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Edited version of your private ruling
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Ruling
Subject: Interest deduction
Question 1
Are you entitled to a deduction for the full amount of the interest expense incurred?
Answer
No.
Question 2
Are you entitled to a deduction for the interest expense incurred up to the amount of interest income received from the borrowed funds?
Answer
Yes.
This ruling applies for the following period
Year ended 30 June 2011
The scheme commenced on
1 July 2010
Relevant facts
You had a home loan for your private residence.
You have since sold your private residence, but did not pay off the home loan.
You instead placed the funds into an investment account earning interest.
You did this in anticipation of purchasing another property in the immediate future, but could not locate an appropriate property.
You are receiving interest from the investment account on the money you originally borrowed.
The interest received from the borrowed funds was less than the interest expense incurred.
Assumptions
None.
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, or relate to the earning of exempt income.
Taxation Ruling TR 95/25 deals with deductions for interest under section 8-1 of the ITAA 1997. Interest is deductible where the expense has a sufficient connection with the gaining or producing of assessable income and it is not of a capital, private or domestic nature.
Whether interest 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 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.
In Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 (Fletcher) the Full High Court took the view that if, on consideration of all 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 have a home loan for your private residence, which you have since sold. You deposited the funds from the sale of your private residence into an investment account which is earning interest. You did this in anticipation of purchasing another property in the immediate future, but could not locate an appropriate property. The interest expense you have incurred is more than the interest income you have received from the borrowed funds.
It is considered that your circumstances are consistent with those examined in Fletcher in that the loan has an objective other than the single pursuit of assessable income and that an apportionment of the interest paid on the loan would be appropriate.
A deduction for interest incurred on the borrowed funds subsequently placed in an investment account is allowed to the extent of the interest received from the borrowed funds.
Please note that if the amount deposited into the investment account was more than the borrowed amount (that is, the sale proceeds exceeded the home loan balance owing), then not all of the interest income has been generated from the borrowed funds. You would have to calculate how much of the interest income relates to the borrowed funds. For example, if the home loan balance owing was only 80% of the amount deposited into the investment account then only 80% of the interest income was generated by borrowed funds and therefore, the deduction for the interest expense would be limited to 80% of the interest income.