Edited version of private ruling

Authorisation Number: 1011725523789

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Ruling

Subject: interest deductibility and family trust election

Question 1

Are interest expenses from a loan used to purchase a rental property which is rented to persons who are not beneficiaries of the trust, deductible against the trust's rental income and share trading income under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Are interest expenses from a loan used to purchase a rental property which is rented to beneficiaries of the trust, deductible against the trust's rental income and share trading income under section 8-1 of the ITAA 1997?

Answer

Yes

Question 3

Will the purchase of the rental property constitute a scheme for the purposes of section 270-10 of the trust loss and family trust election provisions which are contained in Schedule 2F of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No.

This ruling applies for the following periods:

Financial year ended 30 June 2013

Financial year ended 30 June 2014

Financial year ended 30 June 2015

The scheme commences on:

1 July 2012

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

A discretionary trust was created primarily for the protection of assets. The trust carries on a business. The business is currently profitable and expects to be able to distribute income.

A residential property is intended to be purchased to be fully rented out on an ongoing commercial basis to help diversify assets. The trust will borrow funds from a financial institution.

Relevant legislative provisions

Income Tax Assessment Act 1997 s 8-1.

Reasons for decision

Interest deductibility

In order for the interest expense to be deductible under section 8-1 of the ITAA 1997, an individual must establish that the essential character of the interest incurred was to gain or produce assessable income. In determining the essential character of an interest outgoing, regard must be had to its connection with the income producing activities of the taxpayer (Federal Commissioner of Taxation v. Smith (1981) 147 CLR 578).

Taxation Ruling TR 95/25 sets out the deductibility of interest expenses. The interest on money borrowed must be characterised by reference to the use to which the borrowed funds have been put. Interest on borrowings will not continue to be deductible if the borrowed funds cease to be employed in the income producing activity (Federal Commissioner of Taxation v. JD Roberts; Federal Commissioner of Taxation v. Smith 92 ATC 4380; (1992) 23 ATR 494).

Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. The 'use' test, established in FC of T v Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. The interest incurred will be deductible to the extent that the property is used to produce assessable income.

Taxation Ruling IT 2167 discusses arms length and non-arms length letting of a residence. Generally the approach to be followed is based on whether the rent charged by the owner represents a normal commercial rent. Where property is let at a commercial rent then, apart from the effect of any express statutory provision to the contrary, expenses incurred in letting the property under an arm's length arrangement is fully deductible (FC of T v Janmor Nominees Pty Ltd 87 ATC 4813). That is, the arrangement is treated no differently for income tax purposes from any other owner in a comparable arms length situation (paragraph 13 of IT 2167).

Negative gearing occurs when the deductible expenses associated with acquiring and holding an income-producing investment exceed the income earned from the investment, with the resulting net loss being offset against other assessable income of the taxpayer.

In this case, the trust will borrow funds to be used to purchase a rental property which is intended to be rented out for the purpose of producing assessable income. Therefore, the interest incurred on the rental property loan would be deductible under section 8-1 of the ITAA 1997. Where the interest expense exceeds the rental income derived under a commercial agreement, the net loss will be applied against the other assessable income of the trust, namely the income from share trading.

As long as the property is being rented at a commercial rate, the trust will continue meeting section 8-1 of the ITAA 1997 to claim the interest expenses charged on the loan related to the rental property.

Family trust election

Section 270-10 of the ITAA 1936 applies if a deduction is allowable to a trust and under a scheme the trust derives an amount of assessable income and an 'outsider' to the trust directly or indirectly provides a benefit to the trust or to a beneficiary of the trust (or an associate of a beneficiary), and the trust or the beneficiary (or the associate) provides a benefit to the outsider. If section 270-10 applies the deduction is not allowed unless the trust has made a family trust election.

A scheme is any arrangement, plan, action or course of action. The borrowing of funds to purchase a rental property is an arrangement, plan, action or course of action. There is a scheme.

A benefit arises if value is transferred between parties. The funds to acquire the property will be obtained from an arms length dealing with an unrelated party. As a result of the provision of the funds, the trust will have a corresponding liability of the same amount. As the net value to the trust is zero, no value is transferred. No benefit is provided.

The renting of the property under an arms length arrangement at prevailing commercial rates does not give rise to an advantage to a tenant, whether the beneficiary is the tenant or not. The rent payable is the same rent that would be payable on an equivalent property by any tenant. As no value is transferred between the parties involved, no benefit is provided.

The borrowing of funds to purchase a rental property to rent under an arms length arrangement at prevailing commercial rates does not give rise to a benefit. It is not a scheme to take advantage of deductions for the purposes of section 270-10 of the ITAA 1936. Section 270-10 does not apply.

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