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Forward Thinking Magazine : April 2011
22 Interest prepayments Interest expenses that are otherwise deductible are also subject to the prepaid expenses tax rules. These rules effectively limit how far in advance expenses can be prepaid if all the expenses are to be tax deductible in the year of payment. In general, individuals can prepay interest expenses for periods up until the end of the following income year, as long as the period relating to the interest payment does not exceed 12 months. Although interest prepayments for certain tax shelter arrangements are excluded, typical negative gearing arrangements using mortgage backed finance to invest in listed shares, widely held units and/or real property are not subject to this restriction. ExamPlE 4: Walter has a line of credit facility with his mortgage provider. In September 2010 he opened a new account within the facility to draw down $100,000 to invest in a portfolio of income producing listed shares. The account was operated initially on an interest only basis, with monthly interest payments based on the facility’s current variable interest rate. His interest expenses are otherwise deductible. On 1 June 2011, Walter decides to fix the interest rate on this account, and prepays $7,500 of interest for the period 25 June 2011 to 24 June 2012. Because the interest period is wholly within a 12-month period ending before the last day of the next income year, Walter is entitled to a deduction for the expenditure in 2010/11. Compound interest deductibility The term ordinary interest refers to interest derived on original borrowings, or the outstanding borrowings which represent original borrowings less principal repayments plus additional borrowings. In contrast compound interest is interest accrued on unpaid ordinary interest. This occurs when the repayments made (if any) are less than the amount of ordinary interest incurred in a period. The unpaid interest is generally debited back to the loan account, effectively compounding (or capitalising) the unpaid interest. The 2002 Full Federal Court decision2 in Hart was overturned by the High Court in 2004. However, the finding of the Full Federal Court with respect to the deductibility of compound interest was not disturbed by the later decision, and was subsequently confirmed by the ATO in Taxation Determination TD 2008/27. It is now settled law that the determination of deductibility of compound interest is based on the same principles as those which apply to ordinary interest. That is, in general, compound interest expenses incurred in producing assessable income are an allowable deduction, generally requiring identification of the purpose to which borrowings are applied when the compound interest expense is incurred. Mixed purpose loans and Hart’s case The High Court’s application of the Part IVA3 anti-avoidance rules to deny interest deductions in Hart has had a lasting effect on the mortgages industry. It has understandably caused both mortgage providers and financial advisers to adopt a conservative approach when providing advice in this area. In some cases advisers now approach the field with a sense of wariness. However, an understanding of the issues and outcomes in Hart may help advisers build confidence in the area of split loan advice. The arrangement In brief, the Harts were seeking to purchase a new main residence and offer for let their existing residence, upon which they still owed approximately $95,000. Evidence suggested the Harts became aware of the ‘Wealth Optimiser’ loan facility without much further research into the other loan options available to them. The Wealth Optimiser was a single loan requiring principal and interest (P&I) repayments based on the total amount borrowed. The facility offered the option to split the total loan into two accounts – in the Harts’ 2 Hart v Federal Commissioner of Taxation  FCAFC 222 3Income Tax Assessment Act 1936