While it is generally understood that interest paid on loans for investments such as shares and rental properties is deductible, there are many other common scenarios where the ability to claim deductions for interest are not so clear-cut.

Generally, interest on investment loans is deductible provided it is incurred in gaining or producing assessable income. A multitude of case law and rulings show that satisfying this requirement is dependent on all the facts relating to the loan in question. The following general principles should always be considered in determining whether interest is deductible:

• The interest expense must have a sufficient connection with the activities which gain or produce assessable income and not be of a capital, private or domestic nature.
• The character of interest on money borrowed is generally ascertained by reference to where the funds are applied.
• A tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity.
• Interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets.
• The interest will not be deductible, to the extent to which it is private or domestic in nature, or is incurred in relation to the gaining or production of exempt income.

 Below is a broad overview of how the rules apply to some common situations:

Interest on loans to acquire Shares

If you borrowed money to buy shares, you will be able to claim a deduction for the interest incurred on the loan, provided it is reasonable to expect that assessable dividends will be derived from your investment in the shares. Where the loan was also used for private purposes, you will be able to claim only interest incurred on that part of the loan used to acquire the shares.

Borrowing to repay an existing loan (Re-financing)

Interest on a new loan will be deductible if the new loan is used to repay an existing loan which, at the time of the second borrowing, was being used in an assessable income producing activity or used in a business activity which is directed to the production of assessable income.

Interest incurred prior to assessable income

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.

Example: A taxpayer borrows to acquire a block of land with the intention of building a rental property, and every effort is made to construct the property and begin producing assessable income in a timely manner. In this instance interest payments will be deductible from the inception of the loan. 

Interest incurred after assessable income

Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and relevant income earning activities have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing 'the assessable income' if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgment about the connection between the outgoing and the income earning activities.

An outgoing of interest in such circumstances will not fail to be deductible merely because: the loan is not for a fixed term; or the original loan is refinanced, whether once or more than once.

However, if the loan is kept on foot for reasons not associated with the former income earning activities; or if a conscious decision is made to extend the loan for a commercial advantage unrelated to the attempt to earn assessable income in connection with which the debt was originally incurred, the nexus between the outgoings of interest and the relevant income earning activities will be broken.

Example: A taxpayer borrows $500,000 to acquire a parcel of listed securities, with the reasonable expectation of receiving assessable dividend income. Following a downturn in the share market the portfolio is sold for $300,000, with the funds being applies against the loan. Interest on the remaining loan balance of $200,000 will continue to be deductible.

 Interest on capital protected borrowings

A capital protected borrowing is an arrangement under which listed shares, units or stapled securities are acquired using a borrowing where the borrower is wholly or partly protected against a fall in the market value of the listed shares, units or stapled securities.

Interest attributable to capital protection under a capital protected borrowing arrangement for shares, units or stapled securities entered into, or extended, on or after 1 July 2007 is not deductible. The interest is treated as if it were a payment for a put option. This treatment applies where the shares, units or stapled securities are held on capital account for investment purposes.

The amount of interest that is reasonably attributable to the capital protection is worked out using the methodology applicable to the type of capital protected borrowing.

 If you would like some assistance assessing the deductibility of your interest on borrowings contact the team at GMD Chartered Accountants today.