Private ruling: Allowable deductions and subdivision
Date of advice: 22 December 2017
Published: May 2018
Ruling period: Year ended 30 June 2016. | Year ended 30 June 2017.
Date scheme commenced: 1 August 2015.

Ruling: Q1: Can you claim 50% of allowable deductions including interest on loan repayments? | A1: No. | Q2: Can you claim 10% of allowable deductions excluding interest on loan repayments? | A2: Yes.

Relevant facts and circumstances: A property was purchased in the names of Person Y and Person Z (Persons Y & Z). Upon acquisition, it was the intention to build two dwellings, subdivide the land with you taking ownership of one property for the purpose of holding it for investment. The purchase of the property was funded accordingly: ● Persons Y & Z borrowed X%; ● Persons Y & Z funded X%; and ● You funded X%. You are not a party to the loan taken out by Persons Y & Z. You could not put your name on the title due to borrowing restraints, due to the ongoing settlement and construction of your property which has since been completed (the Other Property). The Other Property is owned jointly by you and your spouse as tenants in common in the follow proportions: ● You: X% ● Your spouse: X% Stamp duty was paid equally by both you and Persons Y & Z. Prior to the acquisition of the property, you entered an agreement with Persons Y & Z stating that all expenses, legal liabilities, tax implications, and income will be split equally between both parties. Additionally, prior to the acquisition of the property a joint bank account was established which shows deposits have been made equally between you and Persons Y & Z. All outgoings (including loan repayments) have been paid from the joint bank account. Recently, the two dwellings were currently in the process of construction, with completion of subdivision expected within the upcoming months. You and Persons Y & Z are not related entities and have entered this agreement at arm’s length. You are acquiring the one of the subdivided blocks for its build cost, and not for its market value. You will use the Other Property as security for the subdivided property and you and your spouse will be listed as owners on the title. A copy of the contract for the sale of the property lists you and your spouse as purchaser.

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

Reasons for decision: Summary: You cannot claim 50% of allowable deductions in relation to the property. You cannot claim any deductions in relation to the loan. You can claim a portion of deductions according to your equitable ownership interest, calculated according to your contribution of 10% in the form of a 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 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 they are 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 Taxation Ruling TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. Taxation Ruling 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. The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 ( Munro's case ) is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. The interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income. That is, it is generally accepted that interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction. Taxation Ruling TR 93/32 Income tax: rental property - division of net income or loss between co-owners states that the income/loss from a rental property must be shared according to the legal interest of the owners except in those very limited circumstances where there is sufficient evidence to establish that the equitable interest is different from the legal title. Application to your situation In your case, you are not a legal owner of the property. You have an agreement with Persons Y & Z and will become the legal owner of one of the blocks following completion and subdivision, however your arrangement does not satisfy that you have a 50% equitable interest in the property and therefore, are not entitled to claim the majority of expenses as allowable deductions. You cannot claim a deduction on a loan which is not in your own name. Your agreement with Persons Y & Z to share the losses in different proportions to the legal ownership has no effect for income tax purposes, despite the intentions of the parties. The legal owner may be able to claim 100% of interest expenses. You cannot claim any portion of interest expenses in relation to the loan taken out by Persons Y & Z. Additionally, any portion of expenses which you can claim is limited to the proportion of your contribution made in the form of your deposit. Therefore you can claim a proportion of allowable deductions such as council rates, in accordance with the proportion of your deposit contribution.