Deductibility of compound interest on a split loan facility

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 split loan 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 split loan facility, to acquire an income producing asset. The Commissioner, however, will exercise his discretion under Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) to disallow the deduction otherwise allowable.

The taxpayer took out a loan to purchase a residential property which they used as their main residence (property A).

The taxpayer then purchased another property which was used for income producing purposes (property B).

They took out a split loan facility with a financial institution with one account being used to refinance the loan for property A and the other account being used to purchase property B.

The split loan facility required a minimum principal and interest repayment.

The taxpayer allocated all of their repayments to the account that related to property A.

As interest was capitalised on the account that related to property B, compound interest, being interest on the capitalised interest, accrued on that 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 the compound interest was incurred on funds borrowed, under the split loan facility, to acquire property B which was used solely for income producing purposes. As such, the compound interest was incurred in earning assessable income and is an allowable deduction under section 8-1 of the ITAA 1997.

Notwithstanding the above conclusion, the Commissioner will apply his discretion under Part IVA of the ITAA 1936 to disallow the deduction. A full and detailed explanation of the reasons for the application of Part IVA is set out in Taxation Ruling TR 98/22.