Edited version of your written advice

Authorisation Number: 1051380617184

Date of advice: 1 June 2018

Ruling

Subject: Deductions for interest expenses

Questions and Answers:

1. Are you entitled to claim a deduction for interest expenses on your Bank A loan which was capitalised in the 20XX to 20XX income years?

Yes.

2. If the Bank A interest is not deductible, can the capitalised interest be claimable as a capital loss?

Not applicable; the interest is deductible.

3. Are you entitled to claim for deduction for the compound interest calculated on the unpaid Bank A interest payments which were capitalised?

Yes.

4. For the 2016 to 2017 income years, is it necessary to apportion the Bank A interest expenses?

No.

5. Can a deduction be claimed for the interest on the Bank B loan which was used to make the lump sum payment to Bank A?

Yes.

6. If deductible, are you required to apportion the Bank B interest expenses?

No.

This ruling applies for the following period(s)

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

Year ended 30 June 2017

The scheme commences on

1 July 2009

Relevant facts and circumstances

In 20XX you purchased an investment with a company.

The purpose of this investment was to give you income and capital growth to help fund your retirement.

You financed the investment with a loan of approximately $X from a finance company.

You did this on the advice of your financial advisor, X Pty Ltd; who have since gone into liquidation.

In a letter from Bank A dated 20XX you were informed that your loan with the finance company was transferred to them.

On 20XX the company was placed into voluntary administration and later went into liquidation.

You paid the interest on the Bank A loan up to 20XX then, acting on the advice of your solicitors, you stopped making loan repayments because the investment company had gone into liquidation.

Subsequently your lawyers commenced a series of class actions on behalf of many investors affected by the collapse of the investment company (investment company Class Action). You were a member of the investment company Class Action.

At this time you were XX years old and still working but would have preferred to retire. But because of the uncertainty of the outcome of your legal action, you continued working (including overtime) putting as much away into your superannuation as you could.

You also continued to serve in the army reserves until you were XX years old.

When you turned XX years old the class action was still unresolved so you gave notice to your employer and retired, still believing you would win the class action.

In 20XX Bank A entered into a Deed of Settlement to conclude the class action brought by investors and this was approved by the court in 20XX. The terms of the settlement confirmed that the loans with the bank were valid and enforceable and that class members were required to meet their obligations under their loans. At this time, your debt had grown from $X to $Y, the result of the unpaid interest being added to the capital with the addition of compound interest calculated on the capitalised interest.

As you were no longer working, you asked Bank A to forgive your loan which they refused. You also offered to settle for $X1 which they also refused. They wanted the loan repaid in full.

The other option, which is what they wanted, as you had no other assets outside superannuation, was to sell your home. However, selling your home would leave you homeless and you would still owe them money.

In 20XX Bank A were threatening legal action so rather than losing your home, you agreed to repay the loan from your superannuation.

In 20XX Bank A demanded an upfront payment of $X toward the repayment of the loan. You borrowed $X from Bank B to pay the sum demanded. The money borrowed was a draw down from a line of credit you have with Bank B. The draw down occurred on 20XX.

You are now paying $X per month from your superannuation. You expect to be doing this for several years.

You have provided copies of the original loan agreement and related bank statements.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 25-25

Taxation Administration Act 1953 Subsection 359-10(3) of Schedule 1

Reasons for Decision

Deductibility of interest payments - general

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a deduction is allowable for expenses incurred in gaining or producing assessable income, provided those expenses are not capital, private or domestic in nature.

A deduction is allowable for interest expenses incurred on loans taken out for the purpose of producing assessable income.

Deductibility of interest payments – the Bank A loan

In your situation you purchased an investment in an investment. The purpose of this investment was to give you income to help fund your retirement. You financed the investment with a loan of $X from a finance company. This loan was subsequently transferred to Bank A.

As the investment was purchased with the intention of deriving assessable income and the interest expenses incurred on your Bank A loan are not capital, private or domestic in nature, you are entitled to claim a deduction for the interest expenses under section 8-1 of ITAA 1997.

You do not need to apportion the interest expenses but you can only claim a deduction for the interest expenses for the income years in which you incurred the expenses. This applies to capitalised interest which was incurred in one income year but not actually paid until a latter income year.

Deductibility of interest payments – the Bank B loan

As part of your settlement with Bank A, you were required to make and a lump sum payment of $X toward the repayment of their loan. To do this, you had to obtain another loan, from Bank B, of $X to meet this requirement. As the $X was used to repay part of the loan to Bank A, the interest expenses incurred on your Bank B loan are not capital, private or domestic in nature and, consequently, you are entitled to claim a deduction for these interest expenses under section 8-1 of ITAA 1997.

You do not need to apportion the interest expenses but you can only claim a deduction for the interest expenses incurred in the income years in which you incurred the expenses.

Compound interest

You made no interest payments on your Bank A loan during the 20XX to 20XX income years for which a deduction is allowed under section 8-1 of the ITAA 1997. The unpaid amounts were capitalised by the Bank and you incurred additional expenses for compound interest the Bank charged for the unpaid interest.

Taxation Determination TD 2008/27 Is the deductibility of compound interest determined according to the same principles as the deductibility of other interest? (TD 2008/27) sets out the ATO’s view on the treatment of compound interest payments. TD 2008/27 states that the principles governing the deductibility of compound interest are the same as those governing the deductibility of ordinary interest, that is, deduction is allowed under section 8-1 of the ITAA 1997 for any loss or outgoing that is incurred in gaining or producing assessable income to the extent that it is not of a private, capital or domestic nature. The character of interest payments is determined by the purpose of the loan which can be determined from the use of the borrowed funds and outgoings of interest ordinarily draw their character from that use.

In your case, you incurred compound interest expenses on the unpaid ordinary interest which had been capitalised. As you are entitled to a deduction for the ordinary interest expenses under section 8(1) of the ITAA 1997, you are also entitled to claim a deduction for the compound interest expenses in the income years in which it was incurred.

Interest incurred after assessable income

The ATO view on this issue is detailed 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, (TR 2004/4).

TR 2004/4 at paragraphs 10 and 11 considers deductions for interest incurred after the cessation of income earning activities (the investment) associated with the loan:

10. Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and relevant income earning activities (whether business or non-business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing ‘the assessable income’ if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

11. Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgment about the nexus between the outgoing and the income earning activities.

Accordingly, you are entitled to deductions under section 8-1 of the ITAA 1997 for the interest expenses on the Bank A loan you used to purchase the investment after the investment became worthless. The same applies to the interest you incur on the second loan you obtained from Bank B as this was used to service the Bank A loan.