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Ruling

Subject: Interest expenses and apportionment

Question

Are you entitled to a deduction for the total interest incurred on a loan that relates to the purchase of land for a primary production business, of which a portion was subsequently used for a residence?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commenced on

1 July 2008

Relevant facts

You are carrying on a business of primary production.

You purchased rural land for the purpose of establishing a primary production business.

The income-producing portion of the property occupies two hectares.

You have subsequently built a house on the land, but otherwise the remainder of the land is not used for any purpose other than the primary production business.

You have a separate mortgage loan for the house.

The house occupies a small portion of the total land area.

You had always intended to put a house on the block, in order to be able to travel to and stay on the property to work on and maintain the business. The house has not been, and will not be, rented out.

You do not intend to claim the interest payments that relate to the house mortgage, but rather only interest payments that relate to the initial land purchase.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

You are entitled to claim a portion of your interest expenses in relation to your rural land loan on a reasonable basis. We would consider an apportionment on an area basis in line with the private and income-producing portions of the land to be reasonable. Only the income-producing portion will be deductible.

Detailed reasoning

Interest is deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) to the extent that it is incurred in gaining or producing assessable income or in carrying on a business for that purpose, except to the extent that the expense is of a capital, private or domestic nature, or incurred in gaining or producing exempt income or non-assessable non-exempt income.

Whether an interest expense has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been 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 criterion.

Whether a deduction is allowable will depend on whether the occasion for incurring the interest '...is to be found in the business operations directed towards the gaining or production of assessable income generally...' (Placer Pacific Management Pty v. Federal Commissioner of Taxation 95 ATC 4459; (1995) 31 ATR 253).

It is, therefore, generally accepted that ordinary interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction.

Expenditure may have been incurred, in part, for a purpose other than the production of assessable income. If this is the case, the expenditure must be apportioned and a deduction allowed only to the extent that the expenditure was incurred for the income producing purpose. The appropriate method of apportionment will depend on the facts of each case and the method must be both 'fair and reasonable' in all the circumstances (Ronpibon Tin NL & Tongkah Compound NL v. FC of T (1949) 78 CLR 47; (1949) 8 ATC 431). For example, in Fletcher v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613 (Fletcher's case), the High Court suggested a 'commonsense' or 'practical' weighing of all the factors and in that case found that it was 'fair and reasonable' to limit the amount of the deduction to the amount of the assessable income actually received in that year.

In Fletcher's case the assessable income derived from the annuity in each of the tax years was less than one-eighth of the relevant amount of interest outgoings in that year. The High Court accepted the Commissioner's position that the deduction for interest outgoings should be allowed to the extent of the assessable income received from the annuity investment plan.

Although the decision in Fletcher's case was made in the context of an artificial tax avoidance scheme, we can see no basis for limiting it in this way. Therefore, the principles adopted in Fletcher apply generally to all cases involving the application of section 8-1 of the ITAA 1997.

Taxation Ruling TR 95/33 considers the implications of Fletcher's case and outlines the Commissioner's view on the importance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings. The ruling states that if an outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure, including an examination of the taxpayer's subjective purpose, motive or intention in making the outgoing, to determine whether the outgoing is wholly deductible. If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective, then the outgoing must be apportioned between the pursuit of assessable income and the other objective.

The Court took the view that if, on consideration of all those factors, the whole of the interest could be characterised as 'genuinely and not colourably incurred in gaining or producing assessable income', the interest would be fully deductible. If only part of the outgoing could be so characterised, apportionment between the pursuit of assessable income and of other objectives was necessary.

In your case, you purchased the land for the dual purposes of a primary production business and to provide an area for a dwelling for you to reside in when you are at the property. We consider the dwelling, and the land on which it resides, to be private in nature.

Accordingly, the dual purpose of the property affords a consideration of the apportionment of interest expenses on a reasonable basis. In the case of the interest on the land loan only, we would consider an apportionment on an area basis in line with the private and income-producing portions of the land to be reasonable.