Edited version of private advice

Authorisation Number: 1052038937470

Date of advice: 11 October 2022

Ruling

Subject: Rental - deductions - interest

Question

Is the interest expense incurred on Investment Loan C deductible under section 8-1 of the Income Tax Assessment Act 1997?

Answer

No

This private ruling applies for the following period:

Year ended 30 June 20YY

The scheme commences on:

1 July 20YY

Relevant facts and circumstances

You (Taxpayer 1 and Taxpayer 2) obtained an Investment Home Loan (Investment Loan C) for $X on DD MM YYYY from Financier A.

You also obtained a Home Loan for $X on the same day with Financier A.

The loan proceeds from Investment Loan C and the Home Loan were used to pay out a vehicle loan with Financier B for $X. The remaining balance was deposited into your Offset Account.

The Offset Account is linked to your home loan for the purpose of purchasing your home.

You purchased an investment property for $X at location A (Investment Property A). Settlement occurred on DD MM YYYY at which time you commenced using Property A as a rental property.

The Settlement Record provided for Investment Property A shows amounts contributed towards settlement of the purchase of the property.

You withdrew $X from the Offset Account to contribute towards the purchase of Investment Property A.

You have a Financier A Fixed Rate Investment Home Loan (Investment Loan A) for $X secured by Property A. You used the loan proceeds towards the purchase of Investment Property A.

You purchased an investment property for $X at location B (Investment Property B). Settlement occurred on DD MM YYYY.

The Settlement Record provided for Investment Property B shows amounts contributed towards settlement of the purchase of the property.

You withdrew $X from the Offset Account to contribute towards the purchase of Investment Property B.

You have a Financier Fixed Rate Investment Home Loan for $X (Investment Loan B) secured by Property B. You used the loan proceeds towards the purchase of Investment Property B.

Tax Invoices were provided for expenses incurred on Investment Property B. You withdrew amounts from your Offset Account to pay for the expenses

Investment Property B was leased on DD MM YYYY.

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.

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 Income tax: deductions for interest under subsection 51(1) of the Income Tax Assessment Act 1936 following FC of T v. Roberts; FC of T v. Smith provides the Commissioner's view regarding the deductibility of interest expenses. As broadly outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income (paragraph 3(a) and paragraph 21). 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 (paragraph 3(b)).

Taxation Ruling 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities states:

6. The deductibility of interest is typically determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put (Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613, FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52, and Steele v. FC of T 99 ATC 4242; (1999) 41 ATR 139 (Steele)).

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.

Taxation Ruling TR 93/6 Income tax and fringe benefits tax: loan account offset arrangements, outlines the Commissioner's view on loan account offset arrangements which are used to reduce the interest payable on a taxpayer's loan account. TR 93/6 provides that an acceptable loan account offset arrangement with dual accounts operates as follows:

• There are two accounts - a loan account and a deposit account. It is accepted that where the deposit account is a sub-account, it will be treated as a separate account.

• No interest is received on the deposit account.

• The reduction of the loan account interest should be achieved by offsetting the balances of the two accounts.

As highlighted in paragraph 6 of TR 93/6, to be an acceptable offset arrangement for tax purposes, it is essential that there be no entitlement, either in law or in equity, to receive interest payment or payments in the nature of interest on the amounts credited to the deposit account. The only benefit arising in the deposit account should be the right to ensure that the interest payable on the loan account is reduced.

Paragraph 17 of TR 93/6 states if a loan account offset arrangement links a saving account with a loan on which the interest is deductible, the deduction allowable to the customer for the interest cannot exceed the reduced amount of interest (i.e., the interest payable after the offset has been taken into account) actually incurred by the customer.

A taxpayer with an acceptable loan account offset arrangement is entitled to claim a deduction for the amount of interest incurred on the associated loan account, whilst the loan is used wholly for income producing purposes.

Application to your circumstances

You have an Investment Loan (Investment Loan C) with a financial institution. The drawn loan proceeds were deposited into your Offset Account linked to a separate home loan account. You then withdrew funds from your Offset Account to contribute towards the purchase of Investment Property A, Investment Property B and pay for expenses incurred on Investment Property B.

In order to determine the deductibility of the interest expense on Investment Loan C, it is necessary to examine the purpose of the borrowing and where the borrowed funds were put. This is best achieved by considering the attributes of an offset account.

An offset account is a separate account and deposits to and withdrawals from an offset account will not change the character of the interest expense on the associated loan. The offset account is only a facility to reduce the amount of interest, being an outgoing, paid on the associated loan account.

Depositing funds into the offset account will decrease the interest payable on the loan account but will not decrease the balance of the loan. The amount deposited is reflected as an increase in savings.

Conversely withdrawing funds from an offset account will increase the interest payable on the loan account but will not increase the balance of the loan and is not a borrowing. The money withdrawn from the offset account is not in the form of borrowings and will not incur any interest. The amount withdrawn is reflected as a reduction in your savings. Any use to which these funds are put (including an income producing purpose) is funded by your savings and not a new loan.

In your case, the Offset Account is linked to your home loan. Your Offset Account is a separate account and deposits to and withdrawals from the Offset Account will not change the character of the interest expense on your home loan. The Offset Account is only a facility to reduce the amount of interest you pay on your home loan.

Investment Loan C proceeds deposited into your Offset Account do not reduce the principal amount owing on your home loan. Conversely, the amounts withdrawn from your Offset Account increase the net interest incurred on your home loan and do not increase the principal amount owing.

The purpose of depositing funds into an Offset Account is to reduce the amount of interest owed on your home loan account. An expense incurred, being interest on Investment Loan C, to reduce the net interest expense on the home loan is not considered to be incurred in gaining or producing assessable income.

Having regard to all your circumstances, we do not consider there is nexus between incurring the interest expense on Investment Loan C to gaining assessable rental income on Property A and Property B. Incurring the interest expense is considered one step removed from earning rental income. Therefore the interest expense is not an allowable deduction under section 8-1 of the ITAA 1997.