Firstly what is interest expenditure? It’s the cost incurred by an entity for borrowed funds ie. the interest payable on any borrowings such as bonds, loans, or lines of credit. However when borrowing, there are a range of important factors to consider, including whether the interest expenditure will be tax deductible.
Interest deductibility is determined under the general deduction provisions set out in section 8-1 of the Income Tax Assessment Act 1997. This provision states that interest expenditure will be tax deductible where the borrowed funds are:
- Used in gaining or producing assessable income; or
- Incurred in carrying on a business of gaining or producing assessable income; and
- Are not capital, private or domestic in nature; or
- Incurred in relation to gaining or producing exempt income.
Some common examples where interest will be tax deductible are borrowing funds to acquire a rental property or financing business operations.
What determines tax deductibility?
A common misconception is that interest deductibility is based on the type of borrowing. However it is the purpose of the borrowing that determines the tax deductibility. This means that there may be additional options when obtaining finance, such as drawing down on an existing home loan. It is important to note that if you are drawing down on your home loan for financing an investment activity, you will need to apportion the interest expenditure between deductible interest (relating to the investment activity) and non-deductible interest (relating to your personal home).
Another factor to consider when it comes to the tax deductibility of interest is whether you are using an offset account or redraw facility. Both of these methods effectively work the same in reducing your interest liability, however there may be certain circumstances where a redraw facility will reduce the tax deductible portion of the loan.
An example of this is where you deposit your salary or rental income into the loan account and then redraw on the loan to pay for private expenditure, such as repaying a personal credit card. The ATO may treat the salary or rental income deposits as a repayment of the original loan and the redraw as a new loan. Given the purpose of the redraw is for private expenditure, the interest in relation to this redraw would therefore not be tax deductible.
There are a variety of situations to consider when borrowing and the tax deductibility of interest is just one. If you are thinking of obtaining finance, please speak with our team to ensure all options are considered. Get in touch with BLG Business Advisers online or by calling (02) 4229 2211.