A new ruling has been released by the ATO on the deductibility or otherwise of penalty interest. Ruling TR 2019/2 replaces an earlier ruling on the same topic that has since been withdrawn (TR 93/7W), and spells out the circumstances when penalty interest is generally deductible and the situations where this is not the case.
The term “penalty interest” refers to an amount payable by a borrower under a loan agreement in consideration for the lender agreeing to an early repayment of a loan. The amount payable is commonly calculated by reference to a number of months of interest payments that would have been received but for the early payment.
The new ruling stresses that the deductibility or otherwise is determined by the relevant circumstances, and also that different provisions of the tax law will also influence the outcomes. Relevant provisions dealt with in the ruling include:
- section 8-1 (general deductions)
- section 25-25 (borrowing expenses)
- section 25-30 (expenses of discharging a mortgage)
- section 25-90 (certain debt deductions relating to foreign non-assessable non-exempt income)
- subsections 110-35(9) and 110-55(2) (incidental costs for CGT asset)
- paragraph 40-190(2)(b) (element of cost of holding a depreciating asset)
- section 40-880 (business related costs).
The ruling says that penalty interest is generally deductible under section 8-1 where:
- the borrowings are used for gaining or producing assessable income or in a business carried on for that purpose, and
- it is incurred to rid the taxpayer of a recurring interest liability that would itself have been deductible if incurred.
Also, penalty interest that is incurred to discharge a mortgage is deductible (under section 25-30) to the extent that borrowed funds were used to produce assessable income. The ATO notes here that unlike the general deduction provisions (section 8-1), there’s no outcome influence from the expenditure being capital or revenue in nature.
Deductibility for penalty interest may also be available under section 40-880 if the amount is not otherwise taken into account, or denied a deduction, under another provision (note that section 40-880 is a provision “of last resort”).
No, not deductible
Penalty interest is not deductible under section 8-1 to the extent that it is a loss or outgoing of capital, or of a capital, private or domestic nature.
Also there is no deduction available as penalty interest is not incurred for borrowing money, so is not deductible under section 25-25.
Note also that penalty interest is not viewed by the ATO as being reasonably attributable to a balancing adjustment event occurring to a depreciating asset, so it is not included in the asset cost base under paragraph 40-190(2)(b).
Also to be considered
Other considerations revolve around capital gains tax and foreign sourced income.
Such outgoings that are incidental costs incurred in relation to a CGT event, or to acquire a CGT asset, are included in the cost base or reduced cost base. Any penalty interest incurred in deriving foreign source income may be deductible under section 25-90 if, among other things, it satisfies the definition of a debt deduction in paragraph 820-40(1)(a) because it is calculated by reference to the time value of money.
As is frequently the way, which thankfully the ATO realises is the case, some practical examples can help explain the application of the law. The following examples come from the ATO ruling.
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. Penalty interest is of a revenue character and deductible under section 8-1.
Alternatively, where refinancing affects the discharge of a mortgage securing the first loan, the penalty interest is deductible under section 25-30.
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 deductible under section 8-1. As the penalty interest is not a cost of borrowing incurred in establishing the loan, it is not deductible under section 25-25. It is deductible under section 25-30 as an expense of discharging the mortgage.
The beach house
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 not deductible under section 8-1. As the loan is unsecured, section 25-30 cannot apply.
The penalty interest is an incidental cost that relates to the sale of the beach house and can be included in the cost base under subsection 110-35(9) or the reduced cost base under subsection 110-55(2). However, if Alex did not repay the loan immediately it would be difficult to demonstrate that the penalty interest is an incidental cost.