Private ruling: Interest deduction
Published: May 2014
Ruling period: Year ended 30 June 2012 | Year ended 30 June 2013 | Year ended 30 June 2014 | Year ended 30 June 2015 | Year ended 30 June 2016
Date scheme commenced: 1 July 2011

Ruling: Q1: Are you entitled to claim a deduction for the interest incurred on Loan 1 after the sale of the investment property? | A1: No

Relevant facts and circumstances: You purchased property A. The initial loan amount was fixed (Loan 1). You lived in property A for a period. You moved out of property A and the property was rented up until its sale. You purchased rental property B. The loan set up as a variable interest loan (Loan 2). You realised that property A was not financially viable and was making a considerable loss. Further the body corporates and other rental expenses were very high when compared to other investments and you believed there would be minimal capital growth due to an increase in supply vs demand. For these reasons you decided to sell property A. Property A sold for a considerable loss. You were advised by the bank that should you bank the settlement proceeds from the sale of property A to Loan 1 there would be a penalty for breaking the fixed loan. To avoid the break cost penalty and at the same time reduce your financial debts you decided to bank the proceeds from the sale of property A to 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. Interest expenses are generally deductible under section 8-1 of the ITAA 1997 to the extent that it is incurred in relation to funds used for an income producing purpose. The Commissioner's view on whether interest deductions are allowable after the cessation of the relevant income producing activity is outlined in Taxation Ruling TR 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities (TR 2004/4). TR 2004/4 considers the implications of the Full Federal Court decisions in Federal Commissioner of Taxation v. Brown 99 ATC 4600; (1999) 43 ATR 1 (Browns case) and Federal Commissioner of Taxation v. Jones 2002 ATC 4135 ; (2002) 49 ATR 188 (Jones case). In Brown's case, the taxpayer partners borrowed to acquire a delicatessen. After a number of years of trading, the business was sold at a loss. The proceeds of the disposal were made over to the bank but were insufficient to satisfy the liability fully. There was no entitlement under the relevant loan agreement to repay the loan prior to its term without prior agreement of the bank. In Jones case, the taxpayer, together with her husband, borrowed money to fund a trucking and equipment hire business. After her husband's death, Mrs Jones sold the assets of the business. The proceeds (plus other amounts on hand) were insufficient to pay out the loan and she was unable to fully repay the loan. Brown and Jones cases accordingly demonstrate that the occasion of interest expenditure can be found in the relevant income earning activities even where those activities are now defunct and all the borrowings (or assets representing those funds) are lost. Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgment about the nexus between the outgoing and the income earning activities. If the taxpayer: • keeps the loan on foot for reasons unassociated with the former income earning activities; or • makes a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred, the nexus between the outgoings of interest and the relevant income earning activities will be broken. In your case, you decided to apply the settlement proceeds from the sale of property A to Loan 2 in order to avoid paying the interest penalty that would have generated should you have applied the settlement amount to Loan 1. Therefore, Loan A has been kept on foot for reasons unassociated with the former income earning activity and the nexus between the interest expense and the relevant income earning activity has been broken. As a result, the interest expense from Loan 1 is not an allowable deduction under section 8-1 of the ITAA 1997.