Issue
Is an 'early repayment benefit', received by the taxpayer upon early repayment of their fixed interest rate home loan, ordinary income and therefore, assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?
Decision
No. An 'early repayment benefit', received by the taxpayer upon early repayment of their fixed interest rate home loan, is not ordinary income and therefore, not assessable income under section 6-5 of the ITAA 1997.
Facts
The taxpayer took out a fixed interest rate home loan to purchase their residence.
Prior to the expiry of the fixed interest rate loan, the property was sold and the loan was repaid in full.
A term of the loan agreement was that in the event of early, full repayment, the lender was able to recoup an early repayment cost, plus an early repayment administration fee.
A calculation was carried out by the lender in order to determine its costs arising out of the early repayment. Such costs arise where the prevailing interest rate at the date of early repayment is less than that which applied to the remainder of the taxpayer's fixed interest rate period, thereby denying the lender the higher level of interest they would have earned during that time.
In the taxpayer's circumstances, the prevailing interest rate at the date of the early repayment was actually higher than that which applied to the remainder of their fixed interest rate period. As such, there was no cost to the lender as the early repayment put the lender in a position to lend the funds at a higher level of interest than that which applied to the taxpayer's borrowings. Accordingly, the lender's calculation of its costs actually resulted in a negative figure.
The loan contract stated that the lender had absolute discretion as to whether or not it would pass on to the taxpayer any benefit it gained through early repayment.
Although not contractually obliged to do so, the lender credited to the taxpayer's loan an 'early repayment benefit' equivalent to the lender's notional saving.
Reasons for Decision
Section 6-5 of the ITAA 1997 provides that the assessable income of a resident taxpayer includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources.
Whether a profit from an isolated transaction is income according to ordinary concepts, depends very much on the circumstances of the case.
Where a taxpayer not carrying on a business makes a profit, that profit is income if: (a) the intention or purpose of the taxpayer in entering into the profit-making transaction or operation was to make a profit or gain; and (b) the transaction or operation was entered into, and the profit was made, in carrying out a business operation or commercial transaction.
In this instance, the receipt of the 'early repayment benefit' was incidental to the early repayment of the taxpayer's home loan. Furthermore, the loan contract made it clear that the lender had absolute discretion as to whether or not it would pass on to the taxpayer any benefit it might gain through early repayment.
An objective consideration of the taxpayer's circumstances leads to a finding that the primary intention or purpose of the taxpayer in repaying the loan early was to sell their residence. Upon entering into the agreement to repay the loan and thereby sell the house, the taxpayer had no certainty that they would receive an 'early repayment benefit'. As such, the profit made from the transaction is not income as the taxpayer did not have sufficient intention to profit from the transaction.
In addition, while interest is considered to be ordinary income, the 'early repayment benefit' cannot be characterised as interest. In FC of T v. Century Yuasa Batteries (1998) 82 FCR 288; 98 ATC 4380; (1998) 38 ATR 442, the Full Federal Court stated (at ATC 4383, ATR 444) that interest is the return, consideration, or compensation for the use or retention by one person of a sum of money belonging to, or owed to, another, and that interest must be referable to a principal.
The 'early repayment benefit' is not interest as it did not arise out of the investment of a capital sum, that is, the taxpayer was not compensated for having been deprived of the use and enjoyment of a principal sum (see also FC of T v. The Myer Emporium Ltd (1987) 163 CLR 199 at 218; 87 ATC 4363 at 4371; 18 ATR 693 at 702).
Accordingly, the 'early repayment benefit' received by the taxpayer is not ordinary income and is therefore not included in their assessable income under section 6-5 of the ITAA 1997.