Taxation Ruling

TR 2003/9

Income tax: deductibility of interest expenses incurred by trustees on borrowed funds used to pay distributions to beneficiaries

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FOI status:

may be released

Preamble

What this Ruling is about

Class of person/arrangement

1. This ruling explains the principles to be applied in determining whether a trustee of a trust estate is entitled to a deduction for interest expenses incurred on borrowed funds used to pay distributions to beneficiaries when calculating the net income of the trust estate under section 95 of the Income Tax Assessment Act 1936 ('the Act').

2. The class of persons to which this ruling applies are trustees that make borrowings to fund distributions to beneficiaries and incur interest expenses on the borrowings.

Date of effect

3. This Ruling applies to years of income commencing both before and after its date of issue. However, the Ruling does not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Ruling (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).

Ruling

4. The incurring of interest expenses by a trustee of a trust estate in respect of borrowed funds used by the trustee to discharge an obligation to pay a monetary distribution to a beneficiary^[F1] will not, of itself, result in the interest expense being deductible. This is the case regardless of whether the obligation arises as a result of statute (for example, family maintenance provisions), or as a result of the instrument giving rise to the trust estate.

5. In order to be deductible, the interest expenses incurred by a trustee must be sufficiently connected with the assessable income earning activity, or business, carried on by the trustee in the capacity of trustee of a particular trust estate.^[F2] The interest expenses will be sufficiently connected if the use of the borrowed funds, when viewed objectively, is to repay to the beneficiary an amount previously invested by the beneficiary in an assessable income earning activity, or business, carried on by the trustee, in the capacity of trustee of the trust estate.

6. In this context, the amount invested by a beneficiary in an assessable income earning activity, or business, carried on by the trustee includes:

•

amounts settled by the beneficiary for the purpose of establishing the trust;

•

amounts contributed by the beneficiary by way of additional settlements upon an established trust;

•

an amount of unpaid present entitlement retained by the trustee under an express agreement between the beneficiary and the trustee; and

•

amounts loaned to the trustee by the beneficiary under an express written loan agreement.

This is subject, however, to the proviso that the beneficiary must be entitled to withdraw the amount, and that the amount must have been actually used in the assessable income earning activities of the trust estate.

7. Internally generated goodwill or unrealised revaluations of assets are not, in the relevant sense, amounts invested in the assessable income earning activities of a trust estate by the beneficiary.

8. There must be adequate documentary evidence, including proper accounting records, to demonstrate a sufficient connection between the interest expenses incurred on borrowed funds and the assessable income earning activities of the trust. Such evidence would need to address such matters as:

•

the proper characterisation of the interest expenses incurred;

•

establishing that the amount replaced by the borrowed funds was an amount previously invested by the beneficiary in an assessable income earning activity, or business, carried on by the trustee, in the capacity of trustee of the trust estate; and

•

establishing that the beneficiary was entitled to withdraw the amount invested.

Explanation

9. Section 95 of the Act defines the net income of a trust estate to mean the total assessable income of the trust estate calculated under the Act as if the trustee were a taxpayer in respect of the income and were a resident, less all allowable deductions (subject to certain exceptions).

10. In order for an interest expense to be deductible, the interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature (Charles Moore & Co (WA) Pty Ltd v. FC of T (1956) 11 ATD 147 at 149; (1956) 95 CLR 344 at 351; FC of T v. DP Smith (1981) 147 CLR 578 at 586; 81 ATC 4114 at 4117; (1981) 11 ATR 538). If the use of borrowed funds, when viewed objectively, is to discharge an obligation to pay a distribution that is owed by a trustee of a trust estate to beneficiaries of the estate, there must be a sufficient connection between the obligation to pay the distribution and the income earning activity, or business, carried on by the trustee. The test is one of characterisation. The essential character of the expense is a question of fact to be determined by reference to all the circumstances (Lunney & Anor v. FC of T (1958) 11 ATD 404 at 413; (1957-1958) 100 CLR 478 at 499; Fletcher & Ors v. FC of T 91 ATC 4950 at 4958; (1991) 22 ATR 613; Ronpibon Tin NL v. FC of T (1949) 78 CLR 47 at 56).^[F3]

11. In determining whether the obligation to pay distributions is sufficiently connected to the assessable income earning activity, or business, carried on by the trustee, two principles must be considered:

•

the mere fact that the trustee may have an obligation to make a distribution does not suffice of itself to render the interest deductible (see Hayden v. FC of T 96 ATC 4797 at 4804; 33 ATR 352 at 360); and

•

the refinancing principle discussed in FC of T v. JD Roberts; FC of T v. Smith^[F4] (Roberts & Smith).

Hayden's case

12. Hayden's case stands for the proposition that the mere fact that the trustee may have an obligation to make a distribution does not suffice of itself to render the interest deductible. In this context, it is irrelevant whether the obligation arises as a result of statute (for example, family maintenance provisions), or as a result of the instrument giving rise to the trust estate (see Hayden's case ATC at 4803 and 4804; ATR at 360).

13. In Hayden's case, a son, after the death of his father, commenced proceedings in the Supreme Court of Queensland claiming that his father had failed to make adequate provision from his estate for the proper maintenance and support of his son. The Court ordered that the estate pay the son $150,000. In order to pay the son, the executor borrowed $150,000. By borrowing the sum of money, the executor was able to comply with the court's order without selling the income producing assets of the estate (two properties). The executor argued that the interest incurred on these borrowings was deductible.

14. In holding that the interest incurred was not deductible, Spender J stated:^[F5]

Here, the borrowed funds were used to discharge an obligation by the estate [to pay an amount ordered by a court under family maintenance provisions]. I can see no difference in the present case from a case where an individual taxpayer, in order to discharge an obligation such as school fees, borrows funds on which interest is paid rather than sell income-producing assets and from the proceeds discharge the obligation. The paying of school fees requires funds, on which interest might be otherwise earned; that fact does not make interest on funds borrowed for the purpose of paying school fees deductible. The discharge of the obligation is a purpose quite independent of the property.

Roberts & Smith

15. In Roberts & Smith, a partnership of solicitors wished to admit a new partner, Mr McKay, to the firm, and decided that commencing with Mr McKay all future partners would have to pay a sum to enter the partnership. As Mr McKay did not have the amount required to enter the partnership, the partners resolved to reduce their capital input into the partnership so that Mr McKay could buy into the partnership at a much reduced level. The partnership borrowed from a bank to fund this capital reduction.

16. In deciding that interest on the borrowings taken out by the partnership were deductible, Hill J commented that:

... let it be assumed that there are undrawn partnership distributions available at any time to be called upon by the partners. The partnership borrows from a bank at interest to fund the repayment to one of the partners who has called up the amount owing to him ... The funds to be withdrawn in such a case [are] employed in the partnership business; the borrowing replaces those funds and the interest incurred on the borrowing will meet the statutory description of interest incurred in the gaining or production by the partnership of assessable income ... In principle, such a case is no different from the borrowing from one bank to repay working capital originally borrowed from another; the character of the refinancing takes on the same character as the original borrowing and gives to the interest incurred the character of a working expense ... Similarly, where moneys are originally advanced by a partner to provide working capital for the partnership, interest on a borrowing made to repay these advances will be deductible ...^[F6]

Applicability of the refinancing principle to trusts

17. Where a beneficiary lends an amount to the trustee of the trust under an express written loan agreement on arm's length terms, and the amount is used by the trustee in the assessable income earning activities of the trust estate, interest expenses incurred by the trustee in respect of funds used by the trustee to repay the loan are deductible. This is regardless of the nature of the trust.

18. A beneficiary may have settled an amount of capital as corpus on an existing trust, or expressly allowed income to which they are presently entitled to remain undrawn. In these circumstances, by analogy with the reasoning in Roberts & Smith, the interest expenses incurred by the trustee on funds borrowed to fund a distribution to the beneficiary will be deductible if:

•

the beneficiary exercises an entitlement to call for some, or all, of such an amount to be distributed to him or her;

•

the trustee borrows money at interest to finance that distribution; and

•

the use of the borrowed funds, when viewed objectively, is to repay to the beneficiary an amount previously invested^[F7] by the beneficiary in an assessable income earning activity, or business, carried on by the trustee, in the capacity of trustee of the trust estate.

This, again, is the result regardless of the nature of the trust.

19. The interest expenses will be deductible in the circumstance set out in paragraph 18 even if:

•

the actual borrowed money is paid directly to the beneficiary who exercises the right to call for the money to be distributed, rather than being used directly in the assessable income earning activities of the trust; and/or

•

the moneys refunded to the beneficiary are used by them for private purposes.

20. Whether in any particular case it can be said that the use by the trustee of the borrowed funds, when viewed objectively, is to repay to the beneficiary an amount previously 'invested' by the beneficiary in an assessable income earning activity, or business, carried on by the trustee in the relevant capacity depends upon a close examination of all the facts and circumstances of the case. Ultimately this is a mixed question of fact and law.

21. Two contrasting cases are discussed in paragraphs 22 and 23 with examples 2, 3 and 4 below providing further guidance on this issue. However, it should always be recognised that the facts and circumstances of each particular situation need to be closely examined before determining the deductibility of the interest expense.

22. Take the case of an individual (the unit holder) who has a vested and indefeasible interest in both the income and capital of a unit trust where those fixed interests arise from the individual having subscribed for units in the particular trust estate. Each unit holder has acquired a proportionate, defined interest in the trust measured by each of his or her units. The unit holder is presently entitled to that proportionate amount of the income of the trust estate and usually absolutely entitled to a proportionate amount of the capital. The unit holders may also be entitled to call for the redemption of some or all of their units (albeit usually subject to conditions). Such a power is effectively the equivalent of the unit holders being entitled to demand repayment of the capital they have contributed. The capital contributed by the unit holder in the form of the amount subscribed for units is usually employed by the trustee to derive assessable income. Furthermore the assessable income earning activities of the trust estate are carried on by the trustee on behalf of the beneficiaries. That assessable income earning activity generates income for the beneficiaries proportionately to their unit holding. In such a situation the settled trust capital may be regarded as invested capital owed to the beneficiary who settled the capital on the trust. Likewise, in such a situation, any undistributed amounts of income may be regarded as an amount invested by the beneficiary who has the right to that income. If, then, capital is returned or undistributed income distributed, it is appropriate to regard interest on the money borrowed by the trustee on arm's length terms to make the relevant distributions as within the refinancing principle, and therefore deductible.

23. By way of contrast, consider the case of a trust where the trustee has a discretionary power to distribute some or all of the capital and/or the income of the trust estate to one or more members of a defined class of objects. The members of such a class of objects rarely invest any money of their own in the corpus of the trust. No person is entitled to call for either the capital or income of the trust: both are distributable only at the discretion of the trustee. Further, those settling money on the trust are not entitled to demand repayment of the settled funds. Finally, the trustee does not carry on the assessable income earning activities on behalf of the beneficiaries in the same sense that the trustee of a unit trust does: while the trust corpus might be used to produce assessable income, the trust corpus is not used to produce assessable income for any particular beneficiary.

24. The position of the trustee described in paragraph 23 more nearly resembles the situation considered in Hayden's case, than the situation in Roberts & Smith. In Roberts & Smith the partners jointly used the capital invested by the individual partners to carry on a business that derived assessable income for each partner. The capital so invested was liable to be withdrawn by the partners. The analogy with the situation set out in paragraph 23 is not strong. In Hayden's case the individual who received the payment from the deceased estate had not in the relevant sense 'invested' any amount in the assessable income earning activities of the estate, and had not, prior to the decision of the court, any right to receive the amount ultimately paid. The funds were simply borrowed to discharge the obligation that arose as a consequence of the court's decision. The analogy with the paragraph 23 situation is far clearer. It follows that a borrowing by the trustee of a trust of the type described in paragraph 23 to fund a distribution to a member of the class of objects is likely to have the objective character of being simply for the purpose of discharging an obligation to make a distribution. Interest incurred on such a borrowing is not deductible.

25. However, a different result might arise in the type of trust described in paragraph 23 if the borrowed funds are used to pay an amount to someone who is entitled to call for the capital of the trust where that capital has been invested in an assessable income earning activity, or business, carried on by the trustee.^[F8]

The refinancing principle is inapplicable to borrowings used to distribute amounts attributable to internally generated goodwill and unrealised revaluations of assets

26. Internally generated goodwill and unrealised revaluations of assets are not, in the relevant sense, amounts invested in the assessable income earning activities of a trust by a beneficiary (see Roberts & Smith ATC at 4389 and 4390; ATR at 505-506 for the analogous position for partnerships). The amount invested in a trust is not the same as the property of the trust. The amount invested is at any specific point in time fixed by reference to the trust deed and any additional agreements between the relevant parties (for example, an agreement between the beneficiaries to settle additional capital on the trust, or an express agreement between the trustee and a beneficiary to invest in the assessable income earning activities of the trust an amount to which the beneficiary has an unpaid present entitlement). The actual assets of the trust (that is its property) vary from day to day, and include everything owned by the trust and having monetary value (see Roberts & Smith ATC at 4389; ATR at 505 for a description of the equivalent partnership law position). While amounts attributable to internally generated goodwill or an unrealised revaluation of assets may represent the monetary value of assets of the trust, they do not represent sums contributed by the beneficiaries.

Alternative view

27. There is an alternative view that the refinancing principle advanced in Roberts & Smith applies by analogy with equal force to the situation described in paragraph 23 as it does to the situation described in paragraph 22. It is argued by some commentators that the decision in Begg v. FC of T (1937) 4 ATD 257 provide supports for this alternative view.

ATO response

28. The Commissioner does not agree with the alternative view for the following reasons:

•

the alternative view does not give due weight to the decision of the Federal Court in Hayden's case;

•

the alternative view does not pay sufficient attention to the principles which underpin the Federal Court's analysis in the Roberts & Smith decision; and

•

to the extent that the alternative view relies on the decision in Begg's case, that reliance is inconsistent with the decision of the High Court in FC of T v. Munro (1926) 38 CLR 153.

Examples

Example 1

29. The trustee of a trust with a discretionary power to advance moneys to discretionary objects of the trust for their advancement in life exercises his discretion to make a distribution from the capital of the trust for that purpose (and does so only once). The distribution is not assessable income in the hands of the taxpayer. The trustee, in the capacity of trustee of the trust estate, carries on a business of owning and operating a small local store. The distribution is debited to capital in the accounts of the trust estate; specifically it is debited to an asset revaluation reserve. The source of the distribution is therefore an unrealised profit from the appreciation of capital assets treated for trust law purposes as part of corpus. The trustee borrows the funds necessary to make the distribution from an unrelated third party, and incurs interest expenses in respect of the borrowed funds. This interest expense is not deductible to the trustee when calculating the net income of the trust estate. (The interest would be non-deductible even if the facts were altered so that the beneficiaries had fixed interests in all of the capital and income of the trust. The amount being distributed represents unrealised profits of the trust, and such profits are not, in the relevant sense, invested in the assessable income earning activities of the trust estate.)

Example 2

30. Mr and Mrs Silver are the only beneficiaries of a unit trust, the trustee of which runs a small business of supplying motor vehicle spare parts. A nominal amount was settled on the trust at the time of its creation. Subsequently Mr and Mrs Silver jointly settled $200,000 on the trust so as to provide capital for the business to be carried on for their joint benefit. The trustee borrowed $300,000 for use in the business. Mr and Mrs Silver own all the units in the trust and, under the trust deed, jointly have a present entitlement to 100% of the net income of the trust. Not all the income is distributed; some remains for use as working capital by the trustee. However Mr and Mrs Silver remain entitled to withdraw, at call, the amounts settled on the trust and, pursuant to a written agreement between the trustee and Mr and Mrs Silver, all or part of the undistributed income. As a consequence, Mr and Mrs Silver each have undistributed income to which they are presently entitled invested in the trust totalling $20,000. (These amounts have been assessed in the hands of Mr and Mrs Silver under section 97 of the Act.) The trustee distributes $100,000 to the beneficiaries after borrowing that sum on arm's length terms from an unrelated third party. The distribution is debited first against the $40,000 unpaid present entitlement previously assessed to Mr and Mrs Silver, and the remaining $60,000 is debited against the $200,000 settled on the trust by Mr and Mrs Silver. The interest on the loan is fully deductible. This conclusion follows whether or not the moneys refunded to Mr and Mrs Silver are used by them for private purposes.

Example 3

31. The Brass Family Trust, was set up a number of years ago for the purpose of benefiting the Brass family consisting of Mr and Mrs Brass and their 3 children. A nominal amount was settled on the trust at the time of its creation. Subsequently, Mr Brass settled $200,000 on the trust. The trustee has invested all of the trust funds in dividend yielding shares that are listed on the Australian Stock Exchange. The trustee has a discretionary power to distribute some or all of the capital and/or the income of the trust estate to one or more of the members of the Brass family. To date, the trustee has only exercised this power to make distributions in favour of Mr and Mrs Brass.

32. In the 1989 income year, the net income of the trust was $10,000. The trustee exercised the discretionary power to distribute $10,000 to Mr Brass. The exercise of the power gave rise to an obligation to pay the full amount to Mr Brass. The amount was assessed in the hands of Mr Brass under section 97 of the Act.

33. Shortly after the exercise of the power to distribute, Mr Brass reached an agreement in writing with the trustee to leave the full amount of this obligation (less an amount equal to the tax payable by Mr Brass in respect of the present entitlement) in the hands of the trustee. Under the terms of the agreement, the amount left in the trustee's hands is payable at call to Mr Brass. The trustee uses the unpaid amount in the assessable income earning activities of the trust estate.

34. In the 2002 income year Mr Brass calls for the payment of $4,000 of the unpaid present entitlement that he had agreed to leave in the trustee's hands. The trustee takes out a loan of $4,000 from an unrelated third party on arm's length terms for the purpose of funding the payment to Mr Brass.

35. In the Commissioner's opinion the $4,000 payment to Mr Brass represents the repayment of an amount previously invested by him in the assessable income earning activities of the trust and, accordingly, the interest payable by the trustee on the loan is fully deductible.

Example 4

36. The Gold Family Trust was set up 3 years ago for the purpose of benefiting the Gold family consisting of Mr and Mrs Gold and their 2 children. The trust estate was originally settled by Mr Gold's father. Under the trust deed the trustee has a discretionary power to distribute some or all of the capital and/or the income of the trust estate to one or more of the members of the Gold family. Additionally, Mr and Mrs Gold are default beneficiaries of the trust and have a present entitlement to all the yearly income of the trust which is not distributed as a result of the trustee exercising the discretion to distribute. The trustee has invested all of the trust funds in dividend yielding shares that are listed on the Australian Stock Exchange. Those shares derive both dividend income and capital gains on the disposal of the shares. The trust deed allows beneficiaries with unpaid present entitlements to demand payment from the trustee of all or a part of that entitlement at any time.

37. During the 2001-2002 financial year the trust estate derived income from unfranked dividends only. All of the dividend income was deposited into a non-interest bearing bank account. Prior to the dividends being deposited, this account had a credit balance of $100. At the end of June 2002 the operation of the default clause resulted in Mr and Mrs Gold having an unpaid present entitlement to $8,000. This $8,000 represented the full amount of the net income of the trust for that financial year. The bank account was not income generating.

38. The trustee subsequently made a capital advancement to the children of Mr and Mrs Gold by means of paying the children's school fees, which amounted to $8,000. The full amount of this capital advancement was funded by a cheque drawn on the trust's bank account. This form of capital advancement, and the use of the bank account in this way, is permitted by the trust deed. By using money withdrawn from the bank account, the trustee did not have to realise trust property in order to pay the school fees. However, this also meant that the undistributed dividend income to which Mr and Mrs Gold were presently entitled was not used to acquire additional trust assets, or to carry on any assessable income earning activity.

39. In December 2002 Mr and Mrs Gold called for the payment of $6,000 of their unpaid present entitlement. The trustee takes out a loan for the $6,000 in order to fund the full amount of the payment to Mr and Mrs Gold.

40. The $6,000 paid to Mr and Mrs Gold does not represent an amount previously invested by them in the assessable income earning activities of the trust, as no part of the undistributed dividend income to which Mr and Mrs Gold were presently entitled had been used to acquire additional trust assets which were assessable income producing, or to carry on any assessable income earning activity. The borrowing by the trustee is simply for the purpose of discharging an obligation under the trust deed and interest incurred on the borrowing is not deductible.

Example 5

41. Mr Bronze has a vested and indefeasible interest in one half of both the income and capital of a unit trust. Mr Bronze's fixed interest arises from his having subscribed for half of the units in the trust estate.

42. In July 1998, in accordance with a written agreement made between Mr Bronze and the trustee of the trust estate, Mr Bronze lent the trustee, in her capacity as trustee of the trust estate, $20,000. Under the terms of the loan agreement, the loan is repayable on 30 June 2003. A commercial rate of interest is charged on the loan.

43. The amount borrowed by the trustee from Mr Bronze is used by the trustee in the assessable income earning activities of the trust.

44. In June 2003, the trustee borrows $20,000 from an unrelated third party on arm's length terms. The trustee uses the borrowings to repay the loan principal to Mr Bronze.

45. As the $20,000 payment to Mr Bronze represents the repayment of an amount previously loaned by him and used by the trustee in the assessable income earning activities of the trust, the interest payable by the trustee on the loan taken out to repay Mr Bronze is fully deductible. (The same result would arise (that is, the interest would still be deductible) if all of the facts were the same, other than Mr Bronze being a discretionary object of the trust rather than having a fixed entitlement to the income and/or capital of the trust.)

Detailed contents list

46. Below is a detailed contents list for this Taxation Ruling:

Commissioner of Taxation
30 July 2003

Previously released as draft TD 2003/D4.

References

ATO references:
NO 2003/001923

Related Rulings/Determinations:

TR 2003/9W
TR 92/1
TR 92/20
TR 97/16

Subject References:
deductions & expenses
interest expenses

Legislative References:
ITAA 1936 95
ITAA 1936 97
TAA 1953 Part IVAAA

Case References:
Begg v. FC of T
(1937) 4 ATD 257

Charles Moore & Co (WA) Pty Ltd v. FC of T
(1956) 11 ATD 147
(1956) 95 CLR 344
FC of T v. DP Smith
(1981) 147 CLR 578
81 ATC 4114
(1981) 11 ATR 538
FC of T v. JD Roberts; FC of T v. Smith
92 ATC 4380
23 ATR 494
FC of T v. Munro
(1926) 38 CLR 153
Fletcher & Ors v. FC of T
91 ATC 4950
(1991) 22 ATR 613
Hayden v. FC of T
96 ATC 4797
33 ATR 352
Kidston Goldmines Ltd v. FC of T
91 ATC 4538
(1991) 22 ATR 168
Lunney & Anor v. FC of T
(1958) 11 ATD 404
(1957-1958) 100 CLR 478
Ronpibon Tin NL v. FC of T
(1949) 78 CLR 47
Steele v. DFC of T
99 ATC 4242
41 ATR 139