Private ruling: Interest expense
Date of advice: 19 August 2015
Published: August 2015
Ruling period: Year ending 30 June 2016 Year ending 30 June 2017 Year ending 30 June 2018 Year ending 30 June 2019 Year ending 30 June 2020 Year ending 30 June 2021
Date scheme commenced: 1 July 2015

Ruling: Q1: Are you entitled to a deduction for interest expense on the dual loan facility for the years ended 30 June 20YY to 30 June 20ZZ? | A1: 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 entered into a tenancy agreement to lease this property. You financed this purchase with a loan by way of mortgage for a percentage of the property value, over a X 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 you needed to have available funds to cover all other expenses in relation to this purchase, being, though not limited to: • a percentage deposit to avoid lenders mortgage insurance liability • professional fees, regulatory charges and establishment fees, and • stamp duties. You procured these additional funds by way of loans from an relative under connected loan agreements. Features of the loans are: • terms 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 related 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. A private ruling was issued stating that the interest incurred on both loans was not deductible as the arrangement was private in nature. The Commissioner did not accept that the interest was being genuinely incurred. The ruling's reasons for decision stated that several factors of the loan agreements appeared 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 relative's testamentary beneficiaries who are also your relatives. Additionally there were concerns in relation to: • the interest rate payable on the loans being that of a variable secured housing loan rather than the secured personal loan it reflected • the term of the loan being 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 • the loans are not secured by mortgage over real property • difficulty in tracing incoming and outgoing transactions to and from your accounts as well as the true nature and purpose of those transactions. You have used the balance of the funds to assist in purchasing another property. This property will be used to earn assessable income. You entered into an Amending Deed with your grandparent, effective from the 2015-16 financial year. The Amending Deed amended the loan agreements to: • change the reference point for the interest rate calculations • reduce the term of the loan to less than 10 years. The purpose of the Amending Deed was to address issues including: • a possible issue about an ambulatory repayment date that may cause a finding that that the loan is not in fact a loan • a slight but not insignificant difficulty with regards to tracing the interest and principal repayments against each loan • unrealistic terms, including with regards to repayment dates and interest rates • a possibility that, in the event that the Lender passes away, the beneficiaries of their estate may take legal action on grounds of undue influence or similar grounds.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 Taxation Administration Act 1953 Schedule 1 Section 359-35

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act 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. 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, irrespective of how the borrowed funds have been used. 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 the 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 the reasons for decision accompanying the previous private ruling it was stated that several factors of the loan agreements appeared 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 ITAA 1936 • the loans will pass to your grandparents testamentary beneficiaries, being your other grandparent or your own parent and relative. Since receiving the ruling you have entered into an Amendment Deed to: • change the repayment date to a fixed date - a period of seven years which is the maximum term for loans, other than those secured over real property with a market value of 110% of the loan, under subsection 109N(3) of the ITAA 1936 • change the calculation of the interest rate from a reference to subsection 190N of the ITAA 1936 to the Indicator Lending Rates - Personal Loans; Term loans (unsecured); Variable as published by the Reserve Bank of Australia from time to time, and • remove the varying interest rate calculation clauses. The creation of the Amending Deed supports the Commissioner's view of the non-commerciality of the arrangement between yourself and your relative. It would be unusual for an unrelated party to vary a loan arrangement in such a significant manner after the borrower had received an unfavourable ruling from the ATO. The variation supports the view that the loan can be easily changed by you when circumstances which make it advantageous to do so arise. As the dual loan facility is considered to be non-commercial in nature, the Commissioner does not have certainty that the terms and conditions of the loan including the payment of interest will be met. Therefore no deduction is allowable for interest expenses incurred under the loan facility.