Income tax: is the deductibility of compound interest determined according to the same principles as the deductibility of other interest?

Yes. The principles governing the deductibility of compound interest are the same as those governing the deductibility of ordinary interest: Hart v. Federal Commissioner of Taxation [2002] FCAFC 222, 2002 ATC 4608, (2002) 50 ATR 369 ( Hart ). The Commissioner accepts that this is the law following the Full Federal Court's decision in Hart .

When the final Determination is issued, it is proposed to apply both before and after its date of issue. However, the Determination will not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Determination (see paragraphs 75 to 77 of Taxation Ruling TR 2006/10).

A deduction is allowed 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 reason it arises, which is usually determined by the purpose to which the borrowing is being applied when the interest arises. 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 v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613, Kidston Goldmines Ltd v. Federal Commissioner of Taxation (Kidston ) (1991) 30 FCR 77; 91 ATC 4538; (1991) 22 ATR 168).

Accordingly, ordinary interest incurred on funds borrowed that are used to acquire an income producing asset is generally an allowable deduction.

Compound interest is interest that accrues on interest that is unpaid.

The principles governing the deductibility of compound interest are the same as those governing the deductibility of ordinary interest: Hart v. Federal Commissioner of Taxation [2002] FCAFC 222, 2002 ATC 4608, (2002) 50 ATR 369 ( Hart ). The Commissioner accepts that this is the law following the Full Federal Court's decision in Hart .

The Hart case proceeded to the High Court [1] but the High Court did not have to deal with the question of the deductibility of the compound interest in that case because the Court found in favour of the Commissioner on the question of whether Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) applied to the arrangement in question.

Some have suggested that the deductibility of compound interest is always determined by the use to which the funds originally borrowed were put. This, it is suggested, follows from the following statement of Hill J in Hart at 2002 ATC 4616; 50 ATR 378: 30. ... Accordingly, as the learned primary Judge held, the compound interest, like the ordinary interest, will take its character from the use to which the original funds borrowed are put. [2]

This is not the correct reading of Hill J's statement. The statement needs to be read in light of what His Honour said earlier in his reasons for judgement at 2002 ATC 4615; 50 ATR 376: 25. Two tests have been proposed to determine the deductibility of interest on monies borrowed to acquire income producing assets. The first looks to the purpose of the borrowing; the second, looks to the use to which the borrowed funds are put. Generally, where interest is borrowed to finance the acquisition of an income producing asset it will make no difference which formulation is used. The result will be the same. The interest will be deductible. This is because the purpose of the borrowing will usually be readily seen from examining the use to which the borrowed funds are put. It is unnecessary, therefore, in the normal case to distinguish between the two tests.

When the judgement is read as a whole, it is clear that Hill J did not intend by his statement at paragraph 30 to reject the principles he had just set out at paragraph 25 (whether generally or in the case of compound interest particularly). He was merely indicating that, on the particular facts of Hart , the use to which the funds borrowed were put gave the answer. That is, this was a 'normal case' in which it was unnecessary to distinguish between the two tests. Further, nothing in any of the other judgements in Hart , at first instance or in the Full Court, suggests a contrary conclusion.

The decision of Edmonds J (with whom Spender and Dowsett JJ agreed) in Spassked Pty Ltd v. Commissioner of Taxation [2007] FCAFC 205 is a recent illustration of the principle that deductibility of interest is not always determined only by the use or the initial use of the borrowings on which the interest arises. The issue of deductibility of interest on a loan 'is essentially a question of fact in respect of the year or years of income for which it is to be determined. Moreover, it is clear that the relevant factual considerations can change over the term of the loan so that the facts relevant to the criteria for deductibility in one year will not necessarily mirror those in another year. This is perhaps best brought out by Hill J in Kidston ...'.

In Kidston Hill J noted that 'reliance on the tests both of purpose of the borrowing and of application of the funds present difficulty.' After giving examples of anomalies that the application of each test alone can lead to, his Honour went on to say that '[T]his is not to say that tests such as the purpose of the borrowing or the use and application of the borrowed funds are irrelevant. Rather they are tools to assist in the resolution of what is essentially a question of fact.'

The Commissioner's view is that nothing in Hart is authority for the proposition that the principles in these cases are incorrect or that they apply any differently in the case of compound interest.

This Determination does not deal with the question of the application of Part IVA of the ITAA 1936 to arrangements involving compound interest.

We invite you to comment on this draft Taxation Determination. Please forward your comments to the contact officer by the due date. (Note: the Tax Office prepares a compendium of comments for the consideration of the relevant Rulings Panel or relevant Tax officers. The Tax Office may use a version (names and identifying information removed) of the compendium in providing responses to persons providing comments. Please advise if you do not want your comments included in the latter version of the compendium.) Due date: 3 October 2008 Contact officer details have been removed following publication of the final ruling.