Edited version of your private ruling

Authorisation Number: 1012522785355

Ruling

Subject: Interest expenses

Question Disclaimer

Is entity A entitled to a deduction for the interest expenses incurred on borrowed funds used to acquire an investment property from a related entity under a commercial arrangement?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2014

The scheme commenced on

1 July 2013

Relevant facts

Entity A is acquiring a property.

The property is currently owned by a related party.

Entity A will borrow funds from a bank to purchase the property.

A valuer will determine the value of the property. Entity A will borrow the full market value of the property.

Entity A intends to keep the property as a genuine investment for several years to produce rental income.

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.

Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

Accordingly, it follows that if a loan is used for investment purposes from which assessable income is to be derived, the interest incurred on the loan will generally be deductible. 

Taxation Ruling IT 2167 examines the situation where a property is let to relatives and non arms length transactions. Although the trust may not be letting to relatives, the trust is dealing with a related party when purchasing the property, and therefore the principles outlined in this ruling are relevant. Where a person is dealing with a related entity, the essential question is whether the arrangements are consistent with normal commercial practices. Where the arrangement is not at arms length, an apportionment of losses and outgoings incurred is generally required.

The test that should be considered to show whether the arrangement is at arms length, is whether a reasonable person with no relationship to either party would enter into this arrangement using exactly the same terms and conditions. If the answer is yes, then it would be an arms length arrangement. Whether parties are at arm's length is a question of fact.

In this case entity A is purchasing a rental property from a related entity. As entity A is paying the market value for the property and borrowing the funds from a financial institution, it is considered that entity A is dealing at arm's length and the arrangement is commercially realistic.

Therefore, as the borrowed funds will be used to acquire an investment property for income producing purposes, the associated interest expenses are an allowable deduction. The fact that entity A is purchasing the property from a related entity does not change the deductibility of the expense in these specific circumstances. The interest expenses incurred are an allowable deduction under section 8-1 of the ITAA 1997.