Private ruling: Interest deduction
Published: February 2012
Ruling period: Year ended 30 June 2011
Date scheme commenced: 1 July 2010

Ruling: Q1: Are you entitled to a full deduction for interest incurred on your home loan where the funds were placed into a term deposit? | A1: No. | Q2: Are you entitled to a partial deduction for interest incurred on your home loan where the funds were placed into a term deposit? | A2: Yes.

Relevant facts and circumstances: You are an Australian resident. You have a loan relating to your main residence. You sold your main residence. The proceeds from the sale were deposited into a term deposit by mistake instead of applying the proceeds to the loan. You earned interest from your term deposit. You incurred interest on your loan. The interest that is incurred on the loan is higher than the interest earned from your term deposit.

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

Reasons for decision: Summary: A deduction for interest incurred on the loan will be allowed to the extent of the income received from the term deposit. | 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 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 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 criterion. The interest will be deductible to the extent that the funds are used to produce assessable income. The High Court in Fletcher v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613 ( Fletcher's Case ) considered the circumstances where the interest outgoings of a taxpayer exceeded the assessable income relevant to this expense. It was found that where the assessable income derived from an arrangement is less than the relevant outgoings and the facts lead to the conclusion that there is another objective for incurring the expense, only part of the outgoing is an allowable deduction. The court found it was fair and reasonable to limit the deduction of the amount of income actually received. Taxation Ruling TR 95/33 considers the implications of Fletcher's case . The ruling states that if an outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure, including an examination of the taxpayer's subjective purpose, motive or intention in making the outgoing, to determine whether the outgoing is wholly deductible. If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective, then the outgoing must be apportioned between the pursuit of assessable income and the other objective. The Court took the view that if, on consideration of all those 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 sold your main residence. Instead of depositing the proceeds from the sale into your main residence loan account, the proceeds were deposited into a term deposit by mistake. The loan is incurring interest and the term deposit is earning interest. Your subjective purpose, motive or intention in making the outgoing (that is, the interest incurred on the loan) was a mistake. Accordingly you are entitled to a deduction for the interest expense you incur, limited to the amount of interest you earn from the term deposit.

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