Private ruling: Interest expenses - Connected loans from family member
Published: March 2015
Ruling period: Year ending 30 June 2015 | Year ending 30 June 2016 | Year ending 30 June 2017 | Year ending 30 June 2018
Date scheme commenced: 1 July 2014

Ruling: Q1: Is a deduction allowable, either in whole or in part, with respect to the first loan (loan 1) for interest? | A1: No | Q2: Is a deduction allowable, either in whole or in part, with respect to the second loan (loan 2) for interest? | A2: No

Relevant facts and circumstances: You purchased a property from a third party. You intend to use this property for the purpose of gaining or producing assessable income, and have now entered into a tenancy agreement to lease this property. You financed this purchase with a loan by way of mortgage with a bank for 80 percent of the property value, over a 30 year term with principal and interest payable on a monthly basis. You have also set up a mortgage offset account connected to this loan. This offset account does not reduce any indebtedness to the mortgagor, but no interest is chargeable by the mortgagor on an amount of the mortgage corresponding with the balance in the offset account. You can redraw funds at any time from this offset account without penalty and you state that you will take advantage of this redraw facility from time to time. In order for you to facilitate this property purchase and the mortgage from the bank, you needed to have available funds to cover all other expenses in relation to this purchase, being, though not limited to: • 20 percent deposit to avoid lenders mortgage insurance liability, • Professional fees, regulatory charges and establishment fees, • Stamp duties You procured these additional funds by way of two loans from an elderly family member under connected loan agreements. The purpose of loan 1 was to provide the required funds to facilitate the purchase of the investment property as stated above, covering all purchase costs that could not be covered within the bank mortgage. The purpose of loan 2 is to operate as a periodic drawdown facility, up to a maximum advance amount, less any amount already advanced under loan 1. You can drawdown from this loan at any time, up to the maximum advance amount. Features of loan 1 and loan 2: • Term of approximately 50 years • Unsecured • Establishment fee of one dollar ($1) • Interest payable monthly in arrears - rates to be determined based on 'interest periods' of 30, 60, 90 or 180 days or any other period as agreed to by the lender and borrower • No requirement to repay the principal until 'repayment date' which is declared under ' Definitions ' of the loan agreement as: ..means 31 December 2064 or such other date as the lender and the borrower agree in writing, subject to the provisions of this agreement relating to the accelerated payment of the loan… • Principal can be repaid at any time without penalty • Loan 1 interest rate is equal to the benchmark interest rate within the meaning of s109N(2) of the Income Tax Assessment Act 1936 • Loan 2 interest rate has three different possible rate calculations, the last being that the interest rate will be as governed by the whole of the first agreement You state that the loans will pass to the lender's testamentary beneficiaries with no provision for forgiveness on the death of the testator. Loan 1 has been drawn down to facilitate settlement of the property recently. Loan 2 has been partially drawn down to cover stamp duty costs and to transfer an amount into the bank mortgage offset account. There is still a substantial amount remaining as available redraw of funds in loan 2.

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. 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 ( 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). Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that it is not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances. 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, regard must be given to all the circumstances including the purpose of the borrowing and the use to which the borrowed funds are put. While it is acknowledged that you have recently purchased a property with the intention of renting it out, thereby using the bank loan for the purpose of gaining or producing assessable income, consideration must be given to the commerciality of your arrangement between you and your relation. 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 exactly the same terms and conditions. If the answer is yes, then it would be an arm's length and commercial arrangement. In your case it is not considered that you would be able to enter such an arrangement with an unrelated party. In your case, you have entered into two agreements for connected loans with your relation, of which several factors appear to be non-commercial in character, for example: • Term of approximately 50 years • Unsecured • Establishment fee of one dollar ($1) • No requirement to repay the principal until a changeable 'repayment date' • Interest rates similar to, or same as subsection 109N(2) of the Income Tax Assessment Act 1936 (ITAA 1936) • The loans will pass to your relation's testamentary beneficiaries. Subsections 109N(2) and (3) of the ITAA 1936 state: 109N(2) Benchmark interest rate. The benchmark interest rate for the year of income is the Indicator Lending Rates - Bank variable housing loans interest rate last published by the Reserve Bank of Australia before the start of the year of income. However, the benchmark interest rate is the rate worked out under the regulations, if they provide for working it out. 109N(3) Maximum term. The maximum term is: (a) 25 years for a loan if: (i) 100% of the value of the loan is secured by a mortgage over real property that has been registered in accordance with a law of a State or Territory; and (ii) when the loan is first made, the market value of that real property (less the amounts of any other liabilities secured over that property in priority to the loan) is at least 110% of the amount of the loan; and (b) 7 years for any other loan. The interest rate payable on your loans is that of a variable secured housing loan, rather than the unsecured personal loan it reflects. The term of the loan is at least twice as long as the maximum term declared under subsection 109N(3) of the ITAA 1936, with no defined repayment date where all payments of principal and interest must be paid. Your loans are also not secured by mortgage over real property. It is apparent that your relation is not anticipating having any of the principal of either of these loans repaid in their lifetime. Having regard to all your circumstances, it is not considered that loan 1and loan 2 have been made on a commercial basis. Under the terms and conditions of the loans, there does not appear to be a genuine requirement to repay the loans to your relation. Furthermore it is difficult to trace incoming and outgoing transactions to and from the accounts, as well as the true nature and purpose of those transactions. Rather it is considered that your loans with your relation are largely private in nature and therefore no deduction is allowable under section 8-1 of the ITAA 1997. That is, no deductions are allowable, either in whole or in part, in relation to either loan 1 or loan 2 for interest.