Edited version of your private ruling

Authorisation Number: 1012482612251

Ruling

Subject: Investment loan interest

Question

Can you claim your share of the interest on the total amount of an investment loan when it has been reduced by an amount due to a bank error when restructuring the loan?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts and circumstances

You and your spouse purchased an investment property with a loan, plus additional funds from your personal savings.

Almost X years later, you both refinanced the loan as well as your personal home loan with another lender.

You gave specific instructions to the lender that the investment loan was not to be restructured in any way that would affect the deductibility of the interest.

In the restructuring, the new lender created a new loan for an amount greater than the original loan.

Soon after this, as soon as you realised the error, you immediately repaid the difference, reducing the loan to its original amount.

Within six months you sold your existing principal residence and brought a new home, giving specific instructions to the lending bank not to alter the investment loan.

The bank credited your investment loan with some proceeds from the sale, which reduced the loan by over Y%

When you discovered this, you notified the bank but they refused to immediately rectify the error.

You contacted the banking ombudsman.

As a result, some months after the sale of your residence, a new investment loan for the original amount was setup, and the proceeds of the private residence sale were applied to your personal loans/savings as per your original instructions.

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 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.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

· it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478), 

· there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income; The words incurred in gaining or producing assessable income mean in the course of gaining or producing such income. (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

· it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Taxation Ruling TR 95/25 provides that the deductibility of interest is determined by the use to which the borrowed money is 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 criteria. Where borrowed funds are used for private purposes, such as the acquisition of a home, the interest will not be deductible even if there is a secondary result that other assets are able to be retained for the purpose of producing assessable income. Where a borrowing is used to acquire an income producing asset, the interest on this borrowing is considered to be incurred in the course of producing assessable income.

Taxation Ruling TR 2000/2 discusses the deductibility of interest on drawings against a line of credit or redraw facility. It is considered that a repayment to a loan account is a permanent reduction to the debt and any redrawn funds constitute new lending. Where a loan is for mixed purposes, a deduction is only allowed for the portion of the interest which relates to an income producing purpose.

In your case, you have an investment loan which was used to fund the acquisition of a rental property.

You had money from the sale of your principal residence deposited into the loan account. Therefore a permanent reduction of the debt has occurred. The subsequent paying out of the loan and the creation of a new loan for the original amount for the investment loan does not create full interest deductibility unless all of the funds are used for income producing purposes.

Whilst the circumstances of your case produces an unfortunate result, under tax law any redraw of an investment loan or a portion of a new borrowing that is not made for an income producing purpose would be considered private in nature and a deduction for the associated interest incurred would not be deductible under section 8-1 of the ITAA 1997. In your case part of the funds borrowed was applied to your personal loans and savings and therefore this amount was not used for income producing purposes.

We acknowledge that the loan was intended to be used solely for your rental property, and the bank did not follow your request. However, the fact is that the account has been used for mixed purposes.

As the funds from your investment loan have been used for personal loans/savings, the Commissioner can only consider what actually occurred rather than what was intended to occur. The Commissioner has no discretion to ignore the previous transactions on your loan account.

We understand that the actions of the lending authority were not according to your instructions, and in this case we have not requested a copy of the loan documents, as it is immaterial whether a payment to your investment loan was required by the lender on the sale of your principal residence, or in fact it was a genuine error. The Commissioner is not able to take into account an error made by the lending authority when determining whether a deduction is allowable. 

The legislation applies to what in fact happened rather than what may have been in mind at some earlier point in time. As such you are not entitled to a deduction under section 8-1 of the ITAA 1997 for the interest as calculated on the original amount of the loan. It is accepted that the reduced percentage of the loan is for income producing purposes. Therefore only this relevant percentage of interest on the reduced balance of your loan account will be an allowable deduction from when the permanent reduction in the loan occurred. This includes the period after the new investment loan was set up.