Edited version of private advice

Authorisation Number: 1052262554287

Date of advice: 2 August 2024

Ruling

Subject: Deductions - interest expenses

Question

Are you entitled to a deduction for interest expenses under section 8-1 of the Income Tax Assessment Act 1997, in respect of monies advanced to fund the purchase or refinance of the investment property at the location?

Answer

Yes. To the amount of rental income received for the property during the relevant income year.

This ruling applies for the following:

Year ending 30 June YYYY

Year ending 30 June YYYY

Year ending 30 June YYYY

Year ending 30 June YYYY

The scheme commenced on:

1 July YYYY

Relevant facts and circumstances

You (The taxpayer) are the sole trustee and primary beneficiary of a discretionary trust named 'The Trustee for the Taxpayer Family Trust' (the Family Trust).

The subject of this ruling relates to the deductibility of the interest expense in respect of funds advanced to purchase or refinance the investment property located at the location (the Property).

You are not carrying on a rental property business.

Chronology of events

On DDMMYYYY you entered into a contract to purchase the Property. The purchase price was AU$X. The vendor was an unrelated party and you bought the asset to be a rental property.

On DDMMYYYY, you paid a deposit of AU$X using funds from X (your spouse).

Other costs associated with the purchase of the Property included stamp duty, transfer fees, and adjustments for rates, including council, water and emergency services levies. The credit registration of discharge of mortgage fee was AU$X.

Between DDMMYYYY and DDMMYYYY, your relative (X), transferred AU$X, and your spouse transferred AU$X to be held on behalf of the Family Trust.

Between DDMMYYYY and DDMMYYYY, in your capacity as individual trustee of the Family Trust, you transferred AU$X to your personal bank account in preparation for settlement of the Property.

In addition, the Bank had approved you for an investment loan for the amount of AU$X.

On DDMMYYYY, you took legal possession of the Property after settlement occurred with the vendor. The purchaser's settlement statement totalled to AU$X.

At settlement, the Bank advanced the investment loan amount of AU$X and they registered a mortgage over the Property.

You also advanced the remaining amount of AU$X required for settlement (AU$X), using the funds that had been advanced to you in the days prior.

The Property was immediately rented on commercial terms. On the day prior, DDMMYYYY, your relative signed a fixed term residential tenancy agreement to lease the property for X months for AU$X rent per week.

Between DDMMYYYY and DDMMYYYY, you paid AU$X, AU$X and AU$X (AU$X) to the Bank investment loan to pay the outstanding balance down from AU$X to AU$X.

The Loan Agreement between You and The Trustee for the Taxpayer Family Trust

On or around DDMMYYYY, you entered into a written agreement (the Loan Agreement) with the Family Trust, to finance a loan for AU$X for the full purchase price of the Property as well as other various transaction and related costs associated with the acquisition.

Part of the loan liability related to refinancing almost the entire loan from the Bank to the majority of the loan being from the Family Trust instead.

You signed the Loan Agreement in your capacity as the individual trustee of the Family Trust (the Lender), and in your individual capacity as the purchaser of the Property (the Borrower).

The Family Trust is the lender (the Lender). You are the borrower (the Borrower).

The Loan Agreement with the Family Trust is an interest only unsecured loan over a X year term.

A copy of the Loan Agreement has been provided to us which sets out the following confidential terms between You and the Family Trust:

•                     Interest rate means X% per annum, or the interest rate as notified by the Lender from time to time.

•                     Interest accrues daily. Interest must be paid on or before the last calendar day of each month.

•                     The Borrower must repay the principal to the Lender within X years of the Lender advancing the principal to the Borrower.

You stated that in setting the interest rate of X% per annum on the loan with the Family Trust, regard was had to interest rates on residential loans in the market at the time. You stated that for example, on DDMMYYYY, on the Bank website 'Home Loan Interest Rates' page you identified that its standard variable interest rates on interest only loans with a loan to value ratio of between X% to X% was X% per annum, (comparison rate X% per annum). Regard was also had to the fact that the Bank loans were on a secured basis, whereas the loan from the Family Trust was on an unsecured basis.

Since inception of the loan all interest payments have been made by the last day of each calendar month.

Yearly interest deductions based on an interest only loan of AU$X at X% are AU$X.

Rental income at AU$X per week totals AU$X per annum. Accordingly, deductions exceed income by approximately AU$X per annum.

Source of the investment loan funds

In your capacity as individual trustee of the Family Trust, you borrowed AU$X from a relative at an interest rate of X% for the acquisition of the rental property. No security was provided for this loan.

Remaining funds of approximately AU$X were Family Trust monies which built up over the years in the trusts bank account. You advised us that the Family Trust undertakes several activities to earn income such as business income, income from selling ASX listed securities, trust distribution income and interest income.

The Family Trust was in a position of having significant cash assets to be able to procure funds to lend to you. Your reasons for borrowing from the Family Trust was due to the fact you did not have the borrowing capacity to be able to borrow the full amount from the bank.

Relevant legislative provision

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 your assessable income, except to the extent the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. The ATO view on deductions for interest includes the following statement from Taxation Ruling TR 2000/2 Income tax: deductibility of interest on moneys drawn down under line of credit facilities and redraw facilities:

29. The character of interest is determined by the purpose of the borrowing. Generally, the purpose of a borrowing can be determined from the use of borrowed funds and outgoings of interest ordinarily draw their character from that use (see Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613). It is recognised that it may be appropriate to distinguish between the purpose of the taxpayer in borrowing the money and the use to which the borrowed funds are put in an appropriate case (see Steele v. DC of T 99 ATC 4242, at 4251; (1999) 41 ATR 139, at 150).

30. The term 'use' in this context does not necessarily require a strict tracing approach to the application of the borrowed money (see FC of T v. JD Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494). Rather, the characterisation of interest on borrowed money (and the purpose of the borrowing) is ascertained by reference to the advantages sought from the use of the borrowed funds.

For example, with borrowed funds applied to purchase a rental property, whilst the funds are used to acquire an income producing asset, this does not mean that 'the advantages sought from the use of the borrowed funds' are necessarily always restricted to the objective or 'purpose' of purchasing an income producing asset.

Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings, considers the deductibility and apportionment of losses and outgoings where expenses are incurred for dual purposes. At paragraphs 3, 4 and 6, TR 95/33 states:

3. If an outgoing produces an amount of assessable income greater than the amount of the outgoing, there would normally be no need to examine the taxpayer's subjective thought processes (i.e., motives and intentions) in characterising the outgoing as falling within the first limb of subsection 51(1).

4. However, if the outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is wholly deductible. This may, depending on the circumstances of the particular case, include an examination of the taxpayer's subjective purpose, motive or intention in making the outgoing.

6. If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective, then the outgoing must be apportioned between the pursuit of assessable income and the other objective: see Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 (Fletcher); Ure v. FCT (1981) 11 ATR 484; 81 ATC 4100 (Ure).

An example of the application of this approach is found in Taxation Ruling TR 2002/18 Income tax: home loan unit trust arrangement. Interest deductions are denied or apportioned in an arrangement where rental income is derived indirectly via an interposed related entity from a property in which the taxpayer's family lives. In this situation other objectives or purposes are identified.

In TR 2002/18, paragraph 23 applies the following approach in considering deductibility of interest:

23. As the arrangement is entered into for a number of purposes including, but not limited to:

•                     providing a home for the taxpayer and/or their family;

•                     generating an income tax deduction available to be offset against other income of the taxpayer;

•                     asset protection in the event of litigation and to protect assets in the event of the taxpayer being made bankrupt;

•                     providing for retirement through asset accumulation; and

•                     derivation of income by the trust,

it is necessary to carefully consider all of the circumstances including, the direct and indirect objects and the advantages sought by the taxpayer. The indirect objects may include private or domestic purposes (see Ure v. FC of T 81 ATC 4100 at 4104; (1981) 11 ATR 484 at 488-9) or the manufacturing of a tax deduction (see FC of T v. Ilbery 81 ATC 4661; (1981) 12 ATR 563).

Application of ATO view principles

In your situation the interest on borrowings to purchase an income producing asset has a character of being incurred in the production of income, but indirect 'advantages' need to be considered in regard to ascertaining other 'objectives' or 'purposes'.

As you were both trustee and individual borrower, you entered both loan arrangements as a contracting party. You were a key controlling party in the creation of the arrangement undertaken. The terms of both borrowings were entered into under your control as a contracting party, albeit in different capacities. The incurring of the interest deductions by you in your individual capacity was one element of the arrangement being entered into, as part of the larger arrangement that you entered into.

The arrangement that you entered into had the following outcomes:

•                     You obtained assessable income in the form of rent from a rental property that you own.

•                     You incurred interest expenses where the use of the borrowed funds had been applied for a deductible purpose, being the acquisition of the rental property, and continues to be used to produce assessable income as rent.

•                     Your Family Trust benefited from borrowing money at X% on an unsecured basis and lending it out to you at the higher interest rate of X%.

•                     Your relative earned a return on their loan to the Family Trust at a rate of X% or AU$X per annum.

•                     As part of the arrangement your relative secured accommodation in the Property as a paying tenant at AU$X per week or AU$X per annum.

The net annual cost to your relative in this arrangement is the difference between their yearly rent expense, currently AU$X and the loan interest received from the Family Trust, being AU$X. Your relative benefited by securing accommodation under the terms of this arrangement.

However, the arrangement from their point of view depends on the nature of the loan from them to the Family Trust. Whilst legally there is no recourse for the lender on an unsecured loan, it would be expected that there would necessarily be some agreement or understanding on the nature of this loan. It is reasonable to conclude that the loan is made on an understanding or agreement. It is reasonable to conclude that there is a private aspect to this arrangement. Whether or not the arrangement would continue indefinitely is unknown, but would seem to depend on the nature of the agreement or understanding involved.

The increase of X% charged by the Family Trust over the interest rate they paid to borrow the money from your relative, increases the tax deduction for you. The terms of lending of the money to you and the terms of borrowing by the Family Trust under a different loan are materially similar and provide no commercial reason why the interest rates would differ between the two loans. The terms of your loan are attributable to your relationship with the trustee, being with yourself in a different capacity and the obtaining of a taxation amount.

Application to your circumstances

At the signing of the Loan Agreement on DDMMYYYY, the loan amount was AU$X, with the interest rate being X% per annum on an interest only basis.

In examining 'all the circumstances surrounding the expenditure', being the arrangement that you have entered into in incurring interest expenses, income producing purposes have been identified. However, for section 8-1 deduction purposes, there is both a private purpose or objective and a purpose to obtain a tax deduction.

An appropriate apportionment of deductions methodology is to reduce the deductions for interest to the amount of rental income received for the property in each relevant income year.