offset arrangement, in order to reduce the interest you incur on that part of the borrowing to nil. Therefore that part of the borrowing is not referable to an income producing purpose.

However, when the funds are periodically directed from the offset account to meet your deductible rental expenses, it is accepted that the purpose of those funds directed thus is now referable to your rental property. The interest incurred on your borrowing is calculated on a notional balance which, effectively, means you only incur interest on the amount directed for the deductible purpose as above.

In your situation, it is accepted the purpose and use of the new rental loan is for your tax law partnership to refinance its current rental loans and to meet revenue and capital expenses referable to the tax law partnership's rental properties. While the additional borrowings (held within the offset account) are not directed to the revenue or capital expenditure immediately, they are only used for that expenditure as it arises and are not mixed with any other funds. Accordingly the tax law partnership is entitled to a deduction under section 8-1 of the ITAA 1997 for the interest incurred on the new rental loan.