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Is the taxpayer entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for compound interest incurred on funds borrowed, under a line of credit facility, to acquire an income producing asset?

Yes. The taxpayer is entitled to a deduction under section 8-1 of the ITAA 1997 for compound interest incurred on funds borrowed, under a line of credit facility, to acquire an income producing asset.

The taxpayer took out a line of credit facility, with a financial institution, which was divided into two sub-accounts.

One sub-account was used to acquire an income producing asset (investment sub-account) and the other sub-account was used for non-income producing purposes (private sub-account).

There were no fixed minimum principal and interest repayments required by the lender.

The taxpayer made no payments off the investment sub-account until the private sub-account had been repaid in full.

As interest was capitalised on the investment sub-account, compound interest, being interest on the capitalised interest, accrued on the investment sub-account.

Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing that is incurred in gaining or producing assessable income to the extent that it is not of a private, capital or domestic nature.

The deductibility of an outgoing is determined by its essential character ( Lunney & Hayley v. Federal Commissioner of Taxation (1958) 100 CLR 478; (1958) 11 ATD 404; (1958) 7 AITR 166).

The character of interest is determined by the purpose of the borrowing. Generally, the purpose of a borrowing can be determined from the use of borrowed funds and outgoings of interest ordinarily draw their character from that use ( Fletcher & Ors v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613, Kidston Goldmines Limited v. Federal Commissioner of Taxation (1991) 30 FCR 77; 91 ATC 4538; (1991) 22 ATR 168).

It is therefore generally accepted that ordinary interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction.

In Hart v. Federal Commissioner of Taxation (2002) 121 FCR 206; 2002 ATC 4608; (2002) 50 ATR 369 it was held that compound interest, as with ordinary interest, derives its character from the use of the original borrowings.

In this case compound interest was incurred on funds borrowed, under a line of credit facility, to acquire an income producing asset. As such, the compound interest was incurred in earning assessable income and is an allowable deduction under section 8-1 of the ITAA 1997. Note: While the general anti avoidance provisions of Part IVA of the Income Tax Assessment Act 1936 are not considered applicable in this case, the application of Part IVA depends on a detailed analysis of the facts of each case. The Commissioner considers that a scheme in relation to a loan facility would need to have the same features as those set out in paragraphs 16 to 19 in Taxation Ruling TR 98/22 before Part IVA could be applied.