Edited version of your written advice

Authorisation Number: 1012993950668

Date of advice: 8 April 2016

Ruling

Subject: Interest expense

Question 1

Are you entitled to a deduction for the amount paid to entity A which will be used to pay the interest expenses on your investment loan for 12 months?

Answer

No.

Question 2

Are you entitled to a deduction for a forward payment given to the bank where the bank does not offer an advance payment facility?

Answer

No.

This ruling applies for the following period

Year ended 30 June 20YY

The scheme commenced on

1 July 20XX

Relevant facts

You and your spouse expect to have a capital gains event in the 20XX-YY financial year and wish to pay interest in advance for your outstanding investment loan.

The Bank does not provide a service that offers interest in advance payments. Any forward payments made to your bank loan will be registered initially on their statement as a reduction of the capital with subsequent monthly debits in interest.

You wish to pay the forward lump sum to entity A to manage. Entity A will issue a receipt to you for the lump sum as "payment of interest in advance (12 months of the 20ZZ financial year) for loans".

Entity A will then ensure the payments representing the interest only are made each month to the bank.

You will contract entity A to handle the payments and make payments to entity A via the interest it can gain from the forward deposit.

Entity A will use two separate accounts, one for an interest bearing deposit to pay for administration costs and one transaction account for the month to month interest payments to the financial institution. You are the director of entity A and will be responsible for the actions to achieve the above.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

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 earning of exempt income or a provision of the taxation legislation excludes it. 

Where a loan is used for investment purposes from which income is derived, the interest incurred on the loan will generally be deductible. For an expense to be allowed under section 8-1 of the ITAA 1997, the expense must be incurred.

Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions sets out the Commissioner's views on the meaning of incurred. The ruling outlines rules, settled by case law, which assist in defining when an outgoing is incurred.

Generally, a taxpayer incurs an expense at the time they owe a present money debt that they cannot escape. That is for an expense to be incurred, there must be a presently existing liability to pay a pecuniary sum. A person must be definitively committed to the expense in the year of income for the expense to be incurred. Presently existing liability is determined on the circumstances of the case.

In your case, you do not have a presently existing liability to pay your interest expense in advance. You are not definitely committed to the prepayment of interest expense in the 20XX-YY financial year. That is, the Bank does not offer a prepayment facility and prepayment terms were not included in your loan agreement with the bank. Therefore any attempt to prepay interest on your investment loan before 30 June 20YY will be regarded as a reduction of the capital and not a prepayment of interest.

Taxation Ruling TR 94/26 Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance also provides the Tax Offices views on the meaning of incurred and states at paragraph 6 that: 

Whether there is a presently existing pecuniary liability is a question which must be determined in light of the particular facts of each case, and especially by reference to the terms of the contract or arrangement under which the liability is said to arise.

The High Court in Federal Commissioner of Taxation v. James Flood Pty Ltd (1953) 27 ALJ 481; [1953] ALR 903; (1953) 10 ATD 240; (1953) 88 CLR 492 (James Flood) at (CLR 506) provided that a loss or outgoing will be incurred where the taxpayer is definitely committed or has completely subjected themselves to the loss or outgoing.

Dixon J in New Zealand Flax Investments Ltd v. Federal Commissioner of Taxation (1938) 12 ALJ 313; [1939] ALR 1; (1938) 5 ATD 36; (1938) 61 CLR 179 (New Zealand Flax) stated the term incurred, does not include a loss or expenditure which is no more than impending, threatened, or expected.  

Barwick CJ in Nilsen Development Laboratories Pty Ltd v. Federal Commissioner of Taxation (1981) 144 CLR 616; (1981) 55 ALJR 97; (1981) 33 ALR 161; (1981) 81 ATC 4031; (1981) 11 ATR 505 (Nilsen Development) cited with approval the decision of Dixon J in New Zealand Flax. Barwick CJ in Nilsen Development provided that an impending, threatened, or expected loss or outgoing is not deductible, no matter how certain it is in the year of income that that loss or expenditure will occur in the future.  

Applying the decision in Nilsen Development to your arrangement, the payment of an amount equal to your 12 months future interest expenses does not mean that you have incurred an expense. The amount is merely an impending, threatened, or expected loss or outgoing.  

Taxation Determination TD 93/188 Income tax: for a balance day adjustment to be deductible under subsection 51(1) of the Income Tax Assessment Act 1936 , is it sufficient for it to be a contingent liability? describes these contingent liabilities as a loss or outgoing that has not crystallised nor 'come home' to the taxpayer in their income year. Contingent liabilities are not deductible as the loss or outgoing has not been incurred at the balance date.

Providing money to entity A equal to your future 12 months interest expense may seem that you are definitely committed and/or completely subjecting yourself to the loss or outgoing as these funds will then be used to pay your interest expense for the next year. However, you do not have a current loan or existing liability to pay entity A. The purpose in giving entity A money is a personal arrangement and does not extinguish your investment loan interest liability for the next 12 months.

At 30 June 20YY, the prepayment of an amount to cover future interest expenses is not an expense incurred. Regardless of how certain you are that interest expenses will arise in the 20YY-ZZ financial year, no deduction is allowable until the amount is incurred. Under your current loan agreement, the interest expenses for the 20YY-ZZ financial year are not yet incurred. 

Similarly if an amount is given to the Bank for the equivalent amount of your future interest liability and they do not acknowledge the amount as a prepayment of interest, then such a payment is not a deductible payment. The Bank will process it as a reduction of capital. Such a payment cannot then be later reclassified and the payment cannot change its nature to become an interest payment.

As you have no definite commitment in terms of being definitely committed or completely subjecting yourself to the loss or outgoing of the 12 months interest before 30 June 20YY, a loss or outgoing for this payment has not been incurred. 

Furthermore, the provision of money to entity A cannot be characterised as a prepayment of a prepaid expense. Paragraph 4 of Taxation Ruling TR 94/25 Income tax: implications of the decision in Coles Myer Finance Ltd v. FC of T for the timing of deductions for prepaid expenses defines a prepayment or a prepaid expense as a payment which extinguishes an existing liability or prevents a liability coming into existence at some time in the future, that is made in respect of goods and services to be provided, in full or in part, on or after the date the payment is made and that the amount paid is on the revenue account.  

Paying entity A the money does not extinguish an existing liability or prevent a liability coming into existence. The interest expenses still remain. The fact that another entity may pay the amount on your behalf in the 20YY-ZZ financial year does not extinguish your liability in the 20XX-YY financial year. When an interest liability arises in the future, the Bank will demand money. It is then when you have a present existing liability to pay the interest expenses under your current loan agreement, that the expense will be incurred. Accordingly the payment to entity A cannot be characterised as a prepayment or a prepaid expense.

Therefore, the forward payment of an amount equal to 12 months future interest expense is not a deductible expense incurred in the 20XX-YY financial year. As such you not are entitled to claim a deduction under section 8-1 of the ITAA 1997 for the prepaid amount in the 20XX-YY financial year.

Section 82KZM of the Income Tax Assessment Act 1936 (ITAA 1936) contains the rules which affect the timing of deductions for certain prepaid expenses. The effect of section 82KZM of the ITAA 1936 is to evenly spread the deduction for prepaid expenses over the years comprising the eligible service period.

As the payment is not an outgoing incurred under your loan agreement and the payment is not an allowable deduction under section 8-1 of the ITAA 1997, the provisions of section 82KZM of the ITAA 1936 do not apply.

In your case, while your specific circumstances are acknowledged, a deduction is not available for the prepaid amount. You have not actually incurred an interest expense. You do not actually have a present existing liability in relation to the interest expense. The fact that funds are being set aside for the payment of interest expenses that will be incurred in the 20YY-ZZ does not convert the funds into a deductible expense. Therefore, no deduction is allowed under section 8-1 of the ITAA 1997.