Business costs, and the deductibility of interest expenses
If a business racks up an interest bill from borrowing funds to pay for the expenses of running the business, or to acquire other income-producing assets or investments, this expense is generally allowed as a tax deduction for the relevant year.
For business taxpayers under the accruals accounting method, a claim can be made for the calculated interest liability to the end of the income year (usually June 30), provided the interest on the debt accrues on a daily basis (which would usually be the case).
Deductions for interest incurred
The availability of deductions for interest are typically affected by the following factors:
- interest must have a sufficient connection with the income earning activities of the taxpayer
- interest on a new loan is deductible if the new loan is used to repay an existing loan, which, at the time of the second loan, was used to produce assessable income or as part of a business to produce assessable income
- interest on borrowings will not continue to be deductible if the borrowings cease to be employed in the borrower’s business or for some income producing activity, or which are used to earn exempt income
- interest may still be deductible even if the borrower’s business has ceased. This rule can apply to other assessable income-producing activities but would not apply to the derivation of exempt income
- interest may be deductible if incurred prior to a business commencing or assessable income being derived
- the character of the interest will generally be determined by the use to which the borrowed funds are put
- the “rule of 78” may be used in limited circumstances to calculate the interest component of instalments paid under a fixed term loan or extended credit transaction
- penalty interest for early repayment of a loan may be deductible, and
- an interest deduction can be claimed for money borrowed for the business that is used to pay a tax debt.
Interest costs incurred by companies may be deductible if the money:
- is used to repay share capital to shareholders if that capital was employed as working capital in the company business and is used to derive assessable income, or
- funds the payment of a declared dividend to shareholders where the funds representing that dividend are employed as working capital in the company business and it is used to derive assessable income.
- A deduction is not allowed if the borrowed funds are used to:
- repay share capital to shareholders to the extent it represents bonus shares paid out of an unrealised asset revaluation reserve or other equity account (for example, internally generated goodwill), or
- pay dividends out of unrealised profit reserves.
If costs are incurred to obtain a loan, the costs of arranging it are allowable as a deduction to the extent the loan is used to produce assessable income. Expenses claimable under this heading include:
- legal expenses associated with the mortgage documents
- valuation fees incurred
- procuration fees and mortgage insurance (if any)
- stamp duty payable on mortgage documents, and
- any other cost items for taking the loan.
If the total cost of these expenses is less than $100, it can be claimed in the income year the expense is incurred. However if more, the claim will need to be spread equally over the lessor of the loan term, or five years commencing from the date the loan was entered into.
If you incur borrowing costs on a number of dates for different facilities you cannot simply add them to the opening balance of your yet-to-be-deducted borrowing costs for that year. It is necessary to do a separate calculation for these new borrowing costs.
Not only but also
When early repayment of a loan occurs, and some of the eligible costs of borrowing have not been claimed, these may be deducted in the year in which the borrowings are paid out. Generally any so-called “rebate” given when a loan is paid out is merely a figure to adjust the interest. Any refund would diminish the final claim for the costs of borrowing.
Note also that mortgage protection insurance for a bank loan used to purchase an income-producing asset is deductible. Penalty interest on early repayment of the loan may also be deductible. The tax law also allows a taxpayer to claim in full the cost of discharging a mortgage where the money was used (whether or not in a business) for producing assessable income. If only part of the borrowings were used for that purpose, apportion the discharge expenses.