Edited version of private ruling

Authorisation Number: 1011725773954

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: prepaid interest

Question

Are you entitled to a deduction for prepaid interest expenses incurred on loan money used to purchase units?

Answer: No.

This ruling applies for the following period

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on

1 July 2009

Relevant facts

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· Private ruling application, and

· the product disclosure statements (PDS) investment.

In the year ending 30 June 2010 you purchased investment units.

You took out a compulsory 100% limited recourse loan to fund the investment.

You prepaid interest of more than $1,000.

You are not carrying on a business.

The PDS in relation to the investment included the following information:

· There are two potential Coupon payments during the investment term.

· The First Coupon will be paid at the end of the first year of the investment term, and will be the lower of:

o 8%, and

o the increase in the Strategy Value over the first year of the investment term (from the Issue Date to the First Coupon Determination Date), less Performance Fees paid by the Issuer to the Lead Adviser. The Performance Fee will be 10% of the amount which would otherwise have been payable as the First Coupon if no fees were deducted.

· The Second Coupon will be paid at the end of year two, and will be the lower of:

o 8%, and

o the increase in the Strategy Value over the first two years of the Investment Term (from the Issue Date to the Second Coupon Determination Date), less the amount of the First Coupon and any Performance Fees applicable to the First Coupon and the Second Coupon. The Performance Fee in relation to the Second Coupon will be 10% of the amount which would otherwise have been payable as the Second Coupon if no fees were deducted.

· The Final Value is determined on the Maturity Date, and will be $1.00 plus the amount of the increase in the Strategy Value over the Investment Term, less any Coupons paid and less any Performance Fees paid.

· The minimum Final Value per Unit at Maturity will be $1.00 provided the Units are held to the scheduled Maturity Date

· One of the risks of the investment is that there is no guarantee that the units will generate returns in excess of the prepaid interest.

· The investment is not for people who rely on the units to produce income during the investment term.

· Investors should be able to tolerate risk.

You did not receive a distribution in October 2010.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

You are not entitled to a deduction for the interest incurred on the funds borrowed and used to purchase the investment units. There is insufficient nexus between the interest expense and the income earning purpose of the investment. The investment was largely capital in nature and therefore no deduction is allowable.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (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, or relate to the earning of exempt income.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

· it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478 (Lunneys case)),

· there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47 (Ronpibon's case), and

· it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that it is not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances.

Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, regard must be given to all the circumstances including the purpose of the borrowing and the use to which the borrowed funds are put.

The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 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 generally be deductible to the extent that the borrowed funds are used to produce assessable income. That is, it is generally accepted that interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction.

TR 95/25 lists the following general principles to determine whether interest is deductible under section 8-1 ITAA 1997:

· 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

· the character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower

· a tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity

· interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets, and

· interest on borrowings will not continue to be deductible if the borrowed funds cease to be employed in the borrower's business or income producing activity.

If the money is borrowed for the purpose of, or applied in, producing both assessable and non-assessable income, rather than producing only assessable income, the interest expense may need to be apportioned (see Ronpibon's case at 59; 8 ATD 431 at 437; Kidston Goldmines Ltd v. FC of T 91 ATC 4538 at 4544-46; (1991) 22 ATR 168 at 175-177). This is a question of fact.

Regarding apportionment it has been stated (Brennan J in Ure v. FC of T 81 ATC 4100; 11 ATR 484):

If the borrowed moneys had been laid out solely for the purpose of gaining assessable income, the interest would be wholly deductible; but as they were laid out in part for that purpose, and in part for other purposes, the interest charges must be apportioned.

Taxation Ruling TR 95/33 considers the deductibility and apportionment of losses and outgoings where expenses are incurred for dual purposes. TR 95/33 states that if an outgoing produces an amount of assessable income greater than the amount of the outgoing, there would normally be no need to examine the taxpayer's motives and intentions when determining the deductibility of the expenditure.

However, if the outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is wholly deductible. This may, depending on the circumstances of the particular case, include an examination of the taxpayer's subjective purpose, motive or intention in making the outgoing.

If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective (for example, to derive exempt income or the obtaining of a tax deduction), then the outgoing must be apportioned between the pursuit of assessable income and the other objective: see Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 (Fletcher's case).

In your case, your borrowed funds were used to acquire the units. These investments were for potential capital growth with the possibility of receiving an annual coupon payment, contingent on certain movements in the market. This means the borrowed funds have been applied partly to secure a capital gain at maturity of the investment and partly for the purpose of producing assessable income annually for the period of the investment. Therefore, any deduction for the interest expenses you have incurred will need to be apportioned to reflect each of these purposes.

When it is necessary to apportion a loss or outgoing, the appropriate method of apportionment will depend on the facts of each case. However, the method adopted in any particular case must be both 'fair and reasonable' in all the circumstances (Ronpibon's case). In Fletcher's case, it was 'fair and reasonable' to limit the amount of the deduction to the amount of the assessable income actually received in that year.

Taxation Ruling IT 2684 considers the circumstances in which interest on money borrowed to acquire units in a property unit trust is an allowable deduction. In that Ruling, the Commissioner considers that, in general, interest expenses incurred on borrowed funds used to purchase income units, capital growth units or combined units (units offering returns of both income and capital growth) are an allowable deduction. However, the Commissioner considers that there are exceptions to the general rule.

Your case is somewhat analogous with a capital growth split property unit trust, in which the investor is entitled primarily to capital growth, but which may also produce some assessable income.

The Commissioner's view with respect to capital growth split property units is that where such units are expected to produce only negligible income, interest expenses incurred in borrowing money to purchase the units are deductible only up to the extent of the assessable income actually received (IT 2684 at paragraph 6).

In your case, it is acknowledged that there was potential for an annual income return on your investment. However, this did not result in the first year. The relevant values required to trigger a payment in the first year 2010 did not occur and therefore, no assessable income has resulted from the investment to date. It remains uncertain whether you will receive any income in the second year.

Applying the rule in paragraph 6 of IT 2684 to your circumstances, as no assessable income was received in the 2009-10 income year, no deduction is allowable.

As per the PDS, your investment is not for people who rely on the units to produce income during the investment term. That is, the investments did not guarantee an annual income and no assessable income has been received to date. It is not considered that the interest expense was incurred with one end in view, that is, the gaining or producing of assessable income. The investment is not sufficiently regarded as being an income earning activity. That is, the connection between the incurring of the interest expense and the earning of assessable income from the investments is too remote.

Having regard to all your circumstances, it is considered that your investment is largely capital in nature and therefore no deduction is allowable under section 8-1 of the ITAA 1997. That is, no portion of the interest expenses incurred to purchase your investments units is deductible.

Prepaid interest

Where expenditure qualifies for a deduction under section 8-1 of the ITAA 1997, the deduction is generally allowable in full in the year the expenditure is incurred (Taxation Ruling TR 94/25). However, special payment rules affect the timing of deductions for certain types of payments.

The prepayment provisions (sections 82KZL to 82 KZO of the Income Tax Assessment Act 1936) are written in the negative. If the rule applies, you cannot claim an immediate deduction and have to spread it over the period of the services.

These prepayment rules potentially apply where a taxpayer incurs expenditure for something to be done, in whole or in part, in a later income year. Where these rules apply, the deduction for the expenditure is spread over the period covered by those services, up to a maximum of 10 years. If the rule does not apply an immediate deduction can be claimed.

For the prepayment rule to apply to an entity who is an individual taxpayer and the expenditure is not incurred in carrying on a business, all the following conditions must be satisfied:

1. the expenditure must be deductible as a business or employment expense under section 8-1 of the ITAA 1997 or under the research and development provisions. If the expenditure would not be deductible in this way, or is deductible under some specific provision, the prepayment rule does not apply;

2. the expenditure must not be "excluded expenditure";

3. the "eligible service period" must be:

a. more than 12 months; or

b. 12 months or shorter, but ending after the end of the income year following the income year in which the expenditure is incurred.

As stated above your expenditure is not deductible under section 8-1 of the ITAA 1997. Therefore, the prepayment rule does not apply.

Further information

Please note that under the capital gains tax provisions, the interest on money you borrowed to acquire the units forms part of the cost base (subsection 110-25(4) of the ITAA 1997).

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).