Edited version of private ruling

Authorisation Number: 1011275526832

This edited version of your ruling will be published in the public Register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. Contact us at the address given in the fact sheet if you have any concerns.

Ruling

Subject: Compound interest expenses

Question 1

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for compound interest expenses incurred for your investment in a trust?

Answer

Yes.

Question 2

Does Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to deny some of the compound interest expense as a deduction?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2009

Year ended 30 June 2010

The scheme commenced on

Year ended 30 June 2009

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 177D

Income Tax Assessment Act 1997 Section 8-1

Relevant facts and circumstances

You have purchased an investment in a Trust. You have financed this investment with a business loan. Your business loan is a line of credit and it allows interest to be compounded.

Income received from the Trust is less than the interest expense of the business loan for the income year ended 30 June 2009. Due to financial reasons, you have been unable to make all payments on your business loan and this has led to interest being charged on interest (compound interest).

You have advised that you also have a separate home loan and that you have been making the minimum payments on this loan as legally required.

You also do not expect to be in a position to reduce your compound interest expenses for the income year ended 30 June 2010.

You are requesting a Private Binding Ruling as to the deductibility of the compound interest expenses due to the implications of the decision in Hart v Federal Commissioner of Taxation (2002) 121 FCR 206; 2002 ATC 4608; (2002) 50 ATR 369 (Hart's case).

Assumptions

1. Your business loan is a separate loan from your private loan.

2. The business loan is at arm's length.

3. You have invested in the Trust.

Reasons for decision

These reasons for decision accompany the Notice of private ruling for the taxpayer.

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Question 1

Are you entitled to a deduction under section 8-1 of the ITAA 1997 for compound interest expenses incurred for your investment in a Trust?

Yes.

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature.

The deductibility of an outgoing is determined by its essential character: Lunney v. Federal Commissioner of Taxation (1958) 100 CLR 478.

The character of interest is determined by the purpose of the borrowing. Generally, the purpose of a borrowing can be determined from the use of borrowed funds, and outgoings of interest ordinarily draw their character from that use: Fletcher & Ors v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613; Kidston Goldmines Limited v. Federal Commissioner of Taxation (1991) 30 FCR 77; 91 ATC 4538; (1991) 22 ATR 168.

Simple or ordinary interest (as distinct from compound interest, or interest on interest) incurred on funds borrowed to acquire an income producing asset is an allowable deduction.

In Hart v. Federal Commissioner of Taxation (2002) 121 FCR 206; ATC 4608; (2002) 50 ATR 369 it was held that compound interest derives its character from the use of the original borrowings.

In your case you will be incurring interest on interest, or compound interest, as you are capitalising the interest incurred on this business loan. It is accepted that the compound interest will be incurred on your business loan in relation to an income producing activity. As such, the compound interest will be incurred in the process of deriving assessable income and will be an allowable deduction under section 8-1 of the ITAA 1997.

Question 2

Does Part IVA of the ITAA 1936 apply to deny some of the compound interest expense as a deduction?

No.

Part IVA of the ITAA 1936 is a general anti-avoidance provision.

Generally speaking Part IVA will only apply to an arrangement where:

· you obtain a tax benefit from a scheme - a benefit that would not have been available if the scheme had not been entered into, and

· it could be objectively concluded that you had entered the scheme for the sole or dominant purpose of obtaining the tax benefit.

Scheme

In your case there is a scheme. The scheme consists of the following steps:

· you have a Line of Credit which you use to finance your investment, and

· the interest incurred on your Line of Credit is able to be compounded.

Tax benefit

A tax benefit is something which affects the amount of income tax you are liable to pay under the tax law.

The main kinds of a tax benefit are:

· an amount not being included as assessable income,

· a deduction

· a capital loss

· a foreign tax credit being allowed

In your case, you have a stand alone Line of Credit which you use for financing your investment. As your financial position has not enabled you to make all interest repayments associated with the loan, your interest expenses have increased due to the effect of compounding.

The identification of a tax benefit necessarily requires consideration of the income tax consequences, but for the operation of Part IVA, of an 'alternate hypothesis' or an 'alternate postulate'. This is what would have happened or might reasonably be expected to have happened if the particular scheme had not been entered into or carried out. This alternate arrangement also forms the background against which the objective ascertainment of the dominant purpose of a person occurs in accordance with section 177D of the ITAA 1936.

As the private loan and the business loan are all stand alone facilities with their own terms and conditions (unlike Hart's case where the one loan was split between two accounts), no counterfactual exists per se by reference to which you obtain a tax benefit.

Objective purpose test

There are eight matters specified in Part IVA which, when considered, lead to an objective conclusion as to whether you entered into a scheme for the sole or dominant purpose of obtaining a tax benefit.

The eight matters are:

1. the manner in which the scheme was entered into or carried out

2. the form and substance of the scheme

3. the time at which the scheme was entered into and the length of the period during which the scheme was carried out

4. the result achieved by the scheme under the income tax law if Part IVA did not apply

5. any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result from the scheme

6. any change in the financial position of any person who has, or has had, any connection (whether of a business, family or other nature) with the relevant taxpayer, that has resulted, will result, or may reasonably be expected to result, from the scheme

7. any other consequences for the relevant taxpayer, or for any person referred to in matter 6 (above) of the scheme having been entered into or carried out, and

8. the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in matter 6.

Answering this purpose question will generally be the most critical step in determining whether Part IVA applies.

This question is not concerned with any person's actual purpose. In other words, the purpose test' is not concerned with what a participant actually (or subjectively) thought or intended. It requires an objective conclusion to be reached about the purpose of a relevant person, and is determined after considering the eight specified matters.

In applying the purpose test, it is important to understand the relationship between each of the eight matters, and to consider and weigh them together in a practical and common sense way to get at the substance of what is really going on.

The eight matters embrace three overlapping sets of tests.

The first is about how the scheme was implemented: how its results were obtained. That is, its manner, form and substance, and timing.

Secondly, the effects of the scheme are considered - the tax results, financial changes, and other consequences of the scheme. In other words, what changed?

Finally, the nature of any connection between the parties to the scheme is considered, and whether this sheds light on what might have occurred if there had not been such a connection.

1. How the scheme was implemented

There is no contrivance or artificiality in the manner in which the scheme is carried out.  You will simply not have to pay interest as it is incurred at this stage. The decision to capitalise interest is allowed by your lender and you expect this to occur for the income years ended 30 June 2009 and 30 June 2010. This is a commercially realistic arrangement.

2. The effects of the scheme

This arrangement will produce an increasing amount of deductible interest incurred on the line of credit as the debt increases with the capitalisation of the interest.

The financial advantage you obtain is to ensure you can make the minimum payments on your private loan.

3. The connection between the parties

There is no known connection other than a normal arm's length agreement between yourself and the provider's of the business loan.

Conclusion

The arrangement that is the capitalisation of interest on your line of credit is a scheme. You will obtain a tax benefit from entering into the scheme in the form of the deductibility of interest incurred on the capitalisation of the interest from your line of credit.

However a reasonable person would conclude that you did not enter into the scheme for the dominant purpose of obtaining a tax benefit.  It is accepted that the compound interest expenses have been occurred due to your inability to afford to make all payments on your business loan during the income year ended 30 June 2009.

It is accepted that obtaining the identified tax benefit was not the dominant purpose of entering into the scheme. Therefore this scheme is not one to which Part IVA applies.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).