Edited version of your private ruling

Authorisation Number: 1012319906284

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. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet.

Ruling

Subject: Deductibility of interest on loan where the principal is on-lent to a discretionary trust

Question 1:

Can you claim a deduction for interest with respect to a loan to a discretionary trust?

Answer:

Yes, to the extent of the assessable income actually received from the on-lending to the discretionary trust during the financial year the interest is incurred.

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commences on:

1 September 2007

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.

This scheme incorporates the following documents:

· Application for a private ruling as constituted by correspondence you provided to the Commissioner;

· A discretionary trust deed establishing the discretionary trust; and

· A loan agreement between you, as the lender, and the trustees of the discretionary trust, as the borrower.

You and your spouse are trustees of the discretionary trust (the trustees).

The trustees of the discretionary trust entered into a contract for the purchase of a vacant block of land (the property).

The trustees later entered into a contract to construct a dwelling on the property.

Once the dwelling was completed, the property was leased to an arm's length third party at market rent. This is the only income producing activity carried on by the discretionary trust.

You, in your capacity as an individual, entered into a loan agreement between you, as the lender, and the trustees of the discretionary trust, as the borrower.

Pursuant to the loan agreement between you and the discretionary trust, you and the trustees agreed that any money you lent to the discretionary trust after the date of the agreement would be on the terms set out in the agreement.

Loans to fund purchase the property and construction of dwelling

You entered into three separate loan facilities to fund the purchase of the property and construction of the dwelling:

· Loan 1 in the name of you and your spouse

· Loan 2 in the name of you and your spouse; and

· Loan 3 in your name only.

All three loans are secured over the property and the residence owned by you and your spouse.

Loan 1

You advised that drawn funds were lent by you to the discretionary trust for the purchase of the property.

The loan accounts you provided indicate that interest only payments were made while Loan 1 was in existence.

This loan was repaid and the loan account closed before the start of the 2009-10 financial year. Therefore, the deductibility of interest you may have incurred on this loan has not been considered in this ruling.

Loan 2

You advised that drawn funds were applied by you as follows:

· Repay Loan 1; and

· First instalment pursuant to a building contract for the construction of a dwelling on the property.

The loan accounts you provided indicate that additional debits from this loan account whilst it was in existence represent progress payments pursuant to a building contract for the construction of a dwelling on the property, and debit interest charged by the lender.

The loan accounts you provided indicate that interest only payments were made while Loan 2 was in existence.

This loan was repaid and the account was closed during the 2009-10 financial year.

Loan 3

You advised that drawn funds were applied to repay Loan 2.

The loan accounts you provided indicate that interest only payments have been made since Loan 3 was drawn.

You advised that you incurred certain amounts of interest during the 2009-10 and 2010-11 financial years on Loan 3.

There is an insignificant variance between the interest you stated had been charged to the Loan 3 loan account for the 2010-11 financial year and the debit interest amounts appearing in the bank account statements you provided for that year.

Loan agreement between you and the discretionary trust

Clause 2 of the loan agreement between you and the discretionary trust provides:

· Interest is payable, and is calculated as the Net Income of the Borrower which will be distributed to the Lender while this loan remains in existence.

Clause 3 of the loan agreement between you and the discretionary trust provides, in part:

· The Income calculated each year will be credited to this loan account as at the end of each financial year…

Clause 4 of the loan agreement between you and the discretionary trust provides, in part:

· Net Income of the Borrower means (subject to Clause 7 of the deed of Trust of the Borrower), the net income of the trust as defined in Section 95 of the Income Tax Assessment Act 1936 (Cth) (as amended).

Clause 5 of the loan agreement between you and the discretionary trust provides, in part:

· The net cash funds will be paid to the lender as and when available...

You advised:

As the trust has no other assets or income the taxpayer and the trust agreed to receive all the net rental income as the interest on the loan from the taxpayer to the trust, and this amount is paid as funds permit from the trust each month.

You advised:

As a process, the transaction occurred through the year as:

· Rental income is banked to [trust] bank account

· Expenses are paid out of [trust] bank account

A monthly payment is paid out of [trust] bank account to the taxpayers loan account. Sometimes the funds are insufficient and the taxpayer banks his own funds to ensure the payment is met.

As this last amount may not be the exact NET income, it is treated as a loan repayment, and is therefore debited to [your loan account] in the books of the Trust.

You have advised that you received certain amounts of interest income on the principal sum you advanced to the discretionary trust during the 2009-10 and 2010-11 financial years.

The bank account statements you provided evidence higher amounts of income received by you from the discretionary trust. These higher amounts were calculate by deducting amounts you paid into the discretionary trust's bank account from the amounts paid from the discretionary trust's bank account to the Loan 3 bank account.

Details of the discretionary trust

You and your spouse are trustees and named beneficiaries of the discretionary trust.

Clause 6 of the trust deed provides:

· Until the vesting day, the trustee has an absolute discretion to decide to distribute any part of the Income of the trust fund for a financial year, in any proportions the trustee decides, to any one or more persons who are named in the Schedule as beneficiaries. The trustee has an absolute discretion to exclude a named beneficiary.

Clause 8 of the trust deed provides:

· The trustee may decide to accumulate any Income of the trust fund for any period that is allowed by the law governing this deed. When that decision is made, the relevant Income (less any tax payable on it) becomes capital of the trust fund and the trustee ceases to have any power to distribute it under clause 6.

Pursuant to clause 27 of the trust deed, the trustees have the power to borrow and raise money from any person including a trustee in his or her personal capacity.

Your contentions

In addition to the above facts supported by documents and information you provided, you made the following contention:

The loans were by the bank to the taxpayer. The land loan is shown as a loan to the taxpayer and [spouse]. But this was a misunderstanding by the taxpayer and was corrected when the construction loan was made.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5; and

Income Tax Assessment Act 1997 section 8-1.

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

Reasons for decision

Question:

Can you claim a deduction for interest with respect to a loan to a discretionary trust?

Summary

You can claim a deduction for interest you incurred during the 2009-10 and 2010-11 financial years to the extent of the assessable income actually received from the on-lending to the discretionary trust during the relevant financial year.

Detailed reasoning

Subsection 8-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. However, a loss or outgoing is not deductible to the extent that it is an expense that is capital, private or domestic in nature (subsection 8-1(2) of the ITAA 1997).

In order to claim a deduction for interest expenses under section 8-1 of the ITAA 1997 the outgoing must be incidental and relevant to gaining your assessable income. In Ronpibon Tin v. FC of T (1949) 78 CLR 47 at 57, the Court provided:

'it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income'.

The deductibility of interest is typically determined by reference to the use of the borrowed funds (FC of T v. Munro (1926) CLR 153; FCT of T v. Roberts & Smith (1992) 37 FCR 246; 92 ATC 4380). In Ure v. FC of T (1981) 11 ATR 484 (Ure), the Full Federal Court held that where borrowed money is laid out in part for the purpose of gaining assessable income and in part for other purposes, the interest charges must be apportioned. In Ure, the court upheld the Commissioner's decision to apportion the interest deduction to the extent interest income was derived.

Similarly in Fletcher v. FCT (1991) 103 ALR 97, the High Court held that it may be necessary to weigh the various aspects of the whole set of circumstances, including direct and indirect objects and advantages which the taxpayer sought in making the outgoing, in cases where there is a disproportion between the detriment of the outgoing and the benefit of the income (103 ALR 97 at 107-108). In Fletcher it was found to be fair and reasonable to limit the amount of the deduction to the amount of the assessable income actually received in the year in question (see paragraphs 14 and 39-41 of Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings (TR 95/33)).

Where a new loan is applied to repay an existing loan, the interest on the new loan will be deductible to the extent that the first loan was applied for an income producing purpose (see paragraph 42 of Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith).

You have requested the Commissioner rule on the deductibility of interest incurred on loans between 1 July 2009 and 30 June 2011. In order to determine the deductibility of interest incurred by you during this period we must examine the use to which the borrowed funds were put to determine whether the requisite income producing purpose exists.

What amounts have you incurred?

During the requested period you incurred interest on Loan 2 and Loan 3.

Loan 2 is in the name of you and your spouse and was applied to repay Loan 1, also in the name of you and your spouse.

The available evidence supports a finding that either:

· you and your spouse, as joint account holders, lent the borrowed money to the discretionary trust; or

· the Loan 1 and Loan 2 were intended to be loans taken out by the trustees of the discretionary trust on behalf of the trust,

· notwithstanding your contention set out at paragraph 33 of the Relevant facts, above.

Both you and your spouse were jointly liable for the repayment of interest and principal, bound by the terms of the loan agreement and, in accordance with your correspondence, Loan 1 and Loan 2 were secured over the residence owned by you and your spouse.

Therefore, based on the available evidence it is considered that you only incurred 50 per cent of the interest on Loan 1, and accordingly, Loan 2. Any interest you paid in excess of the 50 per cent for which you were liable will be characterised as a loan to your spouse (for example see paragraph 49 of Taxation Ruling TR 93/32 Income tax: rental property - division of net income or loss between co-owners).

Loan 3 is held in your name only and, as such, you incurred all the interest charged to the loan account, as evidenced by the loan account statements you provided, during the 2009-10 and 2010-11 financial years.

Therefore, the interest you incurred for each financial year for both Loan 2 and Loan 3 is calculated as follows:

Income producing purpose

Once the quantum of the interest you incurred has been determined, a connection between this expenditure and the production of assessable income or, if none is produced, the expectation of assessable income must be established.

The use to which the borrowed funds were put

You purportedly on-lent the borrowed funds to the discretionary trust 'to enable it to buy property that is used to produce assessable income and ultimately assessable income' to you 'in the form of net rent, and [you] will continue to earn that net rent during the course of the loan, and after that as a beneficiary of the trust.'

You have advised, and the evidence supports, the application of funds drawn from Loan 2 to repay Loan 1 and make progress payments pursuant to a construction contract for the construction of a dwelling on the property.

You have advised, and the evidence supports, the payment of funds drawn from Loan 3 to repay Loan 2 in the name of you and your spouse.

As discussed above, Loan 2 was either a loan to you and your spouse as individuals or you and your spouse as trustees of the discretionary trust. The amount paid to refinance Loan 2 is considered to be partly for the purpose of refinancing your existing 50 per cent share in Loan 2 and partly a loan to the discretionary trust to repay your spouse's 50 per cent share in Loan 2.

Production of assessable income

The information and documents you provided with the private ruling application indicate that you advanced the loan to the discretionary trust with the expectation of deriving assessable income in consideration for the advancement of the loan principal.

However, what is not certain is how that return might be calculated or otherwise determined. The loan agreement between you and the discretionary does not calculate the return as one would expect from a typical loan agreement as there is no reference to an interest rate, nor is there an amount calculated at a rate proportionate to the amount of principal advanced (refer paragraph 26 of Taxation Ruling TR 93/27).

The loan agreement between you and the discretionary trust presents several anomalies with respect to the calculation of interest:

Clauses 2 and 7 refer to interest that is payable calculated with reference to 'Net Income'. For the purposes of Section 95 of the Income Tax Assessment Act 1936 (ITAA 1936), net income is a calculation of assessable income less allowable deductions. If an amount of interest would be an allowable deduction to the discretionary trust, then that amount will not figure in the net income. If an amount of interest is not an allowable deduction then it will be included in the net income, but then sections 97, 97A, 98, 98A, and 98B of the ITAA 1936 dictate that the beneficiaries and/or trustees of a trust are to be assessed on the net income. In addition, the calculation of interest payable or net income could only occur after year end, which raises the question of in which financial year would the interest have been incurred by the discretionary trust.

Clause 3 refers to 'The Income' that will be credited to your loan account at the end of each year. However, the term 'The Income' has not been defined in the loan agreement between you and the discretionary trust or the trust deed.

Clause 5 provides that the 'net cash funds' will be paid to you as and when available.

The Loan Agreement therefore provides for amounts to be paid to you and credited to you.

The arrangement in its entirety and the documents and information provided by you in your application for a private ruling, including evidence of the application of the loan funds, supports the existence of an income producing intention. Notwithstanding the impreciseness of the loan agreement between you and discretionary trust, the actions of the trustees and you support a conclusion that the discretionary trust would recompense you for the lending of the principal sum. Therefore, any consideration for the use of the advanced sum would constitute assessable income in the financial year it is received by you or applied at your direction or for your benefit (section 6-5 of the ITAA 1997).

The amounts transferred to you by the discretionary trust in respect of the arrangement consist of:

· amounts transferred from the discretionary trust's bank account to the Loan 3 account, as evidenced in the bank statements you provided, less

· amounts you paid into the discretionary trust's bank account, as evidenced in the bank statements you provided, to ensure the there were sufficient funds in the discretionary trust's bank account to meet the whole interest payment due on Loan 3.

Apportionment

The disparity between interest you incurred on Loan 1, Loan 2 and Loan 3 and the income you derived, and will derive, from the discretionary trust in consideration for advancing the principal to the discretionary trust suggests that the arrangement has another purpose which is private or domestic in character.

You have lent money to a discretionary trust of which you and your spouse are both trustees and named beneficiaries on a non-commercial basis. The assessable income you have derived, and can reasonably expect to derive in the future, falls short of your interest outgoings on Loan 1, Loan 2 and Loan 3. This disparity lends to the conclusion that you have on-lent these funds to the discretionary trust with the intention of obtaining a tax advantage in the form of deductions for the full amount of interest on the loans whilst benefiting all beneficiaries of the discretionary trust, including your spouse.

Accordingly, to reflect the dual purpose of the borrowing, it is fair and reasonable to apportion the expenditure to the extent of the income derived in accordance with the principles and quoted case law set out in TR 95/33, in particular at paragraphs 14 and 39-41. As such, you can only claim a deduction for interest expenses you incurred during a financial year to the extent of the assessable income actually received and returned from the on-lending in that financial year.

Further issues for you to consider

In addition to the above discussion, we have identified and considered the following issues:

Expenses incurred by beneficiaries of discretionary trusts

In your correspondence you provided that the loan to the discretionary trust, once repaid, would additionally produce assessable income to you in the form of trust distributions.

There are a number of decided cases which indicate that expenses incurred by an individual taxpayer in his or her capacity as beneficiary of a trust are not deductible.

Taxation Ruling No. IT 2385 Income tax: expenses incurred by beneficiaries of discretionary trusts considers the Administrative Appeals Tribunal's (AAT) decision in a case where the beneficiary of a discretionary trust claimed deductions for expenses against trust distributions received (AAT reference QT 85/1311). In that case the AAT found that the taxpayer had not shown a sufficient nexus between the expenditure incurred and the receipt of the income (trust distributions). At its highest, the taxpayer had a mere expectancy of receiving income from the trust because they were not presently entitled to the income of the trust when the expenditure was incurred.

In Case U44 87 ATC 318, the taxpayer was a beneficiary of a discretionary family trust and was also a director of the corporate trustee of that trust. In his return for the 1983 year, the taxpayer disclosed as assessable income a trust distribution and claimed various trust expenses which he had met personally as deductions, including bank interest. The Tribunal held that the expenses were not deductible on the basis that a sufficient nexus had not been shown between the expenditure on behalf of the trust and the derivation of the taxpayer's assessable income.

If a taxpayer is not presently entitled to trust income when the expenditure is incurred, the taxpayer is not entitled to deductions for expenses said to be incurred in relation to the trust income.

In FC of T v. Whiting (1943) 68 CLR 199 at 215-216, Latham CJ and Williams J said:

The word presently entitled to share of income refer to a right of income presently existing ie, a right of such a kind that a beneficiary may demand payment of the income from the trustee, or that the trustee may properly reinvest, accumulate, capitalise, carrying to any reserve, sinking fund or insurance fund however designated or otherwise deal with it or as he directs on his behalf.

You are one of two named beneficiaries of a discretionary trust. Pursuant to the trust deed the trustees have the absolute discretion to distribute or accumulate trust income. Therefore, you do not have a vested and indefeasible interest in the income of the discretionary trust and are not deemed to have a present entitlement to the income of the discretionary trust.

As a result, there is an insufficient nexus between the expenditure incurred by you and the expectation of receiving trust income. Therefore, no deduction for interest incurred on Loan 2 and Loan 3 during the 2009-10 and 2010-11 financial years would be allowed on this basis.

Amounts settled on a discretionary trust for the benefit of multiple beneficiaries

Taxation Determination TD 2009/17 expresses the Commissioner's view as to whether interest on a loan is fully deductible under section 8-1 of the ITAA 1997 when the borrowed moneys are settled by the borrower on trust to benefit both the borrower and others.

Paragraph 6 of TD 2009/17 provides:

The interest expense is not deductible at all where the terms of the trust are such that no connection is perceived between the interest outgoing and the taxpayer's assessable income…

As discussed above, you have advanced the principal amount forming Loan 1, Loan 2 and Loan 3 to a discretionary trust where the trustees have the absolute discretion to distribute income to one or more named beneficiaries or classes of beneficiaries or to accumulate income. Accordingly, there is no nexus between the advancing of the principal to the discretionary trust and the earning of assessable income merely because you are a named beneficiary and may receive a trust distribution at some indeterminate point in the future. Therefore, no deduction for interest incurred on Loan 2 and Loan 3 during the 2009-10 and 2010-11 financial years would be allowed on this basis.

ATO view documents

Taxation Determination TD 2009/17 Income tax: is interest on a loan fully deductible under section 8-1 of the Income Tax Assessment Act 1997 when the borrowed moneys are settled by the borrower on trust to benefit the borrower and others?

Taxation Ruling No. IT 2385 Income tax: expenses incurred by beneficiaries of discretionary trusts

Taxation Ruling TR 93/27 Income tax: basis of assessment of interest derived and incurred by financial institutions

Taxation Ruling TR 93/32 Income tax: rental property - division of net income or loss between co-owners)

Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith

Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings

Cases

Case U44 87 ATC 318

Fletcher v. FCT (1991) 103 ALR 97

Roberts and Smith ATC at 4388; ATR at 504

Ronpibon Tin v. FC of T (1949) 78 CLR 47

FC of T v. Munro (1926) CLR 153

FCT of T v. Roberts & Smith (1992) 37 FCR 246; 92 ATC 4380

FC of T v. Whiting (1943) 68 CLR 199

Ure v. FC of T (1981) 11 ATR 484

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).