Timing of deductions for prepaid interest expenditure where the payment includes an amount in advance and an amount in arrears

For the purposes of determining the timing of a deduction under the prepayment rules contained in Subdivision H of Division 3 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936), what is the 'eligible service period' for interest expenditure which includes an amount paid in advance and an amount paid in arrears?

The 'eligible service period' for the amount paid in advance commences on the date on which the expenditure is incurred and ends on the last day to which the payment of interest relates. The amount paid in arrears is wholly deductible when paid.

On 31 May 2003 an individual taxpayer entered into a five year loan agreement for funds borrowed to produce assessable income from a passive investment.

Under the terms of the loan agreement, the taxpayer was required to make an initial interest payment on 30 June 2003 to cover interest on the borrowed funds up to 30 June 2004. This initial payment comprised the interest in arrears for the month of June 2003 and an amount in advance for the 12 month period ending on 30 June 2004.

Interest is then payable 12 months in advance on 30 June of each succeeding year.

A prepaid expense is expenditure incurred in one year for things to be done (in whole or in part) in a later year of income.

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, or are necessarily incurred in carrying on a business for the purposes of gaining or producing such income, except where the outgoings are of a capital, private or domestic nature, or relate to the gaining or producing of exempt income.

The prepayment rules affect the timing of deductions for prepaid expenditure where, inter alia , that expenditure would ordinarily be immediately deductible under section 8-1 of the ITAA 1997 and it is not excluded expenditure. The interest on the money borrowed to make the passive investment is an allowable deduction under section 8-1 of the ITAA 1997.

Subsection 82KZL(1) of the ITAA 1936 provides that the 'eligible service period' in relation to an amount of expenditure incurred under an agreement is the period during which the thing is to be done under the agreement in return for the expenditure. It begins on the day the thing under the agreement commences to be done or on the day the expenditure is incurred, whichever is later. It continues until the last day the thing under the agreement ceases to be done or 10 years, whichever is earlier.

Paragraph 82KZL(2)(a) of the ITAA 1936 further provides that the eligible service period in respect of a payment of interest is the period to which the payment of interest relates and not the period of the loan.

In this case, the 'eligible service period' commenced on 30 June 2003. This is the later of the day the thing under the agreement commenced being done and the day the expenditure was incurred. Any prepaid expenditure incurred on that day for interest relating to a later income year will be subject to the prepayment rules. However, for an individual taxpayer who does not incur the expenditure in carrying on a business, that portion of the expenditure will be deductible in the 2002-03 income year because the eligible service period is 12 months or less and it ends on or before the last day of the next income year (subsection 82KZM(1) of the ITAA 1936).

That portion of the payment made in respect of the month of June 2003 is not subject to the prepayment rules and is deductible in the 2002-03 income year. This is because it was incurred in that year and was not a prepaid expense.