Timing of deduction for prepaid interest on a jointly owned passive investment

Is prepaid interest in respect of jointly owned shares in a company or units in a unit trust immediately deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) where:

the interest on joint borrowings is incurred by individual taxpayers whose investment activities do not amount to the carrying on of a business; and

the interest is incurred for a period not exceeding 12 months and that period ends no later than the last day of the income year following the date on which the payment is made?

Yes. (a) Where investment activities do not amount to the carrying on of a business, joint ownership of a share or a unit in a unit trust does not constitute a partnership at general law. Calculation of the income and expenses attributable to joint ownership is therefore calculated on the basis of each individual's legal interest in the share or unit. (b) The special rules for the timing of deductions for prepaid expenditure contained in Subdivision H of Division 3 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) do not apply to individual taxpayers with non-business expenditure where that expenditure is incurred in relation to a period of service not exceeding 12 months, and that period ends no later than the last day of the income year following the date on which the payment is made.

A husband and wife purchase, in joint names, shares in a company and units in a unit trust. They do not carry on a business of investing in shares in companies or units in unit trusts. They anticipate receiving dividends from the jointly owned shares and distributions from the jointly owned units.

The husband and wife jointly borrow money to purchase the shares and units. On 30 June of income year 1 they prepay interest on the borrowed money to cover interest that will accrue during the period from 1 July to 30 June of income year 2.

Each included half of the dividends and distributions in their individual tax returns in the year those dividends and distributions were received. Each claimed in their individual returns half of the amount of prepaid interest in the year that it was paid.

Section 8-1 of the 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 purpose 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 interest on the money borrowed to purchase the shares and units is an allowable deduction under section 8-1 of the ITAA 1997. As the interest is prepaid, special rules for the timing of deductions for prepaid expenditure must be considered. Those rules are contained in Subdivision H of Division 3 of Part III of the ITAA 1936.

There are rules in Subdivision H of Division 3 of Part III of the ITAA 1936 that apply to prepaid expenditure incurred by taxpayers carrying on a business. However, those rules will not apply to the taxpayers' facts as outlined because the receipt of passive income by joint owners does not amount to carrying on a business.

In Taxation Ruling TR 93/32 the Commissioner clarified the treatment of income or losses between co-owners of a jointly owned rental property where the ownership does not amount to the carrying on of a business. TR 93/32 explains that co-ownership of a rental property is a partnership for income tax purposes but is not a partnership at general law unless the ownership amounts to the carrying on of a business. Where co-ownership is a partnership for income tax purposes only, the income/loss from the rental is derived from co-ownership of the property and not from the distribution of partnership profits/losses.

The reasoning in TR 93/32 to the sharing of income or losses from jointly owned rental properties applies equally to jointly owned investments in shares in a company or in units in a unit trust, where the investment activities do not amount to the carrying on of a business.

Other rules in Subdivision H of Division 3 of Part III of the ITAA 1936 apply to prepaid expenditure by individual taxpayers with deductible non-business expenditure. However the prepayment rules do not apply to the taxpayers' circumstances because: the eligible service period for the expenditure is 12 months or less; and the 12-month period ends on or before the last day of the income year following the year in which the payment is incurred.

Consequently, under section 8-1 of the ITAA 1997, the prepaid interest would ordinarily be immediately deductible in the year it is incurred.