Private ruling: Deductibility of interest expense
Date of advice: 31 May 2017
Published: September 2017
Ruling period: Year ended 30 June 2014 | Year ended 30 June 2015 | Year ended 30 June 2016 | Year ended 30 June 2017
Date scheme commenced: 1 July 2013

Ruling: Question and answer: | Are you entitled to a deduction for the interest expense from your residual loan? | No.

Relevant facts and circumstances: You and your spouse purchased a home and an investment property. The investment property was held by an investment loan with Entity XYZ, which was secured by the investment property. You and your spouse purchased a new home, and as a result were required to dispose of your existing home. To complete the purchase of your new home, you refinanced your loans with Entity XYZ through a broker and were granted a bridging loan and a residual loan. The bridging loan was meant to finance the purchase of the new home while the existing home was being disposed of, while the residual loan was meant to refinance the investment properties. However Entity XYZ applied the loans as follows; ● applied the bridging loan to the investment loan ● applied the residual loan to the purchase of the new residence ● paid out the bridging loan using the proceeds from the sale of the existing residence When you learned of the way the loans were applied you approach your broker who claimed that Entity XYZ had breached its policy in relation to bridging loans by using the bridging loan funds to refinance the investment loan. Your broker then contacted Entity XYZ in attempt to have the loans restructured, however Entity XYZ did not agree with the view of your broker and maintained that the finance was structured correctly. You and your spouse then took the matter to the Financial Ombudsman Service Australia, however they found in favour on Entity XYZ. The conditions of the loans are yet to be amended.

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 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, discusses the deductibility of interest expense on an investment loan. 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. In your case, you have a residual loan that was meant to service your investment properties; however Entity XYZ applied the funds from this loan to the acquisition of your new home. Therefore a permanent reduction of debt for your investment properties occurred. 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 this case, the funds from your residual loan were applied to the purchase of your new home and therefore this amount was not used for income producing purposes. We acknowledge that the residual loan was intended to be used solely for your investment properties, and the bank did not follow your request. However, the fact is that the residual loan has been used for private purposes. As the funds from your residual loan have been used for private purposes, the Commissioner can only consider what actually occurred rather than what was intended to occur. The Commissioner has no discretion to overlook the actual use of the residual loan. Accordingly, you are not entitled to a deduction for the interest incurred on your residual loan under section 8-1 of the ITAA 1997.