1: Can you claim a deduction for the interest expenses incurred in relation to the Loan during the ruling period under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?
1: No. Question 2: Did you have an obligation to interest withholding tax in relation to the interest expenses during the ruling period under section 12-245 of Schedule 1 to the Taxation Administration Act 1953 (TAA)? Answer 2: Yes. This ruling applies for the following period : Year ended 30 June 20XX The scheme commenced on: 1 July 20XX
You are a citizen of Australia. You obtained a loan from a foreign financial institute (Foreign Lender) located in Country X (Loan) to purchase a property located in Country X (Property). You incurred interest in relation to the Loan for some months prior to the start of the ruling period and continued to incur interest during the ruling period, which you paid to the Foreign Lender. The Property was purchased in a semi-finished condition. Activities to finish the Property were completed by the following month after you had obtained the Loan, with the Property being rented out the following month for market value to the same tenant up to and including the ruling period. You are not carrying on a business at or through a permanent establishment in Country X. You are not a tax resident of Country X and as a citizen of Australia you are not required to lodge income tax returns in Country X. You did not withhold any Pay As You Go (PAYG) withholding amounts in relation to the interest expense amounts arising in relation to the Loan prior to or during the ruling period.
You did not include any rental income and/or expense amounts in relation to the Property in your assessment for the ruling period.
Income Tax Assessment Act 1936 Division 11A of Part III Income Tax Assessment Act 1936 section 128B Income Tax Assessment Act 1936 subsection 128B(1A) Income Tax Assessment Act 1936 subsection 128B(2) Income Tax Assessment Act 1936 subsection 128B(3) Income Tax Assessment Act 1997 section 8-1 Income Tax Assessment Act 1997 section 26-25 Income Tax Assessment Act 1997 subsection 26-25(1) Taxation Administration Act 1953 Subdivision 12-F Part 2-5 of Schedule 1 Taxation Administration Act 1953 section 12-245 International Tax Agreements Act 1953
Summary You had an obligation to interest withholding tax in relation to the interest incurred in relation to the Loan, which you did not withhold. Therefore, you are not able to claim a deduction for the interest amounts incurred in relation to the Loan. Detailed reasoning Deductions - rental property interest expenses Section 8-1 of the ITAA 1997 allows a deduction for all rental losses and outgoings to the extent: • the property is rented or available for rent in the income year in which the deduction is claimed; and • they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith provides the Commissioner's view regarding the deductibility of interest expenses. Paragraph 3 of TR 95/25 sets out the following general principles relevant to the question of whether interest expenses are deductible under section 8-1 of the ITAA 1997:
• There must be a sufficient connection between the interest expense and the activities which produce assessable income. The test is one of characterisation, and the essential character of the expenses is a question of fact to be determined by reference to all the circumstances. • The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower (the use test). • Regard must also be had to all the circumstances, including the objective purpose of the borrowing and the nature of the transaction or series of transactions of which the borrowing of funds is an element. In some cases, the taxpayer's subjective purpose, intention or motive may be in deciding the deductibility of interest. Interest is not normally a capital outgoing because it is a recurrent expense which does not secure an 'enduring advantage'; rather, it simply secures the use of borrowed money during the term of the loan. Generally, this applies even where the borrowed funds are used to purchase a capital asset ( Steele
97 ATC 4239; [1997] FCA 167; 99 ATC 4242; [1999] HCA 7 ( Steele's case). Taxation Ruling TR 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities outlines the Commissioner's view in relation to the deductibility of interest expenses incurred prior to the commencement of income earning activities. Paragraph 9 of TR 2004/4 states: It follows from Steele that interest incurred in a period prior to the derivation of relevant assessable income will be 'incurred in gaining or producing the assessable income' in the following circumstances: • the interest is not incurred 'too soon', is not preliminary to the income earning activities, and is not a prelude to those activities • the interest is not private or domestic • the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost
• the interest is incurred with one end in view, the gaining or producing of assessable income; and • continuing efforts are undertaken in pursuit of that end. Deductions for rental interest expenses can be claimed when the above conditions are met if there is no legislative provision/s that prevent the deductions from being able to be claimed in the income year they are incurred as considered below. Interest withholding tax liability Section 128B of the Income Tax Assessment Act 1936 (ITAA 1936) deals with liability to withholding tax. Subsection 128B(1A) of the ITAA 1936 outlines that a reference to a person in section 128B of the ITAA 1936 includes a person who is a resident, the Commonwealth, a State or an authority of the Commonwealth or of a State. Subsection 128B(2) of the ITAA 1936 outlines that if any of the exemptions to withhold in subsection 128B(3) of the ITAA 1936 do not apply, then there is a liability withhold tax in relation to income that is derived by a non-resident after 1 January 1968 which consists of interest that:
• is paid to the non-resident by an Australian resident and is not an outgoing wholly incurred by the Australian resident in carrying on business in a country outside Australia at or through a permanent establishment of that person in that country (subparagraph 128B(2)(b)(i) of the ITAA 1936); or • is paid to the non-resident by a non-resident and is, or is in part, an outgoing incurred by that person or those persons in carrying on business in Australia at or through a permanent establishment of that person or those persons in Australia [subparagraph128B(2)(b)(ii) of the ITAA 1936]. Subsection 128B(3) of the ITAA 1936 provides an exemption from withholding tax income in relation to dividends, non-share dividends, interest and royalties. The following provisions may provide for an exemption to withhold tax in relation to interest when the relevant conditions are met:
• Paragraph 128B(3)(a) of the ITAA 1936 provides an exemption from withholding tax for dividends, interest and royalties derived by various non-resident institutions and organisations whose income is exempt from tax in their country of residence and is also tax-exempt in Australia under one of several specified sections of ITAA 1997. • Paragraph 128B(3)(aa) of the ITAA 1936 exempts from withholding tax interest, dividends and royalties derived by 'overseas charitable institutions' whose income is exempt from tax under subsection 121ELA(1) of the ITAA 1936. • Paragraphs 128B(3)(d) and (e) of the ITAA 1936 allows for an exemption from withholding tax dividends, interest and royalties derived by a trust where the trustee is liable to be assessed under either sections 99 or 99A of the ITAA 1936, or under section 102 of the ITAA 1936. • Paragraph 128B(3)(gc) of the ITAA 1936 exempts from interest withholding tax any interest derived on a nostro account by a non-resident foreign bank. • Paragraph 128B(3)(h) of the ITAA 1936 exempts from withholding tax certain classes of interest.
• Paragraph 128B(3)(j) of the ITAA 1936 exempts from withholding tax dividends, interest and royalties which are liable to be assessed under Part III of Division 9C of the ITAA 1936: and • Paragraph 128B(3)(l) of the ITAA 1936 exempts from withholding tax interest, dividends and royalties that are excluded from the assessable income of a trustee beneficiary of a trust estate. The corresponding provisions to section 128B of the ITAA 1936 imposing the actual obligation to withhold, as outlined above, are in Schedule 1 to the TAA. In regard to the actual withholding, the Australian resident entity's obligation to withhold is prima facie determined by section 12-245 of Schedule 1 to the TAA (as discussed below). Obligation to withhold an amount Subdivision 12-F in Schedule 1 to the TAA sets out the rules governing the application of Pay As You Go (PAYG) withholding to dividend, interest and royalty payments. Section 12-245 in Schedule 1 to the TAA imposes an obligation on an Australian resident entity to withhold an amount from interest. Section 12-245 in Schedule 1 to the TAA states:
An entity must withhold an amount from interest (within the meaning of Division 11A of Part III of the Income Tax Assessment Act 1936 ) it pays to an entity, or to entities jointly, if: a) the recipient or any of the recipients has an address outside Australia according to any record that is in the payer's possession, or is kept or maintained on the payer's behalf, about the transaction which the interest relates; or b) the payer is authorised to pay the interest at a place outside Australia (whether to the recipient or any of the recipients or to anyone else). Generally, interest is an amount paid for the use of borrowed funds. The term interest, at least with respect to its ordinary meaning, is not specifically defined in Division 11A of Part III of the ITAA 1936. It is accordingly necessary to look elsewhere for that meaning of the term. However, paragraph 128A(1AB)(a) of the ITAA 1936 states that interest includes an amount that is in the nature of interest. Limit on deductibility of interest expenses
Section 26-25 ITAA 1997 provides that a deduction is not allowable to the borrower (whether a resident or foreign resident) in determining taxable income until the withholding tax has been deducted and paid to the Australian Taxation Office (ATO). Subsection 26-25(1) of the ITAA 1997 states that a deduction cannot be claimed under that Act for interest (within the meaning of Division 11A of Part III of the ITAA 1936 if: (a) Subdivision 12-F in Schedule 1 to the Taxation Administration Act 1953 requires you to withhold an amount from the interest or royalty; and (b) either: (i) you fail to withhold the amount; or (ii) after withholding the amount, you fail to comply with section 16-70 in that Schedule in relation to that amount. ATO Interpretive Decision ATO ID 2004/848 Income Tax: Deductibility of an amount to a resident taxpayer who has not deducted withholding tax on an amount paid to a non-resident
outlines that section 26-25 of the ITAA 1997 outlines that a deduction under section 8-1 of the ITAA 1997 cannot be claimed for interest where the taxpayer is required to withhold an amount from the interest in accordance with section 12-245 in Schedule 1 to the TAA and the taxpayer either fails to withhold the amount or fails to comply with certain other requirements. Double taxation agreement In determining liability to Australian tax on Australian source interest derived by a non-resident, it is necessary to consider not only the Australian income tax laws but also any applicable Convention or Double Taxation Agreement contained in the International Tax Agreements Act 1953 (Agreements Act) . Section 4 of the Agreements Act incorporates that Act with the ITAA 1936 and the ITAA 1997 so that those Acts are read as one. The Agreements Act effectively overrides the ITAA 1936 and ITAA 1997 where there are inconsistent provisions (except for some limited provisions). The Double Taxation Agreement between Country X and Australia (the DTA) includes the following in relation to interest: Article 11 interest
1. Interest arising in one of the Contracting States, being interest to which a resident of the other Contracting State is beneficially entitled, may be taxed in that other State. 2. Such interest may also be taxed in the Contracting State in which it arises, and according to the law of that State, but the tax so charged shall not exceed 15 per cent of the gross amount of the interest. Application to your situation In this case, you obtained the Loan from the Foreign Lender in Country X to purchase the Property located in Country X. You incurred interest in relation to the Loan. You purchased the semi-finished Property, undertaking some activities to get the Property into rental condition, which were completed some months after you obtained the Loan. The Property was rented out from the month after the activities at the Property were completed. You receive market value rental income with the Property being rented to the same tenant from when it was first rented up to and including the rental period.
In accordance with the principals contained in TR 2004/4 the interest you incurred in relation to the Loan was not incurred 'too soon' before you started earning rental income in relation to the Property, which occurred several months after you obtained the Loan. However, before you can claim any deductions in relation to the Loan interest expenses under section 8-1 of the ITAA 1997 it must be determined whether you had an obligation to withhold tax in relation to the interest expense amounts. Based on the information provided we have considered the following when determining whether you had an obligation to withhold tax as follows, and if so whether any exemption to withholding tax would apply: • The interest expense amounts meet the definition of 'interest' as provided in subsection 128A(1AB) of the ITAA 1936, being referred to as 'interest' in the Loan and other documents issued by the Foreign Lender that is calculated at the specified percentage. • The conditions in section 12-245 in Schedule 1 of the TAA were met as you paid the interest expense amounts to the Foreign Lender located in Country X (subsection 12-245(a) in Schedule 1 of the TAA)
• The conditions in subsection 128(B) of the ITAA 1936 were met as the interest amounts paid by you to the Foreign Lender were not incurred by you in relation to carrying on a business outside of Australia. Additionally, the Property is not viewed as being a permanent establishment in Country X (subparagraph128B(2)(b)(ii) of the ITAA 1936]. • In accordance with Article 11 of the Country X Agreement, the interest amounts would be included in the Foreign Lender's assessable income in the year it is derived as the interest amounts are taxable in Country X. Additionally, in accordance with the DTA the interest amounts can be taxed in Australia • Nothing has been provided to support that any of the exemptions contained in subsection 128B(3) of the ITAA 1936 would apply to your situation so that you were exempt from having to withhold tax in relation to the interest amounts arising in relation to the Loan. Taking all of the available facts into consideration, it is viewed that there was a liability and an obligation to interest withholding tax.
While the liability to the interest withholding tax is imposed on the non-resident, for collection purposes, the obligation to deduct the interest withholding tax and pay it to the ATO is the resident who is paying the interest to the non-resident. You had an obligation to interest withholding tax in relation to the Loan interest amounts you paid to the Foreign Lender under section 12-245 in Schedule 1 to the TAA as you meet the relevant conditions as outlined above. However, you did not deduct any interest withholding tax in relation to the interest amounts you paid to the Foreign Lender and pay this amount to us. Therefore, in accordance with section 26-25 of the ITAA 1997, you are not able to claim any deductions for the interest expenses you incurred in relation to the Loan under section 8-1 of the ITAA 1997.