In order to determine whether interest incurred on a loan is deductible, the ATO will generally look at the purpose and use of the borrowed money.  For example, interest incurred on a home loan for the taxpayer’s main residence will generally be non deductible, because the purpose and use of the borrowed money is for private purposes.  On the other hand, interest incurred on an investment property loan will be deductible, as the purpose and use of the borrowed money is for deriving rental income.

However things can get more complicated in the case of a split loan facility arrangement.  Under such arrangements, the taxpayer typically has 2 or more loans with the same bank.  One of these loans will be for the taxpayer’s home loan whilst the other loan(s) will be for his business or investment property.  The lender usually sets the level of repayments required on the loan facility based on the overall level of indebtedness but is unconcerned as to which loan the repayment is directed at.  The taxpayer will direct all the loan repayments to the home loan whilst interest accrues and compound on the investment loan.

The ATO have generally considered the above arrangement unfavourably and have denied the additional interest incurred which would not have been incurred had the principal and interest repayments been made to the investment loan.

In June 2011 the ATO issued draft Tax Determination 2011/D8.  In the draft determination, the ATO considers an arrangement with the broadly following features:

a)      The taxpayer has at least two properties – one is the taxpayer’s residence and the other is an investment property used to derive rent;

b)      The taxpayer has an outstanding loan against his residence and another outstanding loan against his investment property.  He also has a line of credit facility with an approved limit.  All these loans are typically but not always provided by a single financial institution;

c)       The loan against the investment property is typically an interest only loan for a specified period with principle and interest repayments required thereafter, or the interest only period may be extendable;

d)      The line of credit typically has no minimum monthly repayment obligations provided the balance remains below the approved limit.  Alternatively it may require minimum monthly repayments equal to the accrued interest;

e)      The home loan, investment loan and line of credit are each secured against the taxpayers’ residence and / or investment property;

f)        The line of credit is drawn down to pay the interest on the investment property loan as it falls due.  Where no repayments are required on the line of credit, the taxpayer does not make any repayments, which results in interest on the line of credit being capitalised and compounded.  Where monthly interest payments are required on the line of credit, the taxpayer meets such repayments from their cash flows;

g)      The taxpayer’s cash inflows (including that which the taxpayer otherwise might reasonably be expected to use to pay the interest on the investment loan) are all directed against the home loan which has the effect of reducing the interest otherwise payable on the home loan;

h)      If the line of credit reaches its approved limit before the home loan has been repaid, the taxpayer may apply to increase the limit on the line of credit in conjunction with a corresponding decrease in the available redraw amount in the home loan.

A key feature of the above is the use of the line of credit to pay the interest on the investment loan.  This results in interest on the investment loan, in effect, being capitalised and thus its payment deferred in order to enable the taxpayer to repay an equivalent amount on the home loan.  The ATO considers that the real effect and substance of the above arrangement is to make the payment of interest on the capital sum paid in reduction of the home loan tax deductible.

In the draft determination, the ATO states that they will not rule out applying the tax anti-avoidance provisions to the above arrangement.  The tax anti-avoidance provisions will be triggered where there is scheme which is carried out for the dominant purpose of obtaining a tax benefit.  Even though there may be a commercial purpose of paying the home loan off sooner, the ATO states that this does not prevent a conclusion that the dominant purpose of the arrangement was to obtain a tax benefit.  If the tax anti-avoidance provisions were to apply, the deduction for the interest incurred on the line of credit in the above example will not be deductible.  In addition, there may also be significant interest and penalties levied by the ATO.

When the final Determination is issued, it is proposed to apply both before and after its date of issue.