Warning on Claiming Interest

Imagine how you would feel if you borrowed $100,000 to invest in shares. Then when it came time to do your tax return your Accountant told you the interest is not tax deductible because the money went from your loan to your cheque account so you could write a cheque to your broker. A recent AAT case decided that if loan funds are intermingled with other funds before being used for income producing purposes they are no longer considered to have their source in the loan.
It is accepted that interest is not deductible on a loan unless the proceeds of the loan have been used to purchase or in relation to an income producing investment. The link can be simply lost by paying some spare cash off the loan and drawing it back later or not being able to trace the flow of the funds to the investment. The ATO’s own ruling states ‘a rigid tracing of funds will not always be necessary as appropriate.' Yet in Domjan and Commissioner of Taxation [2004] AATA 815 the ATO successfully argued that the placing of borrowed money into a savings/cheque account with other personal funds broke the link necessary to prove the funds were borrowed for tax deductible purposes.
The AAT is not the highest court in the land but relevant nevertheless. The sitting AAT member stated:
“I accept the Commissioner's submissions. Where the funds have been intermingled it is impossible to determine the use to which they have been put. In other words the purpose of the borrowing cannot be ascertained. It cannot be said that the expenditure – that is the payment of interest – has been incurred in the course of gaining or producing assessable income”
Mrs Domjan also tried to argue that when she deposited private funds into her loan account they were quarantined from the loan so when she drew money from the loan for private purposes it was simply a redraw of those funds not a separate loan for private purposes. She also contended that any private funds put back into the loan after the redraw should go only towards reducing the loan for private redraws. Further she should not be penalised for using her private funds to temporarily reduce the interest on the loan and as a result reduce her tax deduction. In fact all her reasoning could be summed up as it is just not fair. The AAT found that the funds could not be divided so all repayments were to be spread equally over the loan and she could not choose which the character of the funds she was redrawing from.
Mrs Domjan was in for a penny in for a pound. She even claimed that as the bank required her to insure her home because it was security on the loan. The insurance should be tax deductible. No luck here either.
The AAT also found that when Mr Domjan used a lump sum he personally received to pay off his half of the loan the amount had to still be split equally between them as they were co debtors on the loan. Therefore even though he had paid his share back he was still entitled to claim the interest that related to Mrs Domjan’s share. As a result of this it would now be prudent, when only one member of a couple is borrowing to buy their share of an income producing jointly owned investment, the loan should only be in his or her name, not both. Trying to get a bank to agree to this may be a problem. If the bank will accept the non borrowing partner only gives a guarantee but his or her name does not actually appear on the loan, the problem may be avoided.
What was alarming was the fact that Mrs Domjan, who prepared her own tax return received a 25% penalty on the basis she had been careless in claiming the interest in relation to the redraws. The ATO’s argument being she had relied on a draft ruling after the final ruling had been issued. In the ATO’s world taxpayers preparing their own tax returns should have a knowledge of the thousands of ATO rulings available and check regularly for updates. The AAT agreed with the ATO. I have quiet a problem with this conclusion because unlike the draft ruling the final ruling did not cover redraws. So the ATO argument is really that Mrs Domjan should have followed up the daft to read the final ruling and then realise that by ommitting parts of the draft but not issuing a counter view the ATO was really saying they no longer held the view expressed in the draft. The issue of redraws was eventually addressed in another ruling 2 years after Mrs Domjan had lodged the returns in questions.
Probably Mrs Domjan greatest mistake was representing herself before the AAT. Though I have no answer as to how the average taxpayer can afford to be equally represented against the ATO and its unlimited taxpayer funded resources.


Julia Hartman
[email protected]
www.bantacs.com.au
 
julia said:
Probably Mrs Domjan greatest mistake was representing herself before the AAT. Though I have no answer as to how the average taxpayer can afford to be equally represented against the ATO and its unlimited taxpayer funded resources.

If your accountant is a member of the NTAA, they can make a request to the NTAA to fund the case through their legal fund. The NTAA is interested in getting involved in cases that establish important precedents. The NTAA gave taxpayers the ability to claim sun protection expenses through winning 10 out of 10 cases on them.
 
I've glanced at this case in my own amateur way. It appeared to me that in fact Mrs D tended to commingle both the incomings and outgoings to such a degree that it would be virtually impossible to untangle. I believe the ATO uses the word 'tainted' in this regard. I think this is where the penalty came from - that she asserted a certain percentage without the proof.

I certainly agree with comment about self-representation.

My solution has always been very simple - business loans and LOCs and credit cards are never, ever, ever used for private expenditure. I keep separate account for those and when, not if, the ATO comes calling I hope I will have a clean nose.
 
In Domjan's case the sitting member of the AAT even commented at the large amount of detail Mrs Domjan had on the transactions but nevertheless the only transaction to the every day account where it was accepted that the interest was deductible was when the every day account was over drawn before the money went in.
Re the Sunday Mail article. The example about the $100,000 in shares was just an example. Domjan's case was mainly about a rental property.
I also am interested in what other accountants have to say after they have read the full transcript of the case. The NTAAs recon you will be alright if you keep detailed records but I am not that confident. I am not aware of any feed back from the ATO on the issue yet.

Julia Hartman
[email protected]
www.bantacs.com.au
 
julia said:
Imagine how you would feel if you borrowed $100,000 to invest in shares. Then when it came time to do your tax return your Accountant told you the interest is not tax deductible because the money went from your loan to your cheque account so you could write a cheque to your broker.
Julia Hartman
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Julia , I think your opening statement ( from my reading of the Source Document) http://www.austlii.edu.au/cgi-bin/disp.pl/au/cases/cth/aat/2004/815.html?query=^+domjan

is misleading.

My understanding of what they have done is use a redraw facility as a transaction account. Whenever they have paid money ( business or personal funds ) into the account and then subsequently redrawn this money , the people involved felt that they could decide whether they were withdrawing from the " personal or business " funds that had previously been deposited.

To the best of my knowledge that has never been the case. Any subsequent withdraw is considered a new loan , and any payment into a redraw facility is considered paying off the personal and business funds in proportion to the existing allocation of the loan. eg if you have a loan which is allocated $150,000 business and $50,000 personal . You win $80,000 on lotto and pay that into the loan . $60,000 will be considered being paid off the business loan and $20,000 will be considered as paying off you personal loan.

Obviously it's better to have sub accounts in loans to keep loans seperate.

An alternative is to have an offset account , which I have beeen informed can be used for personal and business funds , as you're not paying off the loan or redrawing loans.

See Change
 
There are some very important questions in this thread.
If I extend on see_change example:

If one has a LOC 200K for investment purposes (lets say it is 80K drawn for legitimate investment purposes). Later 80K lotto winnings deposited to this account to reduce tax deductible interest. Lastly the same 80K (i.e. lotto winnings not a cent more) withdrawn from the LOC account to buy a 4WD (i.e. personal purchase). Does it make interest for previously withdrawn 80K not tax deductible any more? This is an absurd really as it encourages unnecessary accrual of tax deductible interest, but after reading the case it looks like it is correct assumption. :confused:

What is the opinion on the subject?

M.
 
Hi Mikhaila

I'm afraid that your conclusion is correct. As the loan was reduced any redraw for personal purposes would see the interest on that portion NOT deductible.

I think that the case in question has not really changed the law, merely raised the bar in terms of:

planning
record keeping
responsibility

that an individual should do in managing their tax and financial affairs. It also shows the benefits of having a well informed and knowledgable broker such as some of the ones on this forum!


Cheers

Dale

Mikhaila said:
There are some very important questions in this thread.
If I extend on see_change example:

If one has a LOC 200K for investment purposes (lets say it is 80K drawn for legitimate investment purposes). Later 80K lotto winnings deposited to this account to reduce tax deductible interest. Lastly the same 80K (i.e. lotto winnings not a cent more) withdrawn from the LOC account to buy a 4WD (i.e. personal purchase). Does it make interest for previously withdrawn 80K not tax deductible any more? This is an absurd really as it encourages unnecessary accrual of tax deductible interest, but after reading the case it looks like it is correct assumption. :confused:

What is the opinion on the subject?

M.
 
Dale,

I’d like to double clarify your answer or/and my understanding:

I talk about LOC only and not anything else. The reason I single out LOC as it is in away similar to transactional account by it’s features, and all other loans with re-draw facilities haven’t got similar characteristics.

Back to the example…

1. Original LOC amount 200K (LOC is used 100% for investment purposes)
2. Withdrawal of 80K (amount A) to purchase OZ shares

The interest on the amount A is clearly tax deductible at this stage.

3. 80K deposit (amount B) from lotto winnings into the above LOC
4. Withdrawal of 80K(amount B) from LOC to purchase 4WD for personal use.

At this stage the interest on 80K(amount B) is clearly not tax deductible, BUT what about 80K (amount A)? Does a deposit and a withdrawal of amount B even for one week into the LOC effectively kills the legitimate tax deductibility for the interest on initial amount A?

If yes, it means that ATO encourages the unnecessary accrual of tax deductible interest. Here is why:

Let’s take the 12 months period @ 6.5% as LOC rate.
80,000 * 6.5% = 5,200 of tax deductible interest;
If I keep/park the lotto winnings for 6 months on this LOC account the tax deductible interest amount is halved. If the above assumptions are correct the ATO forces me not to do that and keep the lotto money somewhere else. It can be a cheque account with 1.4% interest. Where is the logic? :confused:

Thank you for your input.
M.
 
Mikhaila said:
If I keep/park the lotto winnings for 6 months on this LOC account the tax deductible interest amount is halved. If the above assumptions are correct the ATO forces me not to do that and keep the lotto money somewhere else. It can be a cheque account with 1.4% interest. Where is the logic? :confused:

Thank you for your input.
M.

The Solution is to have a loan with an offset account. These have been around for at least twenty years, though at that stage they'd only affset a couple of points , not the whole lot which is what they do now. Down side is that they like to have offsets on Variable loans , not fixed interest loans.

See Change
 
Hi Mikhaila

I am afraid that the tax office have shown a willingness to treat the deposit as a repayment (in full or in part) of the LOC originally withdrawn to buy shares.

As Sea Change has suggested...it might just mean having two sub accounts of the LOC - one used purely for investment purposes and the other for private purposes.

Can I add something else though?

The tax office want to collect the right amount of tax - nothing more and nothing less. They are not encouraging any particular accounting method or investing method.

I understand your concerns, but, the issues really comes down to financial management. What is more important? Paying less tax because we can claim more interest, or, paying less interestbin the first place?

Just a thought

Dale
 
Hi,

I rang ATO and the answer was clear – the interest deduction on the “amount A” will not be allowed after “amount B” is withdrawn for personal use according to the existing general rules, however after explaining my reasons the person advised to apply for a private ruling as it clearly make sense to pay less interest in the first place.

Well, it looks like simple interest only investment loan with an offset is a much better and easier way to go. I must admit this is a first time when common sense didn’t work, as I completely agree with you Dale that usually ATO interested in collecting the right amount of tax (I guess this case is an exception).

Thank you See_Change and Dale for your informative input.

M.
 
Dale and others,

What of the concequences of redrawing from an LOC for a legitamte investment purchase ( eg. shares ) but using a personal cheque account to pay as there may be no cheque facility on the LOC?

Eg. Redraw from LOC 50K, deposit into chq acc., write cheque to share fund.

Surely if records of intent are keep all interest will remain tax deductable? :confused

MJK
 
MJK said:
Dale and others,
Eg. Redraw from LOC 50K, deposit into chq acc., write cheque to share fund.

Surely if records of intent are keep all interest will remain tax deductable? :confused

MJK
I wouldn't risk it in the future and get a bank cheque from LOC(in fact I intend to close existing LOC and open inv. loan with an offset). It sounds silly but after reading the court case decision, talking to you guys and ATO it looks too much of a grey area(i.e. there are different shades of grey and this is too much for me to be comfortable).
M.
 
I suppose I sould mention that the LOC to which I refer is only used for investment. It is the use of the cheque account as a payment vehicle that I want to know more about. I did think of using a bank cheque but it seems a bit "draconian". I also wondered if instead of using a personal cheque acc it may be better to use a business cheque account.

So my question is this.

Do investment puchases need to be paid direct from the investment loan account or is it ok to pay from the loan account into a cheque account (business or personal ) and then write a cheque to the investment provider. Appropriate records kept??

MJK :confused:
 
Hi MJK,
Here is the bit related to your question staright from the AAT transcipt:

44. The Commissioner relies on this authority to submit that once an amount of money is deposited into an account that already contains funds the account becomes a mixed pool of funds and it is not possible to determine the source of each withdrawal. It is impossible to determine whether the funds used to pay an otherwise deductible expense are sourced from the monies at interest or whether the funds used are sourced from Mrs Domjan 's own monies.
45. It is further contended that once the funds that Mrs Domjan has drawn down were commingled with other funds in the cheque/savings and Visa accounts the essential nexus was lost and it became impossible to say whether any particular part of the interest paid on the loan facility related to income producing expenditure.
46. I accept the Commissioner's submissions. Where the funds have been intermingled it is impossible to determine the use to which they have been put. In other words the purpose of the borrowing cannot be ascertained. It cannot be said that the expenditure – that is the payment of interest – has been incurred in the course of gaining or producing assessable income (Federal Commissioner of Taxation v Payne (1994) 28 ATR 58).

Here is the link to the transcript again http://www.austlii.edu.au/cgi-bin/d...uery=^+domjan . Have a read it is a sobering material.

M.
 
Mikhaila,

Sobering alright! : :eek: :confused: :mad:

I would still like to hear from an accountant such as Dale on this one.

MJK
 
HI

It is really a judgement call between you and your accountant based on your own individual facts, and, the legal precedents such as the one posted by Julia at the beginning of this thread.

If your acocuntant is comfortable with you doing what you, then, you should relax and take him/her at their word.

If I was in your shoes I would document the reasons why you are doing what you are doing and I would consider adding a cheque facility or even internet banking facility to your LOC. To be honest, there is no real reason why transferring money to the cheque account might be "necessary" any more.

Dale

MJK said:
Mikhaila,

Sobering alright! : :eek: :confused: :mad:

I would still like to hear from an accountant such as Dale on this one.

MJK
 
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