Private ruling: Interest expenses
Date of advice: 31 August 2015
Published: August 2015
Ruling period: Year ended 30 June 2015 | Year ended 30 June 2016 | Year ended 30 June 2017
Date scheme commenced: 1 July 2014

Ruling: Q1: Are you entitled to an interest deduction on a loan where you have used part of the loan to purchase shares and used the remainder to refinance previous loans on rental properties? | A1: Yes.

Relevant facts and circumstances: You invested in a number of residential properties with the intention of deriving profit from rent received. You sold these properties, some at a loss, and applied the proceeds of the sales against the loans for these properties, but you did not have sufficient funds to pay out the principal of the loan. You refinanced and entered into a new loan agreement to pay out the original loans and to purchase shares. You planned to pay the loan principal with gains that you expect from your shares. Since refinancing, you have not had any significant funds available that you could have applied in repayment of the loan principal. The loan agreement has provision to make lump sum payments off the principal of the loan. You have commitments in servicing your home loan and paying the investment loan interest payments. This means you are unable to pay out the existing loan. All dividends from the share portfolio are used to cover the costs of the loan for the shares and fees associated with the managed fund. You have a small number of Australian shares. You have a small amount of money in one bank account which is used for your living expenses. Your financial situation has deteriorated as your spouse now has a limited earning capacity.

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

Reasons for decision: Summary: In relation to that portion of your loan relating to the purchase of shares, Taxation Ruling IT 2606 states that where interest is incurred on funds used to acquire shares, the interest expenses are deductible, provided that there is an expectation of dividends or other assessable income. You have also satisfied the conditions in Taxation Ruling TR 2004/4 where interest which accrues after the income producing activity for which a loan was raised has ceased is still deductible. As such you are entitled to a deduction for all the interest on your loan. | Detailed Reasoning - Detailed reasoning: 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. Taxation Ruling TR 95/25 considers the deductibility of interest. Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. Taxation Ruling TR 2004/4 discusses interest which accrues after the income producing activity for which a loan was raised has ceased, and considers the nexus between the outgoing and the income earning activities. Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and relevant income earning activities have ceased, it is apparent that the interest is not incurred in gaining or producing assessable income. However, the outgoing will still have been incurred in gaining or producing 'the assessable income' if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period. An outgoing of interest in such circumstances will not fail to be deductible merely because the original loan is refinanced. However, if the taxpayer keeps the loan on foot for reasons unassociated with the former income earning activities; or extends the loan for reasons unrelated to earning assessable income as the original loan was, the nexus between the outgoings of interest and the relevant income earning activities will be broken. In your case, the original loans were entered into to acquire income-producing assets and not for any other purpose. The funds were used to purchase investment properties which produced rental income. Furthermore, an obligation was undertaken to pay interest until the principal was repaid. You then sold the properties and applied the proceeds of the sales towards the loans. You were not in a financial position to repay the entire amount of the loans, as opposed to maintaining the loans for other reasons. You decided to refinance the loans and you entered into a new loan agreement to include an amount sufficient to extinguish the previous rental loans plus an additional amount to purchase shares. The issue, therefore, is whether selling the investment property or refinancing severs the connection between the incurring of the interest expenses and your previous income producing activity. In your circumstances, the selling of the rental property and refinancing did not sever the nexus with your previous income earning activities and the incurring of the interest on those funds used to pay out the rental loans is sufficiently proximate to your former income earning activities for the interest to be deductible. Your existing financial resources and state of liquidity are not sufficient for you to repay the loan principal. Although the issue of the amount of time between the income earning activity for which the original loan was used must be taken into account, it is not considered that you are keeping the loan on foot for reasons unassociated with the original income earning activities. In relation to that portion of your loan relating to the purchase of shares, Taxation Ruling IT 2606 states that where interest is incurred on funds used to acquire shares, the interest expenses are deductible, provided that there is an expectation of dividends or other assessable income. The expectation will usually exist as shares are inherently capable of generating dividends. The expectation must be reasonable and not a mere theoretical possibility. A deduction will not be allowable where the shares are acquired solely for the purpose of a capital profit on resale. In your case you have earned dividends from your share purchases. Accordingly, you are entitled to a deduction under section 8-1 of the ITAA 1997 for the interest expenses incurred on the borrowed funds you used to refinance your outstanding rental property loans and to purchase dividend-yielding shares.