Edited version of your written advice

Authorisation Number: 1051204834458

Date of Advice: 23 March 2017

Ruling

Subject: Loan interest deductibility

Question

Are you entitled to a deduction for any interest following the withdrawal of money from your offset account to purchase a rental property?

Answer

No

This ruling applies for the following period

Year ended 30 June 2017

The scheme commenced on

1 July 2016

Relevant facts

You purchased your main residence and borrowed from the bank toward this. You have a mortgage. You also have an offset account in which you deposited the same amount as that owing on your main residence loan, which effectively meant you paid no interest on the loan for your main residence.

You later withdrew an amount from the offset account to purchase a rental property.

The balance of the loan for your main residence was still the original amount, and the offset account balance was reduced by the amount withdrawn to purchase the rental property.

You are now paying interest on the mortgage account for your main residence.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

You are not entitled to a deduction for any interest when you purchase an income producing asset from your offset account.

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.

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, 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 income is to be derived, the interest incurred on the loan will be deductible. However, where a loan relates to private purposes, no deduction is allowed.

In your case you borrowed money to purchase your home. The associated interest expense incurred for your home loan is not an allowable deduction.

You have since used your offset account to purchase a rental property.

In your case, the original loan relates to your home. As the original home loan is not used for income producing purposes, the associated interest expense is not an allowable deduction and is private in nature.

Depositing funds into the deposit account or offset will decrease the interest payable on the loan account but will not decrease the balance of the loan account.

Withdrawing funds from the deposit account will increase the interest payable on the loan account but will not increase the balance of the loan account.

In your case, as you have an offset account as well as your loan account, the loan account will operate in conjunction with the deposit account. Any credit balance of your deposit account will reduce the interest payable on your loan account.

The use of the funds in the deposit account does not alter the deductibility of the interest on the loan account. That is, where the deposits come from or whether the money from the offset account is used for private or income producing purposes does not increase or decrease the portion of interest expenses that may be deductible.

When you withdrew funds from your offset account, the interest payable on your loan increased. The fact that the funds were used to purchase a rental property does not convert the interest payable on your original home loan into a deductible expense.

In withdrawing money from your offset account, you have not actually increased your loan principal, borrowed any additional funds, or incurred any interest expense.

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. Generally, a taxpayer incurs an expense at the time they owe a present money debt that they cannot escape.

The guidelines developed by the courts that help to determine if an expense has been incurred include:

There must be a presently existing liability to pay a pecuniary sum,

Presently existing liability is determined on the circumstances of the case,

An expense is incurred when actually paid if there was no presently existing liability.

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.

In your case, while it is accepted that the amount in your offset account is reduced and the interest expense on your home loan is increased, a deduction is not available for the notional expense relating to the withdrawn amounts. As your offset account was in credit and you did not actually pay any associated interest, you have not actually incurred an interest expense. You do not actually have a liability in relation to the funds withdrawn from your offset account. Therefore, no deduction is allowed under section 8-1 of the ITAA 1997.

Taxation Ruling TR 2000/2 Income tax: deductibility of interest on moneys drawn down under line of credit facilities and redraw facilities considers the deductibility of interest incurred by borrowers on money drawn down under line of credit facilities and loans offering redraw facilities. Although your account is not a line of credit account, the principles in this ruling are relevant.

The ruling establishes drawing any excess or available funds from a loan account is treated as a new loan. As such the purpose or use of the drawing is relevant. That is, the deductible portion of interest when further borrowings are made depends on the use to which the redrawn funds are put. The redraw facility referred to in TR 2000/2 is where a borrower redraws previous repayments of the loan principal in a loan account.

Please note that the principles of TR 2000/2 apply to a loan account and not a deposit account. That is, a redraw from an offset account has no effect on the allowable portion of interest for a loan account. A withdrawal from an offset account is not a borrowing or a loan and therefore the use of the funds from an offset account is not relevant for tax purposes. That is, a redraw from an offset account is not a redraw from a loan account as discussed in TR 2000/2.

As highlighted in paragraph 40 of TR 2000/2, the redraw facility does not involve separate loan and deposit accounts as discussed in TR 93/6 Loan account offset arrangements.

That is, the offset account is a separate account and does not form part of the loan account or loan facility. A payment or deposit into the offset account is not a repayment of principal on the loan account.