Edited version of private advice

Authorisation Number: 1052145604995

Date of advice: 2 August 2023

Ruling

Subject: Interest deductions

Question

Are you entitled to a full deduction on the interest payable on your investment home loan if you used a redraw for private expenses?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

You have an investment home loan (Loan).

There are two offsets connected to the Loan, Offset A and Offset B.

Offset B is the account used for a mixture of private and investment purposes.

You transferred an amount from Offset A to your Loan. Your Loan has a redraw facility.

You used a redraw to take the amount from the Loan and transfer it to Offset B. You then used an amount in Offset B for personal expenses.

You advised that the initial transfer of the amount to your Loan was an accident.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Section 8-1 of the Income Taxation 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 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 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.

This use is also not altered in the case of a refinance. Paragraph 42 of TR 95/25 addresses borrowings used to repay an existing loan. The paragraph states "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 or used in a business activity which is defined to the production of assessable income (Roberts and Smith ATC at 4388; ATR at 504).

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. If this is for a non-income producing purpose, then the interest on the redraw amount is not deductible. The redraw facilities referred to in Taxation Ruling TR 2000/2 is where a borrower redraws previous repayments of the loan principal in a loan account.

Application to your circumstances

In your current situation, you have an investment home loan (Loan) that was used solely for the purchase of your investment property. As the Loan was used only for income producing purposes the associated interest expenses were an allowable deduction. The Loan has a redraw facility whereby any additional payments on top of the monthly repayment obligations could be redrawn.

When you transferred the amount from Offset A into your Loan, this reduced the balance owing of the Loan and reduced the amount of interest incurred. However, when you then used a redraw facility to take out the amount from the Loan to transfer into Offset B, this is considered a separate borrowing. As you used the redrawn funds wholly for non-income producing purposes, that part of the accrued interest attributable to the redrawn funds is not deductible as it was used for private expenses.

That is, as you used the redraw from the Loan for private expenses (non-income producing purposes), you also used the redrawn funds for a different purpose to the original borrowing, that being for the investment property. As per paragraph 25 of TR 2000/2, the Loan becomes a mixed purpose account and there is an ongoing need to apportion interest whereby any subsequent repayments are apportioned between the outstanding debt used at that time for incoming producing and non-income producing purposes. You cannot repay only the portion of the loan related to the private expenses as per paragraph 44 of TR 2000/2 - any repayments of the loan are apportioned across both income and non-income producing purposes.

While it may be relevant to examine the purposes of borrowing, this does not extend to examining whether a transfer was accidental or whether you were aware of the tax implications after making that borrowing.

Having considered your circumstances, you are not entitled to a full deduction on interest expenses of your Loan and you are required to apportion the interest expenses under section 8-1 of the ITAA 1997. The method of calculations for the apportionment going forward are prescribed in TR 2000/2 at paragraph 20. You can also go to our website ato.gov.au and type in QC 23635 into the search for more information.