Private ruling: the deductibility of interest expenses
Published: October 2011
Ruling period: Income year ended 30 June 2012 | Income year ended 30 June 2013 | Income year ended 30 June 2014
Date scheme commenced: 1 July 2010

Ruling: Q1: 1. Are you required to apportion the deduction for the interest you incur on the Westpac Line of Credit under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) on the basis the capitalised portion is not deductible? | A2: 

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. Property/borrowing details You acquired a property in May 20XX for $XXX,000 in your name solely, which you use as your private residence ( your home ). You currently have a Home Loan ( your home loan ) for $XXX,000. You acquired a property and two car parks in March 20XX for $XXX,000 in your name solely, which you use as a rental property ( rental property 1 ). The property has been rented or available for rent since March 20XX in an arms length transaction at market rates. The purchase of rental property 1 was funded as follows: 1) $XX,X00 loan, held in your name solely and used to meet the deposit (this borrowing has been subsequently repaid) 2) $XX,000 loan, held in your name solely and used to partially pay settlement monies 3) $XXX,X00 loan, held in your name solely and used to fund remainder of settlement monies, stamp duty, titles office and legal costs. You acquired a property in September 20XX for $XXX,000 as joint tenants with your sibling, which you use as a rental property ( joint rental property ). The property has been rented or available for rent since September 20XX in an arms length transaction at market rates. You are contributing 50% of all outgoings and interest costs for the joint rental property. Your projections illustrate you receiving 50% of the income (or loss) from your joint rental property. The purchase of your joint rental property was funded as follows: 1) XX,000 loan, held in joint names with your sibling 2) $XX,000 loan, held in joint names with your sibling 3) $XX,000 loan, held in your name solely 4) $XXX,000 loan, held in joint names with your sibling The balance of settlement monies, duties and legal fees were met by you. You acquired a property in September 20XX for $XXX,000 in your name solely, which you use as a rental property ( rental property 2 ). The property has been rented or available for rent since September 20XX in an arms length transaction at market rates. The purchase of rental property 2 was funded as follows: $XX,XXX loan, held in your name solely and used to meet the deposit and legal fees $XXX,XXX loan, held in your name solely and used to meet the balance of settlement monies and stamp duty. You acquired a property in February 20XX for $XXX,000 in your name solely, which you use as a rental property ( rental property 3). The property has been rented or available for rent since February 20XX in an arms length transaction at market rates. The purchase of rental property 3 was funded as follows: 1) $XX,XXX loan, held in your name solely and used to meet the deposit (this borrowing has been subsequently repaid) 2) $XXX,XXX loan, held in your name solely and used to meet the balance of settlement monies and stamp duty, titles office and legal fees. Operation of loans/other information · You have provided projections which accompanied your application for private ruling, detailing annual rental income, home loan balance, rental property cashflow, line of credit balance and growth in property values for the 2010-11 to 2023-24 income years. These projections form part of and are to be read with this description. · Your projections are based on rental properties 1, 2, 3 and the joint rental property (your rental properties) all being rented or available for rent for the entire period between now and the end of the 2023-24 income years. · The borrowings in respect of rental properties 1, 2 and 3 and your joint rental property as detailed above are on an interest only repayment basis (the rental loans), which your projections anticipate will be maintained throughout the relevant years and to at least the 2023-24 year of income. · You will credit your share of the rental income, with an additional $XX,000 per year sourced from your salary and wages, directly to your home loan, until it is fully repaid. · You will meet your share of rental expenses, that are deductible under section 8-1 of the ITAA 1997 (deductible rental expenses), and interest incurred on the rental loans as listed in the facts above from a new line of credit. The line of credit will not be used for any other purpose. · Your projections anticipate your home loan will be fully repaid during the 2013-14 year of income. · Once your home loan is fully repaid, you will commence repaying your line of credit, using the share of the net rental income and your salary and wages previously directed to your home loan. This is illustrated in your projections, however is contrary to one statement which you make that you will make larger repayments towards the rental loans once your home loan is repaid. · You will continue using your line of credit to meet your share of deductible rental expenses and interest incurred on the rental loans after your home loan is fully repaid and to at least the 2022-23 year of income. · Upon the commencement of repayments to your line of credit, the surplus of repayments to withdrawals remains negative until the 2016-17 year of income, at which time the net balance of the line of credit commences reducing each subsequent year by an amount relative to the increasing rental income (as detailed below). · The outgoings the line of credit remain relatively constant (deductible rental expenses increasing by 1% per year and interest on the rental loans is unchanged) however the rental income is budgeted to increase by 7% per year and salary by $1,000 per year. · The cashflow of your share of all rental properties is projected to become positive during the 2022-23 year of income. · You entered this arrangement as described above during the 2010-11 year of income. · You submit that the purpose of entering the arrangement is to pay off your home sooner. While the interest incurred on the line of credit may be higher than that of the home loan, the after tax interest on the line of credit (accounting for the deductibility of the interest) is less than the home loan and the tax saved will also contribute to repaying the home sooner. · Prior to entering this arrangement, you met your share of the interest expenses on the borrowings in respect of rental properties 1, 2 and 3 and your joint rental property and Deductible Rental Property Expenses from your personal resources (i.e. out of the net cash flow from your salary and rental income).

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1936 Part IVA | Income Tax Assessment Act 1936 Section 177D

Reasons for decision: Summary: While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision. Section 8-1 Section 8-1 of the ITAA 1997 allows you a deduction for any loss or outgoing that is incurred in gaining or producing your assessable income, to the extent that it is not of a private, capital or domestic nature. Whether interest has been incurred in the course of gaining or producing assessable income generally depends on the purpose of the borrowing and the use to which the borrowed funds are put Where a borrowing is used to acquire an assessable income producing asset, or relates to expenses of an assessable income producing activity, the interest on this borrowing is considered to be incurred in the course of gaining or producing assessable income. Interest on a new loan used to repay an existing loan, which at the time of the second borrowing, was being used in an assessable income producing activity, will also be deductible as the character of the new loan is derived from the original borrowing: Taxation Ruling TR 95/25 Compound (or capitalised) interest, as with ordinary interest, derives its character from the use of the original borrowings: Taxation Determination TD 2008/27. In your situation, during the relevant income years, your Line of credit will only be used to pay deductible rental expenses for your rental properties, and interest incurred on the rental loans as listed in the facts. It follows that for each of the relevant income years all the funds from the line of credit were used, or will be used, by you wholly for the purpose of producing assessable income. Subject to the application of Part IVA, you are entitled to a deduction under section 8-1 of the ITAA 1997 in respect of all the interest on the line of credit in each of the relevant income years | Detailed Reasoning - Part IVA: * All legislative references in this section are to the ITAA 1936 unless otherwise stated. Part IVA is a general anti-avoidance rule. Part IVA gives to Commissioner the discretion to cancel a 'tax benefit' (or part of a 'tax benefit') that has been obtained, or would, but for section 177F, be obtained, by a taxpayer in connection with a scheme to which Part IVA applies. In broad terms, Part IVA will apply where the following requirements are satisfied: · there is a scheme · a taxpayer has, or would obtain, but for section 177F, , a tax benefit in connection with the scheme · the dominant purpose of entering into or carrying out the scheme, or any part of the scheme, was to enable the relevant taxpayer and/or another taxpayer to obtain a tax benefit in connection with the scheme. The application of Part IVA depends on a careful weighing of all the relevant facts and surrounding circumstances of each case. Each of the requirements of Part IVA is discussed below in relation to the scheme. Scheme A scheme is defined under subsection 177A(1) as any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and any scheme, plan, proposal, action, course of action or course of conduct. Based on the limited facts stated in the ruling application, the scheme under subsection 177A(1) comprises the following course of action: · the establishment of the line of credit · the crediting of all rental income from your rental properties, and an amount sourced from your salary and wages to your home loan · the drawing of the line of credit to pay the deductible rental expenses for your rental properties, and interest on your rental loans · your not making any repayments (including the payment of interest) on the line of credit and rental property loans until after your home loan is fully repaid.. | Detailed Reasoning - Tax benefit: The identification of a tax benefit in respect of this scheme requires a consideration of what would have happened or might reasonably be expected to have happened if this scheme had not been entered into or carried out. This reasonable expectation forms the background against which the objective ascertainment of the dominant purpose occurs. Having regard to the facts, the Commissioner considers it might reasonably be expected that if the scheme had not been entered into or carried out, the following would have happened: You would have continued to met the deductible rental expenses for your rental properties and the interest payments on your rental loans using your own cash flow, you would not have borrowed money to pay for these using your line of credit; and You would have directed any excess income not required to meet your rental and private expenditure into paying off your home loan This is less complicated than the scheme and satisfies the key commercial requirements of the arrangement. The Commissioner also notes that what you might reasonably be expected to have done if you hadn't carried out the scheme is consistent with your course of action prior to entering into the scheme. Under paragraph 177C(1)(b), a tax benefit is obtained in connection with a scheme if a deduction is allowable to the taxpayer in relation to a year of income where the whole or a part of that deduction would not have been allowable, or might reasonably be expected not to have been allowable, to the taxpayer in relation to that year of income if the scheme had not been entered into or carried out. If you had not carried out the scheme, it is reasonable to expect that you would not have incurred any interest on the line of credit and so would not have been entitled to any deductions in respect of interest incurred on it Accordingly, the relevant tax benefit you obtained in connection with the scheme under paragraph 177(1)(b) is the allowable deduction for the interest incurred on the line of credit in each of the relevant income years. | Detailed Reasoning - Dominant purpose: A key question, for Part IVA purposes, is whether you entered into or carried out the scheme for the dominant purpose of obtaining a tax benefit in connection with the scheme. This requires the drawing of a conclusion about the objective purpose for undertaking the scheme by reference to the eight objective factors identified in paragraph 177D(b). The conclusion to be reached is the conclusion of a reasonable person. An objective purpose of a taxpayer of 'paying their home loan off sooner' or similar, does not prevent Part IVA from applying to this type of arrangement. As was noted in the joint judgment of the High Court in FC of T v. Spotless Services Ltd & Anor (1996) 186 CLR 404 at 416; 96 ATC 5201 at 5206: A particular course of action may be…both 'tax driven' and bear the character of a rational commercial decision. The presence of the latter characteristic does not determine the answer to the question whether, within the meaning of Part IVA, a person entered into or carried out a 'scheme' for the 'dominant purpose' of enabling the taxpayer to obtain a 'tax benefit.' Further, Gleeson CJ and McHugh J of the High Court noted in FC of T v. Hart [2006] HCA 26 at [16]; 2004 ATC 4599 at [16] that: …a transaction may take such a form that there is a particular scheme in respect of which a conclusion of the kind described in s 177D is required, even though the particular scheme also advances a wider commercial objective. Callinan J in FC of T v. Hart [2006] HCA 26 at [96]; 2004 ATC 4599 at [96] similarly distinguished between objectives that are 'entirely irreproachable and proper' and the 'means adopted to achieve these results'. Therefore, the means by which you achieve your objective of 'paying your home loan off sooner' may attract the operation of Part IVA. In the context of applying the eight factors in paragraph 177D(b) to this scheme, the following observations are made: · The scheme involves you using the line of credit to pay the deductible rental expenses on your rental properties and the interest on your rental loans, whilst depositing all your rental income and some salary and wages into your home loan. Further, you will not make any repayments on the line of credit during the relevant income years. Interest on the line of credit will thereby be capitalised and compounded. The effect is the deferral of the payment of your rental property loans in order to enable you to repay an equivalent amount on your Home Loan. · The manner in which the scheme in question is entered into or carried out is explicable only by the taxation consequences. For instance, apart from the purported availability of additional tax deductions, it makes no financial sense for you to, in effect, fund repayments on a borrowing for your home using the Line of credit. · Apart from the purportedly available of additional tax deductions, your financial position under the scheme is no better, and in the early years of the scheme it is worse, than it would be compared with what you would reasonably be expected to have done if you had not carried out the scheme. · The effect and substance of the scheme is that the borrowings under the line of credit are financing additional repayments on your non-deductible home loan that you would otherwise not be able to make. · The total interest deductions available to you under the scheme are greater than the deductions you might reasonably be expected to be entitled to if you hadn't entered into the scheme. That is, if you hadn't entered into the scheme, you would reasonably be expected to be entitled only to interest deductions on your rental loans. · The availability of these additional tax deductions for interest under the scheme could significantly reduce the income tax payable by you in each of the relevant income years. Accordingly, it is open for a reasonable person to conclude (and the Commissioner is satisfied) that you entered into or carried out the scheme, or part of the scheme, for the dominant purpose of enabling you to obtain a tax benefit in connection with the scheme. Conclusion on the application of Part IVA You have obtained a tax benefit in connection with a scheme to which Part IVA applies. The Commissioner is entitled to, and would, make a determination under paragraph 177F(1)(b) that the whole of the deduction for the interest incurred on the Line of credit shall not be allowable to you in each of the relevant income years.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Answer: No, subject to the application of Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) (see (2) below). | 2. Will Part IVA of the ITAA 1936 apply to the scheme? | Answer: Yes. You have obtained a tax benefit in connection with a scheme to which Part IVA applies. The Commissioner is entitled to make a determination under paragraph 177F(1)(b) of the ITAA 1936 that the whole of the deduction for the interest incurred on the LOC shall not be allowable to you in each of the 2011-12, 2012-13 and 2013-14 years of income (Relevant Income Years).