Edited version of your private ruling

Authorisation Number: 1012434984133

Ruling

Subject: Deductibility of interest expenses

Questions and answers:

1. Are you entitled to a deduction for the portion of interest expenses imposed on funds redrawn used to purchase income producing assets, where the account is also used for non income producing purposes?

Yes.

2. When funds redrawn from a loan account are used for both private and income-producing purposes, will the Commissioner accept an apportionment of the amount of deductible interest expenses on a fair and reasonable basis?

Yes.

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commenced on:

1 July 2011

Relevant facts and circumstances

You held a loan account that was used 100% for the purchase of a rental property.

The loan had a debit balance.

You sold your home and deposited the proceeds from the sale of your home into the rental property loan account with the intention of redrawing on the facility.

After this deposit there was small debit balance on the loan account.

You made the decision to deposit the funds into the loan account to save on interest expenses rather than earning approximately 5% in an interest earning account.

You decided to build your new home on the rental property land.

The old building on the rental property land was demolished.

You used part of the then vacant rental property land to build your new home and the remaining part of the land was to be used for another rental property.

The rental building used a slightly higher percentage of the total loan funds than your home building.

Your arguments and references

You refer to:

Hill J in FCT v JD Roberts & FCT v Smith [1992] FCA 363

Hill J in Kidston Goldmines Ltd v FCT [19910 FCA 277 and extracts therefrom:

However, '… a rigid tracing of funds will not always be necessary or appropriate …'

Whether an entity incurs interest in producing or gaining its assessable income, or incurs the interest expense in the course of carrying on its business to produce assessable income, is a question of fact. Identifying the entity's subjective purpose of borrowing the funds and the actual use to which the borrowed funds have been put are a means of resolving the question of fact.

The application of funds test would also present problems if applied in isolation. For example, if a taxpayer borrows for the purpose of buying an income-producing property but the taxpayer deposits the funds into a bank account from which funds are drawn for private purposes and for part of the purchase price of the income-producing property, a tracing of the funds would be necessary and an apportionment of interest would be required. However, the taxpayer should be entitled to a deduction for the whole of the borrowings if the equivalent amount was used to purchase the income-producing property.

You state that your purpose and intention was to borrow funds to build the rental unit and have your home debt free, ownership of which you would move to one spouse for asset protection purposes. You intended to borrow for the rental property and not for the home. You just temporarily reduced the rental property loan to reduce the interest expenses.

You quote FCT v Carberry [1998] FCA 396

Interest expenses on a loan that is used to fund the purchase of an asset that is used partly for a business purpose and partly for non-business purposes must be apportioned.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

The funds you redrew from your loan account were used for both income-producing and private purposes and you created a mixed purpose loan account. As a result, you are able to deduct that portion of your interest expenses that relate to the income-producing use of the funds only.

Detailed reasoning
The principles governing deductibility contained in section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) depend upon satisfying, or being able to demonstrate that the expense has a sufficient connection with the operations or activities which directly gain or produce your assessable income. In other words, relevant to your circumstances, the interest expenses must be incurred in relation to a property which is held for income-producing purposes.

Where the nature of the expense is of a capital, private or domestic nature, such deductions are not allowable.

Deductibility of interest expenses
Whether interest expenses satisfy the general deduction requirements outlined above depends on all the facts relating to that expense. The interest expense must have a sufficient connection with the activities that produce assessable income.

A tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate that connection. The test is one of characterisation. The character of interest on money borrowed is generally ascertained by the use to which the funds are put.

TR 2000/2 Income tax: deductibility of interest on moneys drawn down under line of credit facilities and redraw facilities considers the deductibility of interest incurred by borrowers on moneys drawn down under line of credit facilities and other loans offering redraw facilities, where the borrowed money has been applied for both income producing and non-income producing purposes.

A "redraw facility" allows the borrower to make payments over and above the minimum payments required under the loan agreement, and then permits the borrower to redraw an amount equivalent to those payments in excess of interest, fees and charges at a later time.

TR 2000/2 explains at paragraph 25 that where you use redrawn funds for a different purpose to the original borrowing, the loan account becomes a mixed purpose account. When this happens there will be an ongoing need to apportion the interest expenses between each different purpose the funds were used for on a fair and reasonable basis.

At paragraph 16, TR 2000/2 states that in calculating the portion of the outstanding daily loan balance attributable to an income producing purpose, any repayment of principal is applied proportionately against the outstanding balance of amounts applied to income producing and non-income producing purposes respectively, at a time the repayment is made. That is, you cannot direct that a repayment of principal be applied only to reduce either the income producing or non-income producing portion of the outstanding debt.

However, there are two exceptions.

The first is where the initial borrowed money is recouped in whole or in part in the sense that the amount or some part of it is recovered, for example on the sale of the asset initially purchased with the borrowed funds.

Your loan account was at the outset entirely related to your rental property and the funds from the sale of your home were deposited into the account. The loan funds were not 'recouped from the sale of the asset initially purchased with the borrowed funds.'

The second is where a taxpayer may choose to refinance an outstanding debt on a mixed purpose sub-account by borrowing an equivalent amount under two separate accounts or sub-accounts. If the sums borrowed under those two separate accounts are equivalent to the respective income producing and non-income producing parts of the existing outstanding debt, we accept that interest accrued on the debt incurred in refinancing the income producing portion of the mixed purpose debt will be deductible.

You had a single loan account that was originally 100% related to an income-producing property. The outstanding account balance was reduced by the deposit of funds from the sale of your home which were subsequently redrawn for the purposes of building a new income-producing property and your home.

As you have pointed out, in some cases a full deduction for interest may be allowed where a loan is used to purchase an asset that is used for both private and business purposes.

Generally, if there is a dual purpose asset, the funds borrowed are considered to have the same dual purpose. In such a case, the principles of apportionment will apply to allow a deduction for the interest on the borrowing to the extent to which the asset is used for an income producing purpose.  However, as you have stated, these general rules were considered by the Federal Court of Australia in FC of T v. Carberry 20 ATR 151; 88 ATC 5005 (Carberry), which modified the rules in special circumstances.

In that case, a married couple acting as a partnership purchased a property which comprised a private residence and a separate kindergarten. The purchase price was $120,000, plus a further $20,000 for goodwill, plant and equipment. The taxpayers sold their existing home, and borrowed a further $68,000 to complete the purchase. The taxpayers claimed interest on the borrowings for the 1982/83 and 1983/84 income years on the basis that $70,000 of the purchase price was attributable to the private residence and that it had been fully paid for out of the $80,000 realised from the sale of their previous home, whereas the $68,000 had been borrowed solely for the purposes of the kindergarten business operated by the partnership. The Commissioner disallowed the claim, contending that the $68,000 had been used to purchase the property as a whole and that the interest should be apportioned between the purchase of the residence and the purchase of the kindergarten.

The Federal Court held that the interest was fully deductible. The taxpayers had purchased the property with two distinct ends in mind, namely to use the house solely as a private residence and to use the kindergarten to earn income.

Accordingly, Davies J held the interest was fully deductible as the sum borrowed had been applied solely for the purpose of earning the taxpayers' assessable income.

In Taxation Ruling IT 2661 Income tax: apportionment of interest where money is borrowed to fund the purchase of an asset part of which is used for a business purpose and part for a non-business purpose, the Commissioner states that he agrees with the approach in Canberry's case and it is possible that, where a single asset is purchased using borrowed funds and there is a dual business and non-business purpose in the acquisition, to apply the whole of the borrowings to the business purpose and to allow a deduction for the interest paid on the whole of the borrowings.

The difference between your circumstances and the situation in Carberry's case is there was no existing loan involved. The taxpayers in Carberry's case took out a new loan for the purpose of acquiring a single asset with a dual business and non-business purpose.' The court agreed that the total amount of the loan funds were related to the income-producing part of the property; they were able to trace the use of the funds directly to that purpose. They demonstrated how they used their own cash to purchase the private part of the property.

You had an existing loan investment loan which you deposited funds from the sale of your home and subsequently redrew these funds to use for both income producing and non-income producing purposes. It is clear in TR 2000/2 that under these circumstances a mixed purpose loan is created and an apportionment of interest expenses must occur.

You also draw our attention to FCT v JD Roberts & FCT v Smith [1992] FCA 363 and Kidston Goldmines Ltd v FCT [1991] FCA 277.

Taxation Ruling TR 95/25; Deductions for interest under sub section 51(1) of the Income Tax Assessment Act 1936 following FCT v Roberts, FCT v Smith expresses the Commissioner's view on the principles governing the deductibility of interest expenses incurred where borrowed funds are used to purchase an income producing asset or for business purposes.

The ruling advises that the first aspect to be considered when determining if interest is deductible is what the borrowed funds have been used for. Paragraphs 26 & 27 of TR95/25 states the following from the decision in the Full Federal Court in FC of T v. Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494 (Roberts and Smith);

Use test

26. As Hill J stated (Roberts and Smith ATC at 4388; ATR at 504):

As the cases, including Kidston (Kidston Goldmines Ltd v. FC of T 91 ATC 4538; (1991) 22 ATR 168), all show, the characterisation of interest borrowed will generally be ascertained by reference to the objective circumstances of the use to which the borrowed funds are put. However, a rigid tracing of funds will not always be necessary as appropriate.'

27. Generally, the starting point for determining the essential character of an interest expense is to determine the 'use' to which the borrowed funds have been put, i.e., you trace the borrowed funds......"

It is the use or purpose of the borrowed funds that will determine whether or not a deduction for interest incurred is allowable. In case 95 ATC 175; 30 ATR 1169, BH Burns Deputy President, stated the following at 178;

The primary test in deciding the deductibility of interest paid on borrowed funds depends upon the use to which the money is put. An examination of the cases relevant to this issue makes it quite clear that interest will qualify for a deduction where the monies so borrowed are used to acquire income producing assets or to meet expenditure incurred in the conduct of a business operation.

Conclusion

As we have discussed, the funds you redrew from your loan account were used for both income-producing and private purposes and you created a mixed purpose loan account. As a result, you are able to deduct that portion of your interest expenses that relate to the income-producing use of the funds only.