Taxation Determination
TD 2008/27
Income tax: is the deductibility of compound interest determined according to the same principles as the deductibility of other interest?
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Please note that the PDF version is the authorised version of this ruling.There is a Compendium for this document: TD 2008/27EC .
This publication provides you with the following level of protection:
This publication (excluding appendixes) is a public ruling for the purposes of the Taxation Administration Act 1953. A public ruling is an expression of the Commissioner's opinion about the way in which a relevant provision applies, or would apply, to entities generally or to a class of entities in relation to a particular scheme or a class of schemes. If you rely on this ruling, the Commissioner must apply the law to you in the way set out in the ruling (unless the Commissioner is satisfied that the ruling is incorrect and disadvantages you, in which case the law may be applied to you in a way that is more favourable for you - provided the Commissioner is not prevented from doing so by a time limit imposed by the law). You will be protected from having to pay any underpaid tax, penalty or interest in respect of the matters covered by this ruling if it turns out that it does not correctly state how the relevant provision applies to you. |
Ruling
1. 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.
Date of effect
2. This Determination applies to years of income commencing both before and after its date of issue. However, this Determination will not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of this Determination (see paragraphs 75 and 76 of Taxation Ruling TR 2006/10).
Commissioner of Taxation
3 December 2008
Appendix 1 - Explanation
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This Appendix is provided as information to help you understand how the Commissioner's view has been reached. It does not form part of the binding public ruling.
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3. A deduction is allowed under section 8-1 of the Income Tax Assessment Act 1997 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).
4. 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 (Fletcher) (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).
5. Accordingly, a deduction is generally allowed for ordinary interest incurred on funds borrowed that are used to acquire an income producing asset.
6. There may be limitations to deductibility such as where the amount of assessable income derived, or expected to be derived, is less than the amount of the outgoing. In such cases, it may be necessary to examine all the circumstances to determine the extent to which the outgoing is deductible This is explained more fully in Taxation Ruling TR 95/33. See also Fletcher.
7. Compound interest is interest that accrues on interest that is unpaid.
8. The principles governing the deductibility of compound interest are the same as those governing the deductibility of ordinary interest: Hart. The Commissioner accepts that this is the law following the Full Federal Court's decision in Hart.
9. The Hart case proceeded to the High Court but the High Court[1] did not have to deal with the question of the deductibility of the compound interest in that case because the Court found Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) applied to the arrangement in question. The decision of the High Court does not, in the Commissioner's opinion, detract from the Full Federal Court's decision on the question of deductibility of compound interest.
10. Some have suggested that the deductibility of compound interest is always determined by the use to which the funds originally borrowed were put and so differs from the deductibility of other interest. This, it is suggested, follows from the following statement of Hill J in Hart at 2002 ATC 4616; 50 ATR 378:
30. There is no reason in principle why there should be any difference between ordinary interest and compound interest. Both are simply the cost of the funds which are borrowed. It is artificial to treat compound interest as the cost of some new fund divorced from the original borrowing. The compounding of interest is no more than a formula for computing the interest to be paid on the funds originally borrowed. 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].
11. The Commissioner considers that 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.
12. 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.
13. The decision of Edmonds J (with whom Spender and Dowsett JJ agreed) in Spassked Pty Ltd v. Commissioner of Taxation (Spassked) (2007) 165 FCR 484; [2007] FCAFC 205; 2007 ATC 5406; (2007) 67 ATR 900 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...' (per Edmonds J at paragraph 71). It is also possible that even within a given income year the purpose or use of a loan can change from non-income producing to income producing or vice versa.
14. In Kidston Hill J noted (at FCR page 85, as quoted in Spassked per Edmonds J at paragraph 71) 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'.
15. 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.
16. This Determination does not deal with the question of the application of Part IVA of the ITAA 1936 to arrangements involving compound interest.
Footnotes
Federal Commissioner of Taxation v. Hart (2004) 217 CLR 216; [2004] HCA 26; 2004 ATC 4599; (2004) 55 ATR 712.
The statement that compound interest 'will take its character from the use to which the original funds borrowed are put' is repeated by Hely J in paragraph 75 at 2002 ATC 4625; 50 ATR 387 in the course of expressing his agreement with the reasons of Hill J. Conti J also expressed his agreement with the reasoning of Hill J.
Previously released in draft form as TD 2008/D12
References
ATO references:
NO 2008/3133
Related Rulings/Determinations:
TR 95/33
TR 2006/10
Subject References:
borrowings & loans
deductions & expenses
interest expenses
Legislative References:
ITAA 1936 Pt IVA
ITAA 1997 8-1
Case References:
Federal Commissioner of Taxation v. Hart
(2004) 217 CLR 216
[2004] HCA 26
2004 ATC 4599
(2004) 55 ATR 712
Fletcher v. Federal Commissioner of Taxation
(1991) 173 CLR 1
91 ATC 4950
(1991) 22 ATR 613
Hart v. Federal Commissioner of Taxation
[2002] FCAFC 222
2002 ATC 4608
(2002) 50 ATR 369
Kidston Goldmines Ltd v. Federal Commissioner of Taxation
(1991) 30 FCR 77
91 ATC 4538
(1991) 22 ATR 168
Lunney & Hayley v. Federal Commissioner of Taxation
(1958) 100 CLR 478
(1958) 11 ATD 404
(1958) 7 AITR 166
Spassked Pty Ltd v. Commissioner of Taxation
(2007) 165 FCR 484
[2007] FCAFC 205
2007 ATC 5406
(2007) 67 ATR 900