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Edited version of your written advice
Authorisation Number: 1051219883065
Date of advice: 3 May 2017
Ruling
Subject: Interest expense on loan
Question 1 and answer
Are you entitled to a deduction for the interest expense incurred on borrowed funds up to the amount of interest income received from a term deposit?
Yes.
This ruling applies for the following periods:
Year ending 30 June 20XX
The scheme commences on:
1 July 20WW
Relevant facts and circumstances
You inherited a property during the 20TT-UU financial year.
Some of your relatives disputed the property inheritance. You paid a settlement amount to your relatives during the 20UU-VV financial year.
The property settled in your name on during the 20UU-VV financial year.
You took out a loan from a bank to finance the settlement payment to your relatives. The loan was split into two equal amount sub loans. The two sub loans were:
● A variable rate loan period beginning during the 20UU-VV financial year
● A 5 year fixed rate loan period ending during the 20YY-20ZZ financial year
You lived at the property from the 20TT-UU financial year until the 20WW-XX financial year.
You sold the property the property during the 20VV-WW financial year.
The property settlement date was during the 20WW-XX financial year.
You immediately paid off the variable rate loan on the property settlement date.
The fixed rate loan was for a fixed five year period. The bank refused to discharge the loan and you are required to keep this loan open until the 20YY-ZZ financial year.
You deposited an amount of money during on the settlement date in a term deposit with the bank to act as substitute security for the fixed loan.
At no point was the loan paid down and then redrawn to open the term deposit. The loan balance did not change upon settlement of the property sale.
You earn interest on the term deposit and incur interest on the loan.
The property did not earn assessable income during the period from you inheriting the property to settlement date.
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, or relate to the earning of exempt income.
Taxation Ruling TR 95/25 deals with the deductions for interest under section 8-1 of the ITAA 1997. Interest is deductible where the expense has a sufficient connection with the gaining or producing or assessable income and it is not of a capital, private or domestic nature.
Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. 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.
In Fletcher and Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 (Fletcher) the Full High Court took the view that if, on consideration of all factors, the whole of the interest could be characterised as genuinely and not colourably incurred in gaining or producing assessable income, the interest would be fully deductible. If only part of the outgoing could be so characterised, apportionment between the pursuit of assessable income and of other objectives was necessary.
In your case, you inherited a property during the 20TT-UU financial year. You took out a loan to settle with your relatives who disputed the property inheritance. The loan amount was split into two equal amount sub loans. One was a 5 year fixed rate loan period ending during the 20YY-ZZ financial year and the other a variable rate loan period beginning during the 20UU-VV financial year. You sold the property during the 20VV-WW financial year and the sale settlement date was during the 20WW-XX financial year. You immediately paid off the variable rate loan on the settlement date. You deposited an amount of money in a term deposit with a bank during the 20WW-XX financial year which is earning interest. You did this as the fixed rate loan was for a 5 year period ending during the 20YY-ZZ financial year and the bank required substitute security for the loan after you sold the property. The interest expense on the fixed rate loan you have incurred is more than the interest income you received from the term deposit.
In your case, your circumstances are consistent with those examined in Fletcher in that the loan has an objective other than the single pursuit of assessable income and that an apportionment of the interest paid on the loan would be appropriate.
A deduction for interest incurred on the borrowed funds subsequently placed in a term deposit account is allowed to the extent of the interest received from the borrowed funds.