The Australian Taxation Office (ATO) has released a new Ruling in relation to the tax deductibility of penalty interest. The term ‘penalty interest’ means 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 the number of months of interest payments that would have been received by the lending institution but for the early repayment.
The new Ruling indicates whether the penalty interest is generally tax deductible or not.
Penalty interest is generally deductible where:
- The borrowings are used for gaining or producing assessable income or in a business carried on for that purpose.
- The penalty interest is incurred to relieve the taxpayer of a recurring interest liability that would have been tax deductible if incurred.
- The penalty interest is incurred to discharge a mortgage to the extent the loan moneys were used for producing assessable income (in this case tax deductibility is not affected by whether the expenditure is capital or revenue in nature).
Penalty interest may also be tax deductible under the business-related costs rule if the amount is not otherwise tax deductible under another rule in the tax law. The business-related costs provision is a provision of last resort.
Penalty interest is generally not deductible where:
- The penalty interest is a loss or outgoing of a capital, or of a capital, private or domestic nature.
- The penalty interest is not incurred in relation to borrowing money; for example, the late or non-payment of an account.
In addition, penalty interest that is an incidental cost incurred in relation to a capital gains tax (CGT) event or to acquire a CGT asset is included in the cost base or reduced cost base of the asset.
Penalty interest is not reasonably attributable to a balancing adjustment event occurring to a depreciating asset, so the penalty interest is not included in the asset’s cost.
The following examples explain the ATO’s approach to penalty interest:
John can refinance his rental property at a lower interest rate. In order to refinance, John pays out the first loan early. He incurs penalty interest calculated on the basis of one month’s interest for each year of the loan period remaining.
The advantage sought in practical terms by repaying the first loan early and incurring penalty interest is future interest savings from a lower interest rate. The penalty interest is deductible.
Alternatively, where refinancing affects the discharge of a mortgage securing the first loan, the penalty interest is tax deductible.
Sally sells her rental property, repays the loan to discharge the mortgage over the property and incurs penalty interest.
The penalty interest is a necessary incident of the sale of the property. A payment so connected to the realisation of a capital asset will be on capital account and not tax deductible. Further, the penalty interest is not a tax deductible cost of borrowing incurred in establishing the loan but is tax deductible as an expense of discharging the mortgage.
Alex obtained an unsecured loan to purchase a beach house to use solely as a holiday house for his family. Alex and his family move interstate for work. Alex sells the beach house, immediately repays the loan early and incurs penalty interest.
Penalty interest is incurred in connection with selling a private-use asset; the expenditure is private in nature and is not tax deductible.
The penalty interest is an incidental cost which relates to the sale of the beach house and can be included in the cost base or the reduced cost base when calculating any assessable capital gain or loss. However, if Alex did not repay the loan immediately, the penalty interest would not be an incidental cost.