Edited version of private advice

Authorisation Number: 1051796338843

Date of advice: 29 January 2021

Ruling

Subject: Rental interest expense

Question

Will the interest on a redrawn amount from the loan with the line of credit be deductible where the redraw amount is used to repay a loan from your family member?

Answer

No

This ruling applies for the following period:

Year ending 30 June 2021

The scheme commences on:

14 August 2020.

Relevant facts and circumstances

You currently own rental properties.

You have an investment loan with a loan balance of an amount.

You also have a loan with a line of credit which has been accessed resulting in a current liability.

You intend on entering a loan agreement with a family member. The loan agreement will be documented, your family member does not intend on charging interest on the loan.

Your intention to establish this loan has been triggered by the loss of employment.

You intend to deposit the loan amount from your family member into your loan with a line of credit, which will reduce the current liability.

At some point in the future, you intend to redraw an amount from your loan with a line of credit to extinguish the loan from your family member.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Summary

The redrawn amount will not be used for an income producing activity or to acquire an income producing asset and therefore interest incurred on the redrawn amount is not an allowable deduction.

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.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

•   it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478),

•   there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

•   it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Taxation Ruling TR 95/25 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.

Where a borrowing is used to acquire an income producing asset or relates to an income producing activity, the interest on this borrowing is considered to be incurred in the course of producing assessable income. Where you redraw available funds from an existing loan, this drawing is considered to be a new borrowing and the nature of this borrowing will be determined by its use (Taxation Ruling TR 2000/2).

The Commissioner regards the redraw as a separate instance of borrowing to the original loan. This rationale is explained in paragraphs 39-43 of Taxation Ruling TR 2000/2. The extra repayments that allow the redraw to occur, are not viewed as a debt due by the lender to the borrower (you). The loan agreement merely gives the borrower a right (subject to restrictions in some cases) to borrow a further amount up to the balance of the loan debt that would have been outstanding if the minimum loan repayments required under the loan had been made. Any extra repayments are used to discharge part of the loan and any redraw is funded by a subsequent increasing of the overall loan. The funds used to make extra repayments simply cease to exist as an asset of the borrower after being used to discharge part of the loan debt. The extra repayments do not create a debt payable by the lender to the borrower and are not an asset of the borrower after they have been used to discharge part of the loan debt.

At paragraph 22 of Taxation Ruling TR 2000/2 the Commissioner states that the deductibility of interest on a further borrowing of money under a redraw facility depends on the use to which the redrawn funds are put. If this is for a non-income producing purpose, then the interest on the redraw amount is not deductible.

In your situation, the deposit of the loaned amount from your family member into your loan with a line of credit is considered a permanent reduction or repayment to that loan. This will reduce the balance owing and will reduce the amount of interest incurred. When you redraw the available funds from your loan with the line of credit, this drawing is considered to be a new borrowing and the nature of this borrowing will be determined by its use.

In the future you intend to redraw an amount from your loan with the line of credit for the purpose of extinguishing the loan made to you by your family member. This new borrowing (the redrawn amount) is not being used to acquire an income producing asset, nor does it relate to an income producing activity. As the redrawn funds are being used for a non-income producing purpose, the interest incurred on the redrawn amount will not be an allowable deduction.