ATO ID 2013/44: Assessable income: interest income of money lender
Date of decision: 26 April 2013
Year of income: Year ending 30 June 2008
Business line: Private Groups and High Wealth Individuals

Issue
Has a taxpayer who carries on a business of money lending derived, under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997), interest from a loan calculated on a daily accrual basis that was returned as assessable income in an earlier income year if the taxpayer subsequently recognises that at a point in time in the earlier income year it should have stopped accruing interest on that particular loan?

Decision
No. The taxpayer did not derive interest from that particular loan under section 6-5 of the ITAA 1997 from the time in that earlier income year that it made a bona fide assessment based on sound commercial considerations that there was little or no likelihood that the accrued interest would be received. The taxpayer should have stopped accounting for interest on a daily accruals basis in respect of that particular loan.

Facts
The taxpayer carries on a business of money lending. The taxpayer routinely takes registered mortgages over real property as security. The taxpayer is a 'financial institution' within the meaning of that term as used in Taxation Ruling TR 93/27 Income tax: basis of assessment of interest derived and incurred by financial institutions . The taxpayer uses the straight-line daily accruals method to include interest income derived on money lent in its assessable income. The taxpayer is not required to, and does not report impaired assets to the Reserve Bank of Australia. In accordance with the relevant State legislation, on 1 August 2006 the taxpayer issued a formal written notice of default of mortgage demanding payment of the outstanding principal and interest by the loan debtor in respect of a particular loan (the loan). The notice allowed the taxpayer to take possession of the real property mortgaged (the security) and exercise its power of sale in default of these payments. Subsequently the taxpayer took possession and obtained judgment in the State's Supreme Court for the outstanding debt. At the time the formal written notice of default was issued in respect of the loan the market value of the security was insufficient to cover the outstanding debt including accrued interest. The taxpayer's commercial books of account for the 2007 income year showed that the taxpayer recorded accrued interest in respect of the loan for the entire income year and also recorded impairment expenses, with the loan having a negative net effect on the taxpayer's profit and loss for the year. In its income tax return for the 2007 income year the taxpayer included the interest accrued in the entire year in respect of the loan in their assessable income and a notice of assessment issued on this basis. In fact no principal or interest was received by the taxpayer in respect of the loan in the 2007 income year. At a subsequent date within the amendment period for the taxpayer, it recognised that it should not have included the interest accrued in the entire year in respect of the loan in their assessable income for the 2007 income year and that instead it should have accounted for interest income on a cash receipts basis from the time it issued the formal written notice of default.

Reasons for decision
Summary: Under section 6-5 of the ITAA 1997, taxpayers must include in assessable income their ordinary income as it is derived. According to paragraph 47 of Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings , the general principle is that interest is only derived, or arises, when it is received or credited. Exceptions to this general rule include: According to paragraph 8 of TR 93/27, the adoption of straight-line daily accruals as the basis of tax accounting for interest derived and incurred results in 'a substantially correct reflex' of the taxable income of a financial institution. In this case, the taxpayer uses the straight-line daily accruals method to include interest income on money lent in its assessable income. When a financial institution makes a bona fide assessment based on sound commercial considerations that there is little or no likelihood that the accrued interest will be received, the Commissioner accepts that for income tax purposes a loan can be classified as a 'non-accrual loan'. Any interest accruing thereafter will not be derived for income tax purposes until it is actually received (see paragraph 5 of Taxation Ruling TR 94/32 Income tax: non-accrual loans ). When, at a later point in time, there is an examination of whether such an assessment based on sound commercial considerations was made, only the facts and evidence in existence at the time of the assessment can be taken into account. In this case there are a number of indicators that support that such an assessment was made in respect of the loan, including: It is considered that the above indicators are sufficient evidence that when the taxpayer issued a formal written notice of default on 1 August 2006, the taxpayer had made a bona fide assessment in respect of the loan based on sound commercial considerations that there was little or no likelihood that the accrued interest would be received. Notwithstanding the evidence that the taxpayer had made such a bona fide assessment, the taxpayer included in its 2007 income tax return as assessable income interest accrued from 1 August 2006 to 30 June 2007 in respect of the loan. It is considered that the taxpayer erred in this regard. In this case the taxpayer did not receive any interest in respect of the loan in the period 1 August 2006 to 30 June 2007. It is considered that the amount of the interest accrued during this period included in the taxpayer's assessable income was not derived in that year. Accordingly, provided an amendment is made within the relevant period of review, the taxpayer's assessable income can be reduced by the amount of the interest accrued in respect of the loan that the taxpayer had not derived in that year of income. Note: From 1 July 2010 (or from 1 July 2009 if the taxpayer so elects) the provisions in Division 230 of the ITAA 1997 may apply instead of the principles set out in this interpretative decision .

Legislative references: Income Tax Assessment Act 1997 section 6-5
Related public rulings and determinations: TR 93/27 | TR 98/1 | TR 94/32
Subject references: accrued interest interest income financial institutions money lending by financial institutions