Private ruling: Interest expenses
Published: September 2012
Ruling period: Year ended 30 June 2010
Date scheme commenced: 1 July 2009

Ruling: Q1: Are you entitled to a deduction for the interest expense incurred on borrowed funds up to your share of the amount of interest income received from a term deposit? | A1: Yes.

Relevant facts and circumstances: You and your spouse purchased a property which was used as your principle place of residence during the 2007-08 financial year. You and your spouse financed the purchase with loans including a fixed term home loan. The property was sold in during the 2008-09 financial year. All the loans, other than the fixed term home loan, were paid out in full. You were unable to pay out the fixed term home loan as the period had not expired. The financial institution advised you to place an amount equivalent to the loan balance into a term deposit to act as a 'substitute security' for the fixed loan. The term deposit is held in the names of your spouse and yourself. You earn interest on the term deposit and incur interest on the loan.

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. Taxation Ruling TR 95/25 deals with deductions for interest under section 8-1 of the ITAA 1997. Interest is deductible where the expense has a sufficient connection with the gaining or producing of assessable income and it is not of a capital, private or domestic nature. 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. The 'use' test, established in FC of T 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 criterion. In Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 ( Fletcher ) the Full High Court took the view that if, on consideration of all factors, the whole of the interest could be characterised as genuinely and not colourably incurred in gaining or producing assessable income, the interest would be fully deductible. If only part of the outgoing could be so characterised, apportionment between the pursuit of assessable income and of other objectives was necessary. In your case you and your spouse had a fixed term home loan for your private residence, which you have since sold. You deposited a portion of the funds from the sale of your private residence into a term deposit which is earning interest. You did this as the fixed term home loan was for a minimum period and the financial institution required a substitute security for the borrowed funds. The interest expense you have incurred is more than the interest income you have received from the borrowed funds. It is considered that your circumstances are consistent with those examined in Fletcher in that the loan has an objective other than the single pursuit of assessable income and that an apportionment of the interest paid on the loan would be appropriate. A deduction for interest incurred on the borrowed funds subsequently placed in an investment account is allowed to the extent of your share of the interest received from the borrowed funds.

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