Penalty interest deductibles

The ATO has recently replaced the Taxation Ruling (TR) 93/7W on whether penalty interest is deductible to the new TR 2019/2. This new ruling highlights the circumstances in which penalty interest is deductible and the situations where it is not.

“Penalty interest” refers to an amount charged by a lender to a borrower under a loan agreement if instalments are not paid. The payable amount is then calculated by reference to a number of months of interest that would have been received.

The new ruling made provisions that directly related to the previous rulings of:

• Section 8-1: general deductions.
• Section 25-25: borrowing expenses.
• Section 25-30: expenses of discharging a mortgage
• Section 25-90: specific debt deductions relating to foreign non-assessable non-exempt income.
• Section 40-880: business-related costs.

TR 2019/2 says that penalty interest is generally deductible under section 8-1 where:

• The borrowings are incurred when gaining or producing your assessable income; or
• It is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

Penalty interest that is incurred to discharge a mortgage is also deductible under section 25-30, to the extent that borrowed funds were used to produce assessable income. The ATO makes a note that unlike the general deduction provisions, there's no influence from the expense being capital or revenue in nature.

You cannot deduct a loss or outgoing under section 8-1(2) to the extent that:

• It is of capital or capital in nature.
• It is of a private or domestic nature.
• It is incurred in relation to gaining or producing your exempt income; or
• A provision of the Act prevents you from deducting it.