There is good news and there is bad news.
This may sound like an odd rule, but claiming a deduction for interest borrowed to pay your tax debt is an allowable expense, as long as you are running a business.
In 1990, the ATO was asked about the tax deductibility of interest on a loan a business may have taken out to repay a tax debt. It was the third time, according to its records, that the matter was raised. The first request for clarification was made in 1921 and the next request occurred in 1951.
The 1990 query resulted in the ATO issuing a Taxation Ruling (IT 2582) to put the matter to bed, and the positions taken in this ruling have stood ever since.
In its ruling, the ATO admits that there were, and are, a number of “practical difficulties” associated with denying such a specific deduction for taxpayers carrying on a business. The difficulty goes right to the heart of the Income Tax Assessment Act 1936 (ITAA36), which is the basis for much of the existing Australian taxation rules and regulations. In 1997 the Australian tax legislation was redrafted in an attempt to simplify it, with the new legislation, Income Tax Assessment Act 1997 (ITAA97) taking effect from July 1, 1997.
The new legislation provided clarification of the issue of interest deductibility in clearer and simpler terms.
Specifically, under the old legislation, “All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.”
The “difficulties” the ATO refers to comes about due to the fact that paying a tax debt is neither of a capital nature nor done to gain “exempt” income. Consequently, the 1990 ruling goes on to say, it was decided that “where a taxpayer carries on a business producing assessable income and pays interest on an overdraft, no action is to be taken to disallow the interest attributable to a part of the bank overdraft equal in amount to the income tax paid out of the bank account which is in debit”. This is a practice that has continued to the present day.
The relevant section of the 1990 ruling states: “Where a taxpayer carries on a business for the purpose of gaining or producing assessable income and, in connection with the carrying on of that business, borrows money to pay income tax (whether to preserve the assets of the business, maximise the return on them, retain sufficient money to fund the business or otherwise) then it is considered that the interest incurred on those borrowings is a normal incident of conducting that business”. This means that such an expense on interest borrowed, is considered to be an expense incurred in carrying on that business and hence it qualifies for a tax deduction.
So it is clear that where a business borrows to pay its tax debts, interest charged on those borrowings will be deductible.
The news isn’t as good for individuals who borrow to pay for a tax debt. This is because the ruling would not apply to interest on borrowings that are not connected with the carrying on of a business for the purpose of producing assessable income, The ruling does not consider situations where individuals borrow to pay off a tax debt. In these cases, the ATO confirms that interest incurred by an individual on a loan to pay off a tax debt is not deductible.
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