Is the penalty interest (prepayment fee) incurred to change the fixed interest rate loan facility to a variable interest rate facility deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?
No. Question If the answer to question 1 is "No", is the penalty interest deductible under section 25-25 of the ITAA 1997? Answer No. This ruling applies for the following period : Year ending 30 June 20YY The scheme commenced on: DD MM 20YY
You and your spouse jointly held a fixed interest rate loan facility with a financial institution. The loan was originally for a property that was your principal place of residence, and the loan was secured by the same property. Within the financial institution home loan mortgage terms and conditions, a clause of which applied to the fixed rate loan facility, imposes penalty interest (referred to as a prepayment fee) upon prepayment of the facility (subclause (a)), or upon conversion of the facility to a variable interest rate facility at the borrower's request (subclause (b)). The terms and conditions do not impose a prepayment fee upon the prepayment of a variable interest rate loan facility. You have advised that a clause in the home loan terms and conditions, executing a debt recycling strategy with money borrowed via the fixed interest rate facility necessarily attracts a prepayment fee. On DD MM 20YY, you and your spouse, applied to the financial institution to convert your fixed rate loan facility to a variable rate loan facility.
On DD MM 20YY, the financial institution advised you that the prepayment fee to convert the loan facility to a variable interest rate would be $XXX and sought acceptance of the quote. You and your spouse indicated that the prepayment fee should be withdrawn from the available redraw balance of the loan facility. You have advised that you and your spouse's dominant purpose in converting the loan facility to a variable interest rate was to enable the borrowed money to be repurposed to generate assessable income. On DD MM 20YY, the financial institution confirmed that they had received the prepayment fee of $XX and converted the loan facility to a variable interest rate loan. Over the course of MM 20YY, you and your spouse repaid the loan in full, with the loan balance reaching $0.00 on DD MM 20YY. You have advised, on DD MM 20YY, you withdrew the available redraw amount in full and loaned the full amount to a company in the capacity as Trustee of XXX Trust, on the terms that include a commercial rate of interest. Thus, as of DD MM 20YY, you intend that the entire balance of the loan to be used to produce assessable income.
Income Tax Assessment 1997 section 8-1 Income Tax Assessment 1997 section 25-25
Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings 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. Section 25-25 of the ITAA 1997 allows a deduction for expenditure you incur for borrowing money, to the extent that you use the money for the purpose of producing assessable income. In most cases the deduction is spread over the period of the loan. Taxation Ruling TR 2019/2 Income tax: whether penalty interest is deductible explains when 'penalty interest' is deductible under section 8-1, section 25-25, section 25-30, section 25-90 or section 40-880 of the ITAA 1997. 'Penalty interest' is an amount payable by a borrower under a loan agreement in consideration for the lender agreeing to an early repayment of the loan. The amount payable is commonly calculated by reference to a number of months of interest payments that would have been received but for the early repayment.
Penalty interest is generally deductible under section 8-1 where the borrowings are used for gaining or producing assessable income or in a business carried on for that purpose, and it is incurred to rid the taxpayer of a recurring interest liability that would itself have been deductible if incurred. However, penalty interest is not deductible under section 8-1 to the extent that it is a loss or outgoing of capital, or of a capital, private or domestic nature. Penalty interest is not incurred for borrowing money so is not deductible under section 25-25. Application to your circumstances You incurred penalty interest (prepayment fee) expense when you changed your fixed interest rate loan to a variable interest rate loan. The original purpose of this loan was to purchase of a property which was your principal place of residence thus not an income producing asset. Under section 8-1 a deduction is not allowed where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.
In your case when you incurred the penalty interest (prepayment fee) the loan was still used for a private purpose. The loan was paid down to zero on DD MM 20YY the loan remained a private purpose loan and therefore the penalty interest is not deductible. You advised that on DD MM 20YY when the loan was redrawn for its new purpose of being a loan used solely for the purpose of producing assessable income, the loan account is treated as a new loan, The purpose or use of the drawing is relevant. That is, the deductible portion of interest when further borrowings are made depends on the use the redrawn funds are put. This is, of course, independent to the purpose of the original borrowing. TR 2019/2 provides 3 examples the first two examples regarding rental properties shows that the penalty interest is deducible because the rental properties are income producing assets. Example 3 illustrates a private-use asset the expenditure is private in nature and not deductible under section 8-1.