Compound interest and the current position on linked/split loan facilities
Where interest accrues in relation to a loan and it is not paid, the interest expense incurred may be added to the loan balance. Interest that accrues on interest that is unpaid is referred to as ‘compound interest’. In Taxation Determination (‘TD’) 2008/27, the Commissioner provides that the principles governing the deductibility of compound interest (including capitalised interest) are the same as those that govern the deductibility of ordinary interest. That is, it is the purpose of the borrowing and the use to which the borrowings have been put that determines deductibility. Refer to Hart v FCT [2002] FCAFC 222 (‘Hart’s case’).
However, taxpayers must be aware of the potential application of the general anti-avoidance rules in Part IVA where interest is permitted to compound with respect to an income producing loan, while additional repayments are made with respect to a private (non-income producing) loan. Under these ‘linked’ loan facilities, loan repayments are allocated to the private loan and the unpaid interest on the income producing account is capitalised. Similarly, a ‘split’ loan facility may be taken out with a financial institution, where there is one loan with sub-accounts (used for income producing and non-income producing purposes) being maintained in respect of that loan.