Edited version of private advice

Authorisation Number: 1051868018763

Date of advice: 23 July 2021

Ruling

Subject: Deductions - interest

Question

Are you entitled to claim a full deduction for the interest incurred in relation to the Original Loan under section 8-1 of the Income Tax Assessment Act 1997 from the date Loan X was drawn down?

Answer

No.

This ruling applies for the following periods:

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

Income year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You purchased a property (the Property) for the purpose of demolishing the existing house and constructing several units.

To finance the purchase and development of the Property you used the following bank loans:

•        A portfolio loan; and

•        The Original Loan, which had an offset account attached (Offset Account).

Development on the Property commenced during the following year after the property was purchased with the constructions of the units being completed during the following year. The units have been rented out continuously since their construction until 30 June 20XX.

After several years you purchased another property, being Property A, which you moved into and it has continued to be your main residence until the present time.

The balance of the purchase cost of Property A was added to Original Loan, increasing your total borrowings in relation to that account.

Around that time another loan was created, being Loan X. No amount was drawn from this account for several years as outlined below.

You owned another property, Property B, on which there was no debt or mortgage. You sold this property and used the sale proceeds to reduce your debt as follows:

•        Portfolio loan - paid out in full, with nil balance

•        Original Loan - paid down to (total amount owed); and

•        Offset account - standing at (total amount deposited).

The Original Loan is interest only with interest being paid in full each month as it is charged.

The Original Loan became a mixed purpose loan in the income year in which the balance of the purchase price for Property A was added to the loan and you have calculated that it was made up of the following portions at that time:

•        Less than 50% - Investment properties; and

•        More than 50% - Private portion.

You claimed deductions for all interest and bank charges arising in relation to the Original Loan in accordance with the above percentages.

The balance owing on the Original Loan was reduced after a period, as you decided to restructure your bank loans to separate the deductible investment portion of the loans from your personal non-deductible portion, with the aim of paying down the private portion and better utilising the cash held in the offset account.

You instructed the bank to create two new loans, with one for the investment properties and the other for your private property with an attached offset account, with all of the available funds to be deposited in the account linked to the Original Loan. The purpose was to create separate loans to pay down the Original Loan quicker. However, the bank did not follow your instructions and two new loans were not created.

Around that time Loan X was drawn down with an amount being transferred into the Original Loan to reduce the amount owing on that account.

You also set up a second Offset Account linked to Loan X and transferred funds into it from the other Offset Account. No interest was charged in relation to Loan X as you had sufficient funds in the Offset Account to cover the entire loan balance.

You consider that the amount transferred into the Original Loan from Loan X was more than the private portion of the Original Loan calculated at the time of the transfer.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Interest deductions

Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) to the extent that it is not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances.

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 moneys drawn down under line of credit facilities and moneys redrawn under other loans offering redraw facilities. It considers the operation of section 8-1 of the ITAA 1997 (formerly subsection 51(1) of the Income Tax Assessment Act 1936) where the borrowed money has been applied for both income producing and non-income producing purposes.

TR 2000/2 contains the following paragraphs and example:

Line of credit facilities

12. Where a line of credit facility is divided into sub-accounts and each sub-account is used for a specific purpose, interest is fully deductible where funds drawn down on an investment sub-account continue to be used exclusively for an income producing purpose. Interest is not deductible where funds drawn down on a private sub-account are used for a non-income producing purpose.

15. Where a taxpayer has a mixed purpose sub-account, the interest needs to be apportioned between the income producing and non-income producing purposes. Apportionment must be made on a fair and reasonable basis at has accrued on a daily basis on a mixed purpose account is set out in the following paragraphs. We accept that this approach to apportionment is not the only approach that is fair and reasonable.

16. Where interest accrues daily under a mixed purpose sub-account, a taxpayer is entitled to a deduction in respect of that part of the interest that has accrued on the portion of the outstanding daily loan balance attributable to an income producing purpose. In calculating the portion of the outstanding daily loan balance attributable to an income producing purpose, any repayment of principal is applied proportionately against the outstanding balance of amounts applied to income producing and non-income producing purposes respectively, at the time the repayment is made. However, there are two exceptions.

Second Exception - Refinancing mixed purpose debt

18. A taxpayer may choose to refinance a debt outstanding on a mixed purpose sub-account by borrowing an equivalent amount under two separate accounts or sub-accounts. If the sums borrowed under those two separate accounts are equivalent to the respective income producing and non-income producing parts of the existing outstanding debt, we accept that interest accrued on the debt incurred in refinancing the income producing portion of the mixed purpose debt will be deductible.

Apportionment calculations

19. Where interest on borrowed money accrues daily, we accept that it would be unnecessarily onerous to require a manual daily apportionment calculation. We accept that the interest accrued in a month is deductible under section 8-1 where it is calculated using an apportionment approach based on the average outstanding principal used that month for income producing purposes.

Redraw facilities

22. The deductibility of interest on a further borrowing of money under a redraw facility depends upon the use to which the redrawn funds are put.

23. Where the original borrowing is for non-income producing purposes and the taxpayer uses the redrawn funds wholly or partly for income producing purposes, that part of the accrued interest attributable to the redrawn funds used for income producing purposes is deductible.

24. Similarly, where the original borrowing is for income producing purposes and the taxpayer uses the redrawn funds wholly or partly for non-income producing purposes, that part of the accrued interest attributable to the redrawn funds used for non-income producing purposes is not deductible.

25. Where a taxpayer uses redrawn funds for a different purpose to the original borrowing in circumstances described in paragraphs 23 or 24, the loan account becomes a mixed purpose account and the same principles discussed above in relation to mixed purpose line of credit sub-accounts will apply to the mixed purpose loan account. There is an ongoing need to apportion interest on a mixed purpose loan account. That apportionment needs to be made on a fair and reasonable basis. Subsequent repayments are apportioned between the outstanding debt used at that time for income producing and non-income producing purposes. However, the two exceptions for borrowed money recouped and repaid and for the refinancing of a mixed purpose debt, discussed above at paragraphs 17 and 18 in relation to mixed purpose line of credit sub-accounts, are equally applicable to mixed purpose loan accounts.

Second Exception - Refinancing mixed purpose debt

46. A taxpayer may choose to refinance a mixed purpose debt by borrowing an equivalent amount under two separate accounts or sub-accounts. Where a mixed purpose line of credit sub-account debt is replaced by two new debts and the advantage sought by these borrowings is the refinancing of the respective parts of the previous debt used at that time for income producing and non-income producing purposes, we consider that a strict tracing approach is not appropriate. It is relevant to bear in mind the comments of Dixon CJ. in Hallstroms Pty. Ltd. v. FC of T (1946) 72 CLR 634, cited with approval by Hill J in FC of T v. JD Roberts; FC of T v. Smith 92 ATC 4380, at 4391; (1992) 23 ATR 494, at 507, that the question of characterisation depends on:

... what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of legal rights...

47. The sole purpose of the borrowing used to refinance money used at that time for income producing purposes is to continue to have the use of those funds for income producing purposes. Similarly, the sole purpose of the borrowing used to refinance money used at that time for non-income producing purposes is to continue to have the use of those funds for non-income producing purposes. Therefore, we accept that interest accrued on the debt incurred in refinancing the income related portion of the previous mixed purpose debt will be deductible.

Example three

65. Rod has a mixed purpose line of credit debt comprising $5,000 used for investments in income producing shares and $5,000 used for holidays. Rod refinances the income producing and non-income producing components of this mixed purpose debt with borrowings under two new line of credit sub-accounts. The interest accrued on the line of credit sub-account used solely to refinance the borrowed money used for investments in income producing shares will be fully deductible. The interest accrued on the line of credit sub-account used solely to refinance the borrowed money used for holidays will not be deductible.

It is important to note that the concession provided by the second exception applies only to the new loans and that the existing mixed purpose loan has to be extinguished. The principle expressed in paragraph 16 will apply if the existing mixed purpose loan is only partly repaid.

Application to your situation

You used the Original Loan to partially fund the purchase of the Property for the purpose of developing it and constructing several units to be used for rental purposes. The remainder of the funding for those activities was funded by your portfolio loan.

You purchased Property A several years after you had purchased the Property, which has continued to be your main residence since the property was purchased until the present time. Part of the purchase price for this property was added to the Original Loan, increasing the total borrowings for that loan.

Around the same time, you obtained another loan, being Loan X, that you did not draw down from for several years as outlined below.

You used some of the proceeds from the sale of Property B to pay down the balance of the Original Loan.

You decided to restructure your bank loans to separate the deductible and non-deductible portions of the Original Loan and had instructed your bank to create two new loans. However, the bank did not follow your instructions and the two new loans were not created.

Around that time Loan was drawn down with an amount being transferred into the Original Loan, reducing the balance of the Original Loan.

You are seeking a ruling decision in relation to the deductibility of the interest charged in relation to the Original Loan which had been used to earn rental income from a date earlier than the date Loan X was drawn down. However, nothing has been provided to support that the date you have suggested is the correct date that the split had occurred given that the amount was not transferred from Loan X into the Original Loan until after that date. Therefore, it is viewed that the date Loan X had been drawn down is the relevant date given that this is the date that the relevant amount was transferred into the Original Loan.

You estimated that less than 50% of the Original Loan related to your investment properties with the remaining percentage relating to your private portion. It is stated that an amount higher than the calculated private portion had been transferred from Loan X into the Original Loan.

While it is stated that your intention was to obtain two new loans, and that you had instructed the bank to create them, that had not occurred and you had used Loan X which had been created several years prior to the draw down to transfer an amount from into the Original Loan.

As outlined in TR 2000/2, you needed to have created two separate loans, or sub-accounts, to account for the deductible and non-deductible portions of the Original Loan so that each of their purposes was clearly identifiable as being deductible or non-deductible, and to have used those two loans to pay off the Original Loan. However, that had not occurred in your situation and you have not met requirements to separate the mixed loan into two separate accounts in respect of the deductible and non-deductible portions of the Original Loan.

Reference has been made to Product Ruling PR 2013/22 Income tax: tax consequences for a borrower under a mortgage reduction program managed by Allstate Home Loans and it is stated that it was your intention to duplicate the arrangement deemed acceptable in that ruling.

PR 2013/22 relates to a specified scheme designed to accelerate the repayment of a refinanced home loan that was managed by Allstate Home Loans. The Product Ruling does not address the deductibility of interest incurred by the borrower in relation to the investment loan under section 8-1 of the ITAA 1997 with the ruling decision considering whether Part IVA of the Income Tax Assessment Act 1936 would apply to the benefit provided by the scheme.

Subparagraph 19(a) of the Product Ruling outlines that each of the borrowers had a residential home loan for their main residence and an investment loan used to fund the acquisition of an assessable income producing asset prior to the scheme commencing. Under the scheme the borrowers could refinance both loans with the new loans retaining the same nature of the loans held prior to the refinancing. Therefore, the borrowers already had two loans that were identifiable as either deductible or non-deductible, and the two new loans acquired as a result of the refinancing retained the same nature of the individual loan they were obtained to refinance.

The scheme as outlined in the Product Ruling is very different to your situation and it cannot be viewed that the Product Ruling is applicable when making a decision in this ruling as it does not consider the application of section 8-1 of the ITAA 1997, the issue being considered in this ruling. Therefore, it is not viewed that the Product Ruling is applicable to your situation.

Therefore, after reviewing the facts of your situation and considering the principles contained in TR 2000/2, it has been determined that you are not entitled to claim a full deduction for the interest amounts incurred in relation to the Original Loan under section 8-1 of the ITAA 1997 from the date Loan X was drawn down. It is not accepted that the nature of Original Loan has changed from being a mixed loan as you have not undertaken activities as provided in TR 2000/2 to unmix the Original Loan.

However, you will be eligible to claim a deduction for the interest amounts that are attributable to the portion of the total Original Loan interest amounts arising in relation to your investment properties.