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Penalty interest on breaking a fixed interest mortgage

Mortgage “break fees” or “penalty interest” is a cost that has become more common place in the current economic times. With the recession starting to bite and with some taxpayers owing large sums to the banks on fixed loans with comparatively high interest rates, decisions about breaking the fixed-rate term to get lower rates have to be made. Invariably decisions like this come with a cost as banks want to be compensated for the loss of revenue that they would have received relative to the higher interest rate.

To many taxpayers their perception is that there should be no difficulty in deducting the cost of breaking a fixed-rate term — surely it is a cost of doing business? In this article Carl Brandt, tax partner in Brandt Segedin, reviews a number of important tax issues which need to be considered before reaching that conclusion.

Section DB5 — expenses incurred in borrowing money

Expenses incurred in borrowing money are deductible under s DB 5 of the Income Tax Act 2007. Borrowing costs are deductible under this provision even though they would normally be regarded as capital expenditure under traditional principles, as for example in New Zealand Dairy Farm Mortgage Co Ltd v C of T [1941] NZLR 83. Common examples of borrowing costs that are deductible under s DB 5 include loan application fees, property valuation fees to support a mortgage and legal fees incurred in raising the finance.

An early example of the beneficial affect of s DB 5 was King v C of IR (1973) 1 NZTC 61,107. In that case the taxpayers carried on the business of farming in partnership and during the year ended 31 March 1970 borrowed $81,400 from the State Advances Corporation. In the Corporation’s letter of offer the advance was described as a farm loan made for the purpose of purchasing “property (including stock and plant)”. The taxpayers were obliged to make a contribution of 2% of the amount of the loan to the Corporation’s General Reserve Fund pursuant to s 27 of the State Advances Corporation Act 1965. They elected to have the amount of the contribution added to the amount of the loan secured by the mortgage.

The taxpayers claimed the amount of the contribution as a deduction under the forerunner to s DB 5. The Commissioner disallowed the deduction on the basis that the contribution to the General Reserve Fund was of a capital nature and was for that reason precluded from deductibility by the predecessor of the capital limitation, now s DA 2(1).

The Supreme Court held that the specific borrowing provisions in s DB 5 permitted a deduction for the contribution to the State Advances Reserve Fund. The contribution was required as part of the conditions granting the loan.

The question that we are now turning to is whether a deduction can be claimed along similar grounds for “penalty interest” or a “mortgage break fee” charged when a fixed interest mortgage is broken. The amounts can be relatively large.

An initial concern is the word “penalty” used to describe these costs, for in a number of circumstances penalties and fines are not considered deductible for tax purposes. The other primary issue is of course whether s DB 5 permits a deduction or whether the payment is prohibited under the capital limitation.


While the “penalty interest” fee (break fee) is often described as a penalty, it is in reality a fee for breaking the fixed interest rate contract, and is to compensate the bank for the reduction in income from re-lending at lower rates. The calculation does bear some relationship to the difference between the fixed interest and interest at the floating rate on that loan. For example, in some situations where the interest rate is rising there is often no “penalty interest” charged.

Capital limitation?

Despite the method of calculation, the nature of the amount is a bank fee rather than a penalty or fine. In tax law it is the nature of the amount and not how it is calculated that determines its tax treatment. This principle has been confirmed by the courts on several occasions, a leading case being the Privy Council decision in Glenboig Union Fireclay Co Limited v IR Commrs (1922) 12 TC 427. Like most fees relating to bank loans (loan application fees, valuation costs, legal expenses) a break fee is capital in nature under normal principles and will be non-deductible unless a deduction is available under the specific borrowing provisions in s DB 5, or alternately the financial arrangements rules (discussed later).

A key feature of s DB 5 is that it applies only to expenses incurred in borrowing money, therefore it does not apply to expenses incurred in paying money back. Accordingly it is an accepted principle that s DB 5 does not allow a deduction for expenses incurred in repaying a loan or discharging a security, because in that context there is no borrowing of money.

In discussing this point most commentators note that a different outcome may apply where the discharge of a security such as a mortgage is part of the refinancing of existing borrowings. A new lender will generally require old securities to be discharged before lending under a new security, and the expenses of discharge are regarded as part of the expenses of the new borrowing. The generally accepted position is that where the taxpayer has to pay penalty interest in respect of the early repayment of the old loan, the penalty interest is allowed as a deduction if the repayment is required in order to obtain the new loan, provided:

•             the parties to the old loan arrangement are at arm’s length

•             the new finance is used to repay the old loan

•             the repayment of the old loan and the raising of the new one takes place concurrently, and

•             the old loan finance (as well as the new finance) was used in the derivation of income.

As the preceding comments show, a break fee may be incurred in both scenarios when the borrowing is paid back or when the borrowing is “refinanced”.

In the first situation the fee will not be deductible under s DB 5 because it has not been incurred to borrow money.

In the second situation, arguably it is deductible under s DB 5 because the ability to refinance the loan would not exist without the original loan being repaid.

If we stopped at this point, many taxpayers who are incurring break fees in the current climate would receive the unhappy news that they do not get a deduction as they are simply not borrowing money. However, it would be short-sighted to stop without considering the application of the financial arrangement rules.

Treatment under the financial arrangement rules

The bank loan is clearly a financial arrangement under s EW 3(3), and as the financial arrangements rules take precedence over other provisions unless expressly provided (see s EW 2(1)) they must be considered in relation to a break fee. Section DB 5 does not override the financial arrangement rules so the latter take precedence.

One of the fundamental principles of the financial arrangements rules is that the distinction between capital and revenue payments and receipts does not exist. Items are either deductible or taxable as determined by various rules and formulas in the rules. The timing of deductions and income receipts are also determined according to the financial arrangements rules.

The rules contain an exemption from the spreading requirements for individuals who meet the requirement of a cash basis person (CBP). Thus the timing of expenses incurred by CBPs is determined under normal rules.

Non-cash basis person

The definition of a CBP is detailed later in this article. Non-CBPs must use a spreading method to claim expenditure that is part of the “consideration” relating to a financial arrangement. In the writer’s view a break fee is part of the consideration relating to a financial arrangement. Accordingly it must be spread over the remaining term of the arrangement under the appropriate spreading method. There is an exception from the spreading requirement for “non-contingent fees” incurred when a financial arrangement is entered in to; however, this definition does not apply to break fees. A break fee is contingent rather than non-contingent, as it is only payable if in fact the person breaks the fixed rate loan.

The tax treatment for non-CBPs must be determined by considering whether the financial arrangement has terminated, in which case the base price adjustment must be performed, or whether the financial arrangement has merely been varied.

Variation of financial arrangement

A variation might occur where the fixed interest rate is broken, but the loan continues with simply a change in the rate of interest being paid.

Determinations G25 (“Variations in the Terms of a Financial Arrangement”) and G26 (“Variable Rate Financial Arrangements”) need to be considered.

Determination G25 notes that a financial arrangement may be varied for many reasons. It may be varied by mutual agreement between the parties, by operation of the terms of the arrangement (such as an option), or by a partial remission of debt. One way of effecting a change is by terminating the existing financial arrangement and issuing a new one. That situation is straightforward and does not need a specific determination. A base price adjustment is calculated and income or expenditure under the new financial arrangement is calculated using the yield to maturity method or an appropriate alternative.

It then specifically notes that:

“This determination does not apply to variable rate financial arrangements, where the only variation is a change in the index, price, or rate (these will be dealt with by a subsequent determination entitled Variable Rate Financial Arrangements). It does apply where a variation occurs that does not result from a change in the indicator rate. For example when the amount of principal is varied without a corresponding payment or the margin above the indicator rate is varied.”

This indicates that for break fee situations, Determination G26 is the relevant determination to apply. The explanatory notes in Determination G26 state:

“Reviewable rate arrangements are those where the Interest rate is set periodically in line with market rates. Any change in the Interest rate reflects and is consistent with changes in market Interest rates. The most common form of reviewable rate loan is a mortgage where the Interest rate is subject to periodic review by the lender.

The income or expense in relation to a variable rate arrangement could consist of:

(a)  Periodic Interest payments as determined from time to time;

(b)  A premium or discount on the issue or face value of the arrangement;

(c)  Fees paid or received in relation to the arrangement.

These amounts must be accrued.”

In summary, a non-CBP who incurs a break fee during a variation of the financial arrangement must spread the break fee over the term of the loan pursuant to Determination G26. If for example the remaining loan term is 20 years then the break fee will be spread over that term.

Termination of financial arrangement

By contrast, where a financial arrangement ceases the break fee expense will be treated as expenditure (interest) incurred under the base price adjustment (BPA) in the year in which the loan is terminated. This will occur when the original loan is repaid rather than just merely varied. In the writer’s view, if at the time the break fee is paid there are other changes to the fundamental terms of the borrowing (for example a change of term, a change in the amount borrowed, refinancing with another bank, perhaps changes to the security or guarantor) the first financial arrangement ends and a new arrangement begins. The loan documentation should also assist in providing evidence as to whether it is a mere variation, or a cessation of an old financial arrangement and commencement of a new one. For example, if the loan document records a new loan number along with changes to the principal sum borrowed, and the term etc, the BPA is triggered. The break fee will the form part of the BPA calculation for the old loan and, as noted above, the result of the BPA is that expenditure is incurred in that year equal to the break fee.

The BPA will also result in an amount of expenditure incurred even where the payment of the break fee is refinanced into the new loan, as will often be the case for large break fees. Support for this, besides the application of normal tax and accounting principles, is King v C of IR referred to earlier. The court held that the expense in that case (a contribution to the State Advances Reserve Fund) was regarded as having been incurred even though it was “merely added to the amount due under the taxpayer’s loan”.

Having determined that the break fee is expenditure incurred under the BPA, the deductibility of the amount needs to be considered separately. The reason for this is that while a positive BPA calculation is automatically assessable income, a negative BPA under s EW 31(4) is “expenditure incurred by the person in the income year for which the calculation is made”.


A negative BPA is treated as expenditure incurred in the nature of interest. The term “interest” is defined in s YA 1 for the purposes of the interest deductibility provisions in s DB 6 and DB 7 (paragraph c of the definition) to include “expenditure incurred under the financial arrangement rules”.

Consequently a negative BPA amount which comprises a break fee must satisfy the normal interest deductibility tests in order to be claimed. Two key points can be made about the deductibility tests:

1.  Interest deductions under s DB 6 override the capital limitation (see s DB 6(4)). Therefore a break fee will not be disqualified simply by being capital in nature. This is an important difference from the application under s DB 5 outlined earlier and shows that with the commencement of the financial arrangements rules the capital/revenue distinction has disappeared for costs like break fees. In other words, a break fee incurred on termination of a business-related loan, as distinct from the refinancing of a loan, will be deductible under the BPA regardless of the fact that it does not relate to the borrowing of money. As a deemed interest cost it is deductible whether or not it is paid upfront, at the end, or during the course of the arrangement.

2.  Normal companies, other than qualifying companies, get an automatic deduction for interest under s DB 7 subject to satisfying the other tests in that section.

Section DB 11 limitation?

Although we have noted that s EW 31(4) treats a negative BPA as expenditure incurred (in the nature of interest), the provision goes on to state that the person is allowed a deduction for the expenditure under s DB 11.

Section DB 11 states that “a person who has a negative base price adjustment under section EW 31(4) is allowed a deduction for the expenditure to the extent to which it arises from assessable income, under section CC 3 (Financial arrangements), derived by the person under the financial arrangement in earlier income years”.

The writer understands that some officers within Inland Revenue take the view that s DB 11 permits deductions under the BPA only for amounts which have previously been returned as income.

That view would deny deductibility for a break fee as it is clearly not an amount that arises from assessable income derived in earlier years.

Although a superficial reading of s DB 11 might appear to convey this view, the writer considers that this is an incorrect interpretation. In trying to understand the provision it is helpful to review the former version. In the Income Tax Act 1994, s EH 47(2) provided the general rule in relation to a BPA result — that a positive amount is income derived and a negative amount is expenditure incurred. Section EH 47(3) and (4) then followed with further requirements to apply in appropriate situations:

•             A positive amount was not income to the extent to which it arose from expenditure incurred under the financial arrangement in earlier years for which a deduction had not been allowed (s EH 47(3)).

•             A negative amount was deductible to the extent that it arose from income derived under the financial arrangement in previous years and a deduction would not be permitted other than by subsection (4).

The intent of these provisions was to ensure that a person was not unfairly double taxed by operation of the BPA. In relation to a negative BPA it effectively provided a guaranteed deduction for amounts which had previously been assessed as income. Put another way, for these specific amounts a person did not have to try and satisfy the normal deductibility tests — s EH 47(4) authorised the deduction on its own terms.

Moving now to the Income Tax Act 2007 and the interpretation of s DB 11, there has been no intended policy change which gives a different outcome to that explained above. Nor in the writer’s view is there an “unintended” policy change which has produced a differing result by accident. The key to applying s DB 11, and which confirms its consistency with the former provisions, is s DB 11(2). That subsection states that the section “supplements” the general permission and overrides all the general limitations. To “supplement” in accordance with s YA 1 means “to allow a person a deduction without requiring them to satisfy the general permission”.

Therefore in the writer’s view the interpretation of s EW 31(4) points a taxpayer to two operative provisions and, in relation to our discussion on break fees, can for ease of understanding be broken down as follows:


A base price adjustment, if negative, is expenditure incurred by the person in the income year for which the calculation is made.”

•             The negative BPA comprising the break fee is expenditure incurred in the nature of interest. For persons other than normal companies it must satisfy deductibility under s DB 6 by meeting the general permission. For normal companies, automatic deductibility under s DB 7 arises.

“The person is allowed a deduction for the expenditure under section DB 11 (Negative base price adjustment).”

•             To the extent that the negative BPA includes income assessed in previous years, the person will be entitled to an “automatic” deduction under s DB 11 without having to satisfy the general permission.

To interpret s EW 31(4) and DB 11 in any other way would make a mockery of the general permission for interest under s DB 6. It would also make a mockery of the automatic deduction for companies under s DB 7 if it were then somehow denied by s DB 11.

Cash basis persons — break fee less than or greater than $40,000

The definition of a CBP is contained in s EW 54 together with s EW 56 and EW 57. To qualify, the person must be an individual (but from 1 April 2009 can now include non-individuals) where certain thresholds are not exceeded as follows:

(a)   The absolute value of all financial arrangements to which the person is a party, added together, is $1m or less.
(b)   The person’s income and expenditure in the income year under all financial arrangements to which the person is a party is $100,000 or less.
(c)   The difference between the person’s aggregate income and expenditure on a “cash basis” and an “accrual basis” does not exceed $40,000.

If the break fee is incurred by a CBP it will be deductible under the financial arrangements rules and claimable when incurred, irrespective of whether it is incurred as part of a refinancing or when the borrowing is repaid (a BPA would be required then with an outcome the same as discussed above for non-CBPs). It is deductible in a refinancing scenario in the year it is incurred simply because it is “interest”, the general permission is satisfied, and the sum has been incurred and paid on a cash basis.

The general rules applying to adding back the unexpired portion of prepaid expenditure in s EA 3 do not apply to break fees as there is no unexpired portion.

Where a break fee on a mortgage exceeds $40,000 the threshold under (c) above will be breached because the difference between income and expenditure on an accrual basis versus a cash basis will exceed $40,000 by virtue of this amount alone. In these cases the treatment will revert to the treatment for a non-CBP as detailed above.


Tax relief by way of an immediate deduction will be available for many persons who incur break fees in relation to their business-related loans. For others, the break fee might have to be spread over the remaining term of the loan. By putting suitable arrangements in place with their banks, persons can ensure that they do more than just vary an existing loan, by terminating the old loan and commencing a new one, and in doing so will ensure that immediate deductibility of the break fee is available in the current year.

To summarise the conclusions reached in this article:

•             Non-CBPs will be required to spread the break fee over the remaining loan term if the interest rate reduction is merely a variation of their existing loan. By contrast, non-CBPs who replace their loan with a new financial arrangement will get a current-year deduction for the break fee under the BPA.

•             CBPs who do not break the $40,000 threshold will get a current-year deduction for the break fee, regardless of whether the loan is terminated or refinanced, on the basis that the amount is “interest” and the general permission is satisfied.

•             CBPs who exceed the $40,000 threshold due to the size of the break fee are disqualified from the CBP definition and will need to apply the same rules as for non-CBPs.

•             Persons who terminate their existing loans, rather than refinancing them, and incur a break fee in doing so will get a current-year deduction under the BPA regardless of whether they are CBPs or non-CBPs.

2 Responses

Alan Brown on August 6, 2009 at 1:56 pm

Pleasing to see a detailed analysis of the break costs.

Steve Taylor on February 1, 2010 at 2:12 pm

Thanks for the article. Quite an eye-opener. Another example that shows that tax is not as simple as it might at first appear. The simple answer is not always correct for all cases. It pays to cover all bases before jumping to conclusions.

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