Tax Tip 439: 2 loans from the one lender, can the borrower choose which to pay back first?

It is easy to distinguish loans with lenders such as banks as they have account numbers. But what would happen if there was a private lender who had lent 2 different amounts, under different terms, to the one borrower. If the borrower wanted to repay one loan but not the other, could they?


Example

Homer lends his company $50,000 interest free. Later on the company needs more money so Homer borrows from redrawing on one of this loans and lends it $50,000 at the same interest rate he is paying his bank.

Later on the company makes a good profit and has $50,000 it wants to repay Homer.

It would like to repay the interest free loan because it could still claim the interest on the $50,000. Is this possible?

Homer might have some issues if he is the director of the company. It would be in the company’s best interest to repay the loan on which it is charged interest as this would save the company more money. But putting this legal issue aside for now, could it choose which loan to repay from a tax point of view?

He could I think. But I know of no ATO document where this question is covered. It could even potentially be argued by the ATO that it is a scheme with the dominant purpose of gaining a tax deduction by repaying the interest free loan first.

To strengthen the borrowers position it might be useful to play around with the terms of the loans so that any interest free loan has a repayment term being of a relatively short period with the at interest loan having a relatively longer repayment period.

And, to make it even easier it might be possible to have different loans lent by different people. Homer could lend the interest free amount and Marge could lend the at interest amount under separate contracts. They could jointly lend a third amount too perhaps.


Just make sure you get both legal and tax advice on this one.

 

I encountered a common law case decision regarding this and it was within a tax ruling. And of course I cant recall where or the case name. The courts considered that a taxpayer is free to choose which loan they reduce provided they do so within the terms of each loan. Part IVA shouldnt apply to a taxpayer making a choice. That doesnt satisfy a scheme arrangement. The split loan ruling concerns were a factor - Maybe it was in a split loan ruling ? . A split loan where the lender agreed to Nil repayments on the deductible while requiring larger payments & interest on the non-deductible may be a scheme.

I recall the case included comment by one judge which considered that a taxpayer may elect to pay one loan down rapidly in the manner of say a non-deductible loan to ensure the deductible is repaid at its minimum. And then capitalisation is also a Part IVA concern hence the "minimum" repayments may be IO for example.

In Homers case it would be wise to keep each loan distinct and maintain its accounting on the written terms. If Homer and Marge did a round robin it could still be caught by Part IVA if there is a scheme and the dominant purpose is to produce a tax benefit.

This is not unlike a customer of a bank. They may have multiple accounts (loan or savings) and they are each independent of the other. Even a offset v a loan is a matter within the control of the taxpayer, not the lender.

 

Yes there is bound to be some legal case discussing this as it can go towards the enforceability of a debt.
e.g. Homer lends Ned $50,000 on 1 July 2013
He lends Ned another $50,000 on 1 July 2021
2022 Ned repays $50k
Homer gets the ***** and sues Net
the limitations act means the 2013 loan is unenforceable
so it will come down to which loan was repaid.