Private ruling: Deductions for interest
Date of advice: 29 January 2021
Published: March 2021
Ruling period: Year ending 30 June 2021 | Year ending 30 June 2022 | Year ending 30 June 2023 | Year ending 30 June 2024
Date scheme commenced: 1 July 2020

Ruling: Q1: Is a deduction allowable for interest payments, either in whole or in part, made to a related individual? | A1: No

Relevant facts and circumstances: You took out X separate loans with Financial Institution. You provided a loan contract (Loan Offer) from the Financial Institution dated XX/XX/XXXX. The Loan Offer, for an overall loan amount totalling $XXX,XXX consists of X investment loans and X home loans. The Additional information section of the Loan Offer indicates you can utilise a redraw facility. Clause xx provides where you have accessed your loan and you pay more than the scheduled payments, the extra amounts become available funds you can redraw in your loan account. There are eligibility criteria and redraw conditions. Once such condition says you will be charged interest on any amount that you redraw because it will increase your loan account balance. You also have the option to reduce interest charged on your investment loan with an offset account. Clause xx of the Additional information section indicates an offset account must be in the same name(s) as your loan account. The Financial Institution will subtract the credit balance of your offset account from your loan account balance when interest is calculated at the end of each day. When your offset account credit balance is greater than your loan account balance, the two will be treated as being equal. You will not earn interest on any credit balance you have in your offset account. You also borrowed money from a related entity (Related Entity Loan). The loan funds were deposited in an offset account in your name. The offset account is linked to the investment loans with the Financial Institution. You provided an unsigned loan agreement (Loan Agreement) dated XX/XX/XXXX for the Related Entity Loan. You provided a Statement of recent transactions from the Financial Institution. The statement is for an offset account linked to the Investment Loans. The account is solely in your name. You provided a Statement of recent transactions from the Financial Institution. The statement is for Investment Loan. The account is solely in your name.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1

Reasons for decision: Summary: 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 Financial Institution used wholly for the purchase of an investment property. The investment loan is linked to a separate 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 took out a Related Entity Loan. In order 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. Please note that 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 the Related Entity Loan 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 Related Entity 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 would not be deductible to the extent that the expense is private in nature. Therefore, consideration must also be given to the commerciality of the Related Entity Loan. 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 various issues in determining the deductibility of losses and outgoings. Where a person borrows money from a related entity, a deduction for any interest expense incurred will only be allowed where the money is borrowed on a commercial basis. The test that should be considered to show whether the arrangement is at arm's length, is whether a reasonable person with no relationship to either party would enter into this arrangement using the same terms and conditions. If the answer is yes, then it would be an arm's length and commercial arrangement. After reviewing the terms and conditions of the Loan Agreement it is not considered that you would be able to enter such an arrangement for a loan amount of $XXX,XXXX.XX with an unrelated party. Having regard to all your circumstances, it is not considered that the Related Entity Loan has been made on a commercial basis. Rather it is considered that the loan is largely private in nature. Therefore, no deduction for the interest paid on the Related Entity Loan is allowable under section 8-1 of the ITAA 1997 as the expense was not incurred in gaining or producing assessable income and is private in nature. | Detailed Reasoning - Other information: It is noted that you asked for the private ruling from year ending 2021 and into future. The Commissioner does not rule for indefinite or extended periods as there may be changes to the facts of the arrangement or the law in question. Also, a public ruling may issue which affects the private ruling. Therefore, we have only ruled for the 2020-21 to 2023-24 income years.