Edited version of private advice

Authorisation Number: 1052103070022

Date of advice: 14 April 2023

Ruling

Subject: Deductions - interest

Question 1

Is the interest you pay your parents deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA)?

Answer

No. The outgoing does not have sufficient connection to gaining or producing assessable income. The essential character of the expense is private in nature.

Question 2

If you use the money borrowed from your parents, to pay out the investment loan will the interest the be deductible?

Answer

Yes. Interest on a new loan will be deductible if the new loan is used to repay an existing loan which, at the time of the second borrowing, was being used in an assessable income producing activity

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You borrowed money from the Bank to purchase a rental property.

You have been claiming interest on the loan as a tax deduction against the rental income of the investment property.

Some time later you borrowed money from your parents and you have a written loan agreement in place. The interest paid on the loan is commensurate with commercial rates of interest.

You placed this money into the 100% offset account attached to the loan for the investment property.

You provided a Statement of the Offset Account from the Bank. The account is solely in your name and it shows:

•         The account number

•         The period of the statement

•         The current balance

•         Transactions including monthly debit amounts.

You provided a Statement of recent transactions from the Bank for the investment account. The statement is for you and has the property address listed as Security Address. The account is solely in your name and it shows;

•         The account number

•         The period of the statement

•         The current balance

•         Transactions including monthly deposits and interest charged.

You have started to make monthly repayments to your parents under the loan agreement.

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 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith 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.

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.

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

In your case, you have an investment loan with the Bank used wholly for the purchase of an investment property. The investment loan is linked to an offset account. You will not earn interest on any credit balance you have in your offset account and funds kept in the offset account will reduce the amount of interest you pay on your investment loan balance.

As the investment loan is wholly used for income producing purposes, and there is an acceptable loan offset account arrangement in place, the associated interest expense on the investment loan is an allowable deduction. However, the property must be rented, or genuinely available for rent, in the income year for which you claim a deduction.

You also made a loan agreement with your parents. To determine the deductibility of the associated interest expense, it is necessary to examine the purpose of the borrowing (to reduce interest expense on an investment loan) and where the borrowed funds were put (deposited in an offset account). This is best achieved by considering the attributes of an offset account and comparing these to a redraw facility.

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 money drawn down under line of credit facilities and loans offering redraw facilities.

The ruling establishes drawing any excess or available funds from a loan account is treated as a new loan. As such the purpose or use of the drawing is relevant. That is, the deductible portion of interest when further borrowings are made depends on the use to which the redrawn funds are put. This is independent of the purpose of the original borrowing. The redraw facilities referred to in TR 2000/2 is where a borrower redraws previous repayments of the loan principal in a loan account.

Where a person uses the redrawn funds for different purposes then the loan account becomes a mixed purpose account. In a mixed purpose loan, the interest must be apportioned between the income producing and non-income producing purposes. The part of the accrued interest attributable to the funds used for private purposes is not deductible.

The principles of TR 2000/2 apply to a loan account and not a deposit account. That is, a redraw from an offset account has no effect on the allowable portion of interest for a loan account. A withdrawal from an offset account is not a borrowing or a loan and therefore the use of the funds from an offset account is not relevant for tax purposes. That is, a redraw from an offset account is not a redraw from a loan account as discussed in TR 2000/2.

As highlighted in paragraph 40 of TR 2000/2, the redraw facility does not involve separate loan and deposit accounts as discussed in TR 93/6. Therefore, in your situation, depositing funds into the offset account will decrease the interest payable on the investment loan, but will not decrease the balance of the investment loan. The amount deposited is reflected as an increase in your savings.

Conversely, withdrawing funds from the offset account will increase the interest payable on the investment loan, but will not increase the balance of the investment loan. 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. Consequently, any use to which these funds are put (including an income producing purpose) is funded by your savings and not a new 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 the investment loan. The offset account is only a facility to reduce the amount of interest, being an outgoing, you pay on your investment loan.

In your case the borrowed funds from your parents were deposited into your offset account for the sole purpose of reducing the amount of interest owed on the existing investment loan. An expense incurred, being interest on the loan, to reduce an outgoing is not considered to be incurred in gaining or producing assessable income.

Under Section 8-1 of the ITAA 1997, interest is not deductible to the extent that the expense is private in nature.

The circumstance of borrowing money to pay out an existing loan is considered in TR 95/25 at paragraph 42. Where a second loan is taken to pay out an existing loan, interest on the second loan will be deductible where the existing loan was used for income producing purposes.

If you use the funds borrowed from your parents to pay out the existing loan the interest will be deductible to the extent that the existing loan was being used for income producing purposes.