Edited version of your written advice

Authorisation Number: 1012790899164

Ruling

Subject: Interest deduction

Questions and answers

1. Are you entitled to an interest deduction on the loan for your rental property renovation on the interest payments to a foreign bank?

Yes

2. Are you entitled to an interest deduction on the loan for your rental property renovation on the interest payments to your parent?

No

This ruling applies for the following period:

Year ending 30 June 2015

The scheme commences on:

1 July 2014

Relevant facts and circumstances

You are an Australian resident for tax purposes.

You own two properties in a foreign country as follows:

Property A: this is jointly owned with your parent and you use it as an investment property. There is no mortgage against this property.

Property B: you intend to use it as an investment property and the property needs renovation in order to be rented out. Renovation has started and will be finished soon.

You would like to use property A as security to borrow money from a foreign bank and the money will be used for property B renovation. The loan will be joint names. You parent will pay 50% of interest and principal and you pay 50% of interest and principal. And you will refund your parent in the future.

You have some people expressed their interests in renting property B. In the future, when property B is rented out, you would like to refinance and transfer the loan over to property B.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Tax deductibility of interest expenses

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 earing of exempt income.

Taxation Ruling TR 95/25 provides that the deductibility of interest on borrowed funds is determined by the use of the borrowed money. 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. The interest incurred will be deductible to the extent that the property is used in the course of producing assessable income.

An outgoing of interest will not fail to be deductible merely because the original loan is refinanced.

Interest payments

Under Australia's tax treaties with the overseas countries you do not have to withhold an amount from interest if both of the following apply:

• the interest is derived by a financial institution that is unrelated to and deals wholly independently with you

• the transaction does not involve back-to-back loans.

Your circumstances

A taxpayer may be able to claim a deduction for interest expenditure under section 8-1 of the ITAA 1997. A deduction is allowed if interest is incurred for the purpose of earning assessable income regardless of whether the taxpayer is an employee, carrying on a business or an investor. In determining the deductibility of interest, the purpose and use of the loan must be examined.

In your case, you would like to settle a loan from a foreign bank and the money will be used to renovate property B. You intend to use property B as an investment property after the renovation. Property B will be rented out to produce assessable income and you will declare rental income in Australia.

You will pay 50% of the interest and principal on the loan directly to the bank. You will repay your parent the 50% of the loan interest and principal your parent incurs on the loan. Therefore, the interest on the loan may be deductible.

Where an Australian resident pays interest to a foreign resident (individual, company, partnership, trust or superfund), the gross amount of each of those payments is generally subject to a withholding tax rate of 10%. The interest payer is required to withhold 10% from each payment and remit these funds to the ATO.

In some situations, there may not be a requirement to withhold from interest payments made to a resident of a country with which Australia has a tax treaty. Australia has a tax treaty with the foreign country, under Australia's tax treaty, if an Australian resident pays the interest of the loan to financial institution of the foreign country, there will be no withholding tax.

As a result, for your 50% share of the interests which will be paid directly to a bank of the foreign country, you do not have to withhold an amount from interest and you are entitled to claim a deduction. For the 50% share of the interests which will be paid to your parent, you may not be able to claim a deduction unless you withhold 10% from each payment and remit to the ATO.

In the future, when property B is rented out, you would like to refinance and transfer the loan over to property B. When a taxpayer borrows money, they may use assets they own as security for the loan. It does not matter if a taxpayer uses a private asset or income producing asset as security for a loan. The security does not impact on whether interest on that loan is deductible. Moreover, the purpose of the loan has not changed and funds have not been used for any other purposes. Therefore, you will be entitled to claim a deduction for the interest incurred on the refinanced loan under section 8-1 of the ITAA 1997.

A comprehensive guide to the withholding tax requirements can be found by searching the ATO website for QC 17760 and follow the link.