When borrowing money, there are often many expenses incurred. These expenses may be tax deductible if the borrowed money is used to produce assessable income.
For example, section 25-25 of the Income Tax Assessment Act 1997 (ITAA 1997) is a section that specifically provides a deduction for expenditure incurred in borrowing money to the extent that the money is used for the purpose of producing assessable income.
Section 25-30 of ITAA 1997 provides a deduction for expenses incurred by a taxpayer in discharging a mortgage where the money has been used for the purpose of producing assessable income.
Of course, the interest paid on the borrowed monies may also be deductible where certain criteria are met.
Borrowing expenses – Section 25-25 ITAA 1997
This section provides a specific deduction for borrowing expenses to the extent that the money is used for the purpose of producing assessable income (e.g. to buy a rental property). The section is necessary as where such expenditure is of a capital nature it will not be deductible under the general deduction section – sec 8-1 of ITAA 1997.
These are expenses which relate to the actual borrowing of monies. Typically, these would include costs such as:
- application and other fees charged by the lender
- stamp duty on the mortgage contract
- costs (including legal fees) for preparing and filing mortgage documents
- valuation and survey fees
- broker’s commission
- underwriter’s fees
- loan establishment fees
- lender’s mortgage insurance
- the cost of arranging bank overdrafts.
The following cannot be claimed as borrowing expenses under section 25-25 (but may be deductible elsewhere, e.g. by being included in the cost base of an asset):
- stamp duty charged by the state/territory government on the transfer (purchase) of the property title
- land titles office fee
- registration of title fee
- legal expenses for the purchase of the property
- interest on the loan. This is not regarded as a borrowing expense for section 25-25 purposes. However, it may be deductible under sec 8-1
- borrowing expenses on any portion of the loan used for private purposes.
When a loan does not proceed, the associated borrowing costs are not deductible under sec 25-25 since the section requires that the money must in fact be borrowed and used for assessable income-producing purposes.
Timing of the deduction
If total deductible borrowing expenses are more than $100, the deduction is spread over five years or the term of the loan, whichever is less.
If the total deductible borrowing expenses are $100 or less, a full deduction can be claimed in the income year they are incurred.
Where the loan is obtained part way through the income year, the deduction for the first year will be apportioned according to the number of days in the year of the loan.
Mortgage discharge expenses – Section 25-30 ITAA 1997
Section 25-30 of ITAA 1997 governs the deductibility of mortgage discharge expenses. It applies to expenses incurred by a taxpayer in discharging a mortgage given as security for the repayment of borrowed moneys, or for the payment, in whole or in part, of the purchase price of the bought property.
The section provides a 100% deduction in the year the expenses are incurred.
However, the deduction is only available in respect of so much of the expenses as is attributable to the use of the moneys or the property in producing assessable income.
The section does not apply to payments of principal or interest.
Deductible expenses incurred in discharging a mortgage include a penalty interest payment arising from early repayment of a loan.
Interest expense – Section 8-1 ITAA 1997
Section 8-1 provides that interest will be deductible in an income year when it is incurred in connection with:
- income producing investments and assets; or
- assessable income producing business operations.
The Use Test
In determining whether this connection exists, the courts have applied the “use test” (i.e. they have looked to the objective circumstances of the use to which the borrowed moneys are put).
The question to ask is: Have the borrowed moneys been used to acquire assets which generate assessable income or been used in carrying on a business?
A tracing of the borrowed money which establishes it has been applied to an income producing use will generally demonstrate the relevant connection between the interest and the income producing activity.
If the funds are to be used as working capital (e.g. an overdraft to meet business expenses, the interest will be deductible).
It doesn’t matter that a deduction is not available for the cost of the assets acquired. If those assets are used for income producing purposes, interest on borrowings to acquire the assets will be deductible.
If a borrowing is used only partly for income producing purposes, only a part of the interest will be deductible.
The security given for a loan is irrelevant in determining the deductibility of interest on a borrowing – Tax Determination TD 93/13 (e.g. security over an income producing property will not make interest on a loan for a non-income-producing asset deductible and vice versa). It is the use made of the borrowed moneys that is the test.
Interest on borrowings to pay tax
In 1990, the Commissioner issued IT 2582 which states that interest on moneys borrowed by businesses to pay income tax will be deductible. The ATO considers the interest on those borrowings is a normal incident of conducting that business and therefore qualifies for deduction under the second limb of section 8-1.
However, it appears the Commissioner will not allow a deduction for interest on borrowings to pay tax by any person or entity not carrying on a business.
The cases have not allowed such a deduction when claimed by an individual not carrying on a business (Case V48 88 ATC 380) or by a partner in a partnership (Case 14/98 98 ATC 201).
Tax Determination TD 2000/24 expressly states that partners are not entitled to a deduction for interest on borrowings used to pay personal income tax liabilities. The individual expenses of an individual partner are not regarded as incurred in the carrying on of a partnership business. The determination states that any borrowing by the individual partner because of income tax will be viewed as relating to the partner’s personal income tax obligations and lacking any direct connection with the business or income activities of the partnership.
The Purpose Test
The establishing of a connection between the interest expense and income producing investments or assessable income producing business operations will make the interest deductible.
However, if there is a disproportion between the interest expense and the income derived (e.g. no income is derived, or the income derived is less than the interest outgoing), the courts will also look at other factors including the taxpayer’s subjective purpose when making the borrowing.
If having regard to all the factors in such cases it can be concluded that only some part of the outgoing can be characterised by reference to the actual or expected production of assessable income, the interest expense will generally only be allowed as a deduction to the extent to which the funds are used for income producing purposes.
Generally negative gearing is acceptable to the ATO and the full interest expense will be deductible. However, there can be situations where on the facts the ATO is convinced that a borrowing is not for an income producing purpose but solely or predominantly minimise tax. In these situations, the ATO will not allow a deduction for the interest expense under section 8-1 and will also seek to apply Part IVA ITAA 1936 (the general anti-avoidance provisions).
Example – Borrowing expenses
On 25 March 2018 a business incurred borrowing expenses of $30,000 in obtaining a business loan repayable at the end of three years (i.e. for 1,095 days). Interest was payable on the loan each year. At the end of the loan, there were mortgage discharge expenses of $3,000.
The period applicable to the 2018 year was 97 days.
Section 25-25 provides deductions would be allowable as follows:
Year ended 30 June $
2018 97/1095 x $30,000 2,660
2019 1/3 x $30,000 ………………..10,000
2020 1/3 x $30,000 ………………. 10,000
2021 balance ………………….. 7,340
If the loan had been for more than five years, deductions would be calculated over a deemed five-year period of 1,826 days (assuming one leap year). The amount applicable to each year of income would be determined by multiplying the total amount of the loan by the fraction of that 1,826-day period which applied to that particular year.
The full amount of the interest payable each year will be deductible under section 8-1.
Section 25-30 provides a deduction for the mortgage discharge expenses of $3,000 in the year the mortgage is discharged.
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