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Ruling

Subject: Deductibility of interest

Question

If you borrow money to repay your relatives, will interest on the borrowed money be deductible?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commences on:

1 July 2011

Relevant facts and circumstances

You moved to Australia as a student a number of years ago.

Your relatives wanted you to buy a place to live in but you did not want to have a mortgage. To help you settle in Australia, your relatives offered to provide you with the funds to enable you to buy an apartment to live in.

In a previous income year, your relatives transferred an amount of money into your bank account to enable you to pay the deposit when you found a suitable apartment.

You paid a deposit for an apartment several months later.

In the same income year, your relatives transferred another amount of money into your bank account to enable you to pay the balance of the property.

The purchase of the apartment was funded entirely by the monies transferred into your bank account by your relatives.

You lived in this apartment for a few years, and the apartment was then rented out.

When you moved out of the apartment you travelled, and you used the extra money from renting the apartment for your travels. When you came back from travelling you rented another place to live in because the apartment was tenanted.

You and your relatives did not sign a loan agreement between yourselves, and you do not have to pay any interest on the funds provided by your relatives.

You agreed verbally that you would pay back the money to your relatives when you were able to, after you had established yourself properly in Australia.

There was no stipulation regarding the time frame for repayment, your relatives just said 'pay it back when you can'. The arrangement was very loose and was pretty casual.

For the following personal reasons (your relatives' health and financial circumstances have changed and they are likely to need the funds in the near future), you want to repay at least a portion of the money:

One of your relatives has health problems.

Your relatives live in an overseas country and there's uncertainty there, so they may have to leave that country and migrate to another country in the future.

You are thinking of borrowing a portion of the amount of money transferred by your relatives from a bank against the value of the property, and using it to repay your relatives.

Your relatives have not requested repayment.

You feel that it is a good time to pay the money back as the exchange rate is good and you are in a position to pay it back now.

If you repay money to your relatives you are not expecting that they would give it back, it would only be if you inherit something.

You have not really made previous repayments to your relatives, not formally, but you try and pay for their holidays. You feel obligated so you pay for everything when they come for a holiday.

The issue of what would happen if you don't repay the funds to your relatives was never discussed. You have a sibling and your relatives have not given any money to your sibling to buy a place to live, so it would be unfair if the money were not paid back.

You are considering borrowing the amount of money that you have specified as you just thought that amount was a good number. You haven't thought about the balance of the funds provided by your relatives for the purchase of the apartment.

The lease on your apartment is expiring soon. After it expires, you may move back into the apartment. Although you have no definite plans at the moment, it is possible that in the future you will move out of the apartment and rent it out again.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: 'Part IVA: the general anti-avoidance rule for income tax'.

Reasons for decision

Summary

There is no evidence in your case that a bona fide loan with your relatives was set up, or that a loan was being serviced. There is no evidence to distinguish the transfer of funds for the purchase of the apartment from that of a gift from your relatives. Therefore, any interest incurred on moneys borrowed to repay your relatives will not be deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Detailed reasoning

Interest is deductible under section 8-1 of the ITAA 1997 to the extent that it is incurred in gaining or producing assessable income, except to the extent that the expense is of a capital, private or domestic nature or incurred in gaining or producing exempt income.

Whether interest has been incurred in the course of producing assessable income generally depends on the purpose of the borrowing and the use to which the borrowed funds have been put. The 'use' test, established in FC of T 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.

For example, interest on moneys borrowed in order to purchase a property to live in (that is, a home) is not deductible under section 8-1 because it is not incurred in gaining or producing assessable income. Furthermore, the interest has a private or domestic nature. On the other hand, interest may be deductible where the borrowed moneys are used to acquire an income producing asset, such as a rental property.

In your case, you are considering borrowing money to repay your relatives funds they transferred into your bank account to enable you to buy an apartment to live in. The purchase of the apartment was financed entirely by the funds transferred by your relatives. You lived in this apartment for a few years and then the apartment was rented out. You have asked if interest on the borrowed money will be deductible against the rental income from the apartment while it is rented.

Where an original loan has been used for the purchase of an income producing asset such as a rental property and the original loan is refinanced, the interest expense on the refinanced loan will have the same character as the original borrowing, as long as the property continues to be a rental property. That is, the interest expense on the refinanced loan will be deductible under section 8-1 of the ITAA 1997 as it is incurred in gaining or producing assessable income.

However, in your case there are other considerations because the arrangement between you and your relatives regarding the funds transferred to enable you to buy an apartment is not an arms length arrangement. The following factors do not support the existence of an original loan from your relatives:

There is no loan agreement, setting out the terms and conditions and repayment requirements. You stated that the arrangement was very loose and pretty casual.

There was no stipulation regarding the time frame for repayment, your relatives just said 'pay it back when you can'.

You do not have to pay any interest on the funds provided by your relatives.

You feel obligated to your relatives so you pay for everything when they come for a holiday.

There have been no previous repayments to your relatives even after the apartment became income producing (a rented property) some time ago.

Your relatives have not requested repayment.

You are considering borrowing the amount specified as you just thought that amount was a good number. You haven't thought about the balance of the funds provided by your relatives for the purchase of the apartment.

There is no evidence in your case that a bona fide loan with your relatives was set up, or that a bona fide loan was being serviced. There is no evidence to distinguish the transfer of funds for the purchase of the apartment from that of a gift from your relatives. The arrangement between you and your relatives is private and domestic in nature, and any interest incurred on moneys borrowed to repay your relatives will not be deductible under section 8-1 of the ITAA 1997.