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Ruling

Subject: interest expenses

Question

Are you entitled to a deduction for the interest expenses incurred on money's on lent to the trust after the repayments by the trust stopped?

Answer

No.

This ruling applies for the following periods:

Year ending 30 June 2012

Year ending 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

The scheme commenced on

I July 2011

Relevant facts

You borrowed money from a bank in 20XX. These funds were on lent to a trust at an interest rate 1% higher than the bank rate.

You are trustee of the trust.

The trust invested the funds in a term deposit which was used as security on an investment made by the trust into a company. The trust in return for this investment received shares in the company.

You were an employee of the company. You were not a director or public officer in the company. You decided to invest in the company through the trust to earn assessable income and to help out the company.

The trust's term deposit paid x% interest during the initial few months. The monthly interest received by the trust was passed on to you.

The interest rate charged to the trust was higher than x%, however you believed that the repayments would no longer be in arrears once dividends were received by the trust.

The decision in relation to the borrowed funds was made in 20YY

The written loan agreement between you and the trust was signed in June 20ZZ.

Under the terms of the loan agreement between you and the trust, repayments were to be made by consecutive monthly instalments in arrears.

You believed that the trust would have the capacity to repay all the amounts under the loan, by way of dividends from the investment and future capital gains arising from the eventual sale of the asset.

The company appointed liquidators in the relevant year and the trust's deposit was then called upon under the security.

A return of some money was made to you in the relevant year. The remainder of the term deposit money was taken by the liquidators.

You are liable for the loan balance.

You have paid the interest on the loan for the subsequent income year.

You refinanced the balance of the loan in the subsequent income year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

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, 

§ 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 (Munro's case) 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.

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 derive income for another entity 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 Ure v Federal Commissioner of Taxation 81 ATC 4100 (Ure's case) the derivation of assessable income was not the sole purpose of the loan, and a deduction was only allowed up to the amount of assessable income.

Where a person lends money to a related entity, a deduction for any interest or associated expense incurred will only be allowed where the money is lent on a commercial basis. That is, there must be a reasonable expectation that the person will receive a return.

It is considered that you did not lend the funds to the trust on a commercial basis. This is because

§ the repayments made by the trust were less than the interest expenses incurred by you for the borrowed funds,

§ the written loan agreement between you and the trust was signed more than two years after the borrowing of the funds and after the company was in liquidation,

§ there was no action taken by you in relation to the arrears repayments as you believed you would eventually get them.

In your case, your borrowed funds were used to on lend to the trust. The amount of assessable income derived from the loan was less than the associated interest expenses and loan fees incurred by you. That is, an overall loss was made during the initial years of the loan.

As the loan was not made on a commercial basis, it is considered that the arrangement was made for some other purpose other than to produce assessable income for you. The purpose in lending the money to the trust cannot be seen as characterising the expenditure as incurred solely in gaining or producing assessable income. Therefore, any deduction for the interest expenses you have incurred will need to be apportioned.

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.

As in Ure's case and Fletcher's case, it is considered fair and reasonable in your circumstances to allow a deduction only up to the amount of assessable income derived. No assessable income has been derived after 1 July 2011. Consequently no deduction is allowable after this date for the expenses on the funds on-lent to the trust under section 8-1 of the ITAA 1997.

We acknowledge that a loss or outgoing can be deductible even if it is incurred after the cessation of income earning activities, but in order to be deductible the occasion of the outgoing must be found in those income earning activities.

The issue of the deductibility of interest after the cessation of income earning activities has been examined by the courts in FCT v. Brown (1999) 43 ATR 1; 99 ATC 4600 (Browns case) and Commissioner of Taxation v. Jones (2002) 117 FCR 95; (2002) 49 ATR 188; 2002 ATC 4135 (Jones' case ). In both these cases the taxpayers incurred interest on outstanding loans that were unable to be repaid after the income earning activities of the taxpayers had ceased. In both cases the courts held that the interest expense was deductible despite the interest having been incurred in a year after the year in which the relevant assessable income was earned, and despite the fact that the income earning activities of the taxpayers had ceased prior to the incurring of the interest expense.

The Commissioner's view on whether interest deductions are allowable after the cessation of the relevant income producing activity is outlined in Taxation Ruling TR 2004/4. The implications of the decisions in Brown's case and Jones' case were considered.

However, the above cases can be distinguished from your situation, in that the borrowed funds were not solely used for income producing purposes. The borrowed funds were used to on lend to the trust in a non-commercial arrangement. As the funds were not used solely for income producing purposes, the principles of TR 2004/4 have little application in your case. Therefore no interest deduction is allowable for the subsequent or future years.

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