Edited version of your written advice

Authorisation Number: 1012866406857

Date of advice: 28 August 2015

Ruling

Subject: Interest expenses

Question 1

Are you entitled to a deduction for interest expenses, rates and other costs incurred in relation to your block of land?

Answer

No.

Question 2

Is the capital gain or loss made on the sale of the property subject to the capital gains tax provisions?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

The scheme commenced on:

1 July 20XX

Relevant facts

A few years ago you purchased land.

Your original intention was to build an investment property which would be rented.

You borrowed part of the funds needed to purchase the land.

You had a draft schematic design done and hoped to have the final plans completed and construction to commence and completed within a few years.

The required earthwork and associated expenses were more than expected. The final plans were never completed.

You looked at various options, however have decided not to go ahead with building the investment property.

You have tried to sell the property, but have been unsuccessful.

You have incurred interest expenses and rates.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 104-10.

Income Tax Assessment Act 1997 Section 108-5.

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.

Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that it is not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances.

Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith 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, regard must be given to all the circumstances including the purpose of the borrowing and the use to which the borrowed funds are put. The interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income.

The Commissioner's view on whether interest deductions are allowable prior to the commencement of income earning activities and the implications of the decision of the High Court in Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's case) are outlined in Taxation Ruling TR 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities.

In Steeles case, the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. TR 2004/4 concludes that interest incurred in a period prior to the derivation of relevant assessable income will be incurred in gaining or producing the assessable income in the following circumstances:

• the interest is not incurred too soon, is not preliminary to the income earning activities, and is not a prelude to those activities,

• the interest is not private or domestic,

• the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost,

• the interest is incurred with one end in view, the gaining or producing of assessable income, and

• continuing efforts are undertaken in pursuit of that end.

While Steele's case deals with the issue of interest, the principles can be applied to other types of holding expenditure such as rates.

TR 2004/4 states that, in considering the final of the above conditions, a test of 'continuing efforts' would need to be set within the context of the normal time frames of the relevant industry. However, if a venture becomes truly dormant and the holding of the asset is passive, relevant interest will not be deductible even if there is an intention to revive that venture sometime in the future.

Interest deductions in relation to the purchase of a block of land were also discussed in Temelli v. FC of T 97 ATC 4716; (1997) 36 ATR 417 (Temelli's case). In this case it was found that there was not a sufficient connection between the interest paid and the prospective income producing activity for a deduction to be allowed. In Temelli's case the taxpayers purchased a block of land with the intention of building a house for rental purposes. Three years later, they had not proceeded beyond having drawings and cost estimates prepared. In distinguishing the matter from the earlier decision of the Full Federal Court in Steele v. FC of T 97 ATC 4239 (Steele), the Court noted at 4243 that Steele had demonstrated the required commitment to the redevelopment of grazing land into a motel and townhouse complex. After purchasing the land, Steele had in fact obtained Councils assent to a zoning change, employed architects and engineers, entered into a joint venture arrangement and pursued the project with some tenacity until litigation with her collaborator put a complete stop to it. She demonstrated her commitment from the beginning by putting $1 million into the venture plus the time, energy and considerable expense of the subsequent architectural and engineering work and negotiations with the local council, sewerage authority and prospective joint venturers and financiers. The level of commitment demonstrated by Steele to the project was not an issue in the appeal to the High Court.

In Temelli's case the Court found that the taxpayers had not made a decision to proceed with the building of a house on the land for a number of years. Their lack of commitment to the project lead to the conclusion that the associated expenses were not an allowable deduction. It was found that the temporal gap left open the possibility of a non-income producing purpose to such an extent that the required nexus did not exist.

As stated in TR 2004/4, to be entitled to claim interest deductions, income producing activities should commence in a reasonable period of time. You purchased the block of land, however, the building of an investment property never commenced.

Although your intention in purchasing the land was initially for income producing purposes, your intention has now changed and plans to construct the rental property were never completed. You no longer intend to build an investment property.

Since the purchase of the land, it cannot be said that continuing efforts have been made to produce assessable income from the property. It is considered that the venture has become dormant.

The necessary connection between the interest and other costs and assessable income is lost. Accordingly, you are not entitled to a deduction for the interest expenditure or other costs you incurred in relation to your vacant land.

Capital gains tax provisions

A capital gain or capital loss may arise if a CGT event happens to a CGT asset.

Section 108-5 of the ITAA 1997 states that a CGT asset is any kind of property, or a legal or equitable right that is not property.

Land is a CGT asset.

Section 104-10 of the ITAA 1997 makes the disposal of a CGT asset a CGT event. You dispose of an asset when a change of ownership occurs from you to another entity. A sale of an asset is therefore a CGT event (CGT event A1).

You make a capital gain if the capital proceeds from the disposal are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base.

Further information about CGT can be found in the Tax Office publication Guide to capital gains tax 2015 which is available on our website www.ato.gov.au.