Private ruling: Repayment of additional loan balance
Published: November 2013
Ruling period: Year ended 30 June 2013
Date scheme commenced: 1 July 2012

Ruling: Q1: Are you entitled to claim the interest on the total amount of a loan when a portion of the loan was paid out due to an error by a lending authority? | A1: No.

Relevant facts and circumstances: You own an investment property (property A) which was subject to a loan. Another property (property B) which you owned was used as security for the rental property. Property B was sold and the bank required a portion of the sale funds to be used to reduce the loan on property A. You requested that a certain amount be used to reduce the loan on property A. However the bank reduced your loan by a larger amount than the amount you had requested. The lenders later submitted a loan variation to increase the loan on property A. The additional loan amount was placed in a loan offset facility and these additional funds were not used for any investment or business purpose.

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 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. A number of significant 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; The words incurred in gaining or producing assessable income mean in the course of gaining or producing such 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 provides that the deductibility of interest is determined by the use to which the borrowed money is put. The 'use' test, established in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criteria. Where borrowed funds are used for private purposes, such as the acquisition of a home, the interest will not be deductible even if there is a secondary result that other assets are able to be retained for the purpose of producing assessable income. Where a borrowing is used to acquire an income producing asset, the interest on this borrowing is considered to be incurred in the course of producing assessable income. Taxation Ruling TR 2000/2 discusses the deductibility of interest on drawings against a line of credit or redraw facility. It is considered that a repayment to a loan account is a permanent reduction to the debt and any redrawn funds constitute new lending. Where a loan is for mixed purposes, a deduction is only allowed for the portion of the interest which relates to an income producing purpose. In your case, you have an investment loan which was used to fund the acquisition of a rental property. You had money from the sale of another residence deposited into the loan account. Therefore a permanent reduction of the debt has occurred. The subsequent creation of a new loan variation to bring the loan balance up to the original amount for the investment loan does not create full interest deductibility unless all of the funds are used for income producing purposes. Whilst the circumstances of your case produces an unfortunate result, under tax law any portion of a new borrowing that is not made for an income producing purpose would be considered private in nature and a deduction for the associated interest incurred would not be deductible under section 8-1 of the ITAA 1997. In your case, the additional amount of the loan variation was not used for income producing purposes. We acknowledge that the loan was intended to be used solely for your rental property, and the lending authority did not follow your request. However, the fact is that the loan has now been used for mixed purposes. As the funds from your investment loan have been used for personal loans/savings, the Commissioner can only consider what actually occurred rather than what was intended to occur. The Commissioner has no discretion to ignore the previous transactions on your loan account. It is immaterial whether a payment to your investment loan was required by the lender on the sale of your property, or in fact was a genuine error. The Commissioner is not able to take into account an error made by the lending authority when determining whether a deduction is allowable. The legislation applies to what in fact happened rather than what may have been in mind at some earlier point in time. As such you are not entitled to a deduction under section 8-1 of the ITAA 1997 for the interest as calculated on the original amount of the loan. It is accepted that the reduced percentage of the loan is for income producing purposes. Therefore only this relevant percentage of interest on the reduced balance of your loan account will be an allowable deduction from when the permanent reduction in the loan occurred. This includes the period after the new investment loan variation was set up.