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Ruling

Subject: borrowed funds

Question 1

Is the interest received assessable income?

Answer

Yes.

Question 2

Are you entitled to a deduction for the interest expenses incurred on moneys on lent?

Answer

Yes.

This ruling applies for the following periods

Year ending 30 June 2013

Year ending 30 June 2014

The scheme commenced on

I July 2012

Relevant facts

You and your spouse are lending money to a related entity.

The funds are to assist in the purchase of a property.

The property has been purchased and is due for settlement in 2013.

You will not live in the house.

The source of the funds for the loan is money currently held as redraw in your personal mortgage. The mortgage interest rate is currently X%. This rate is variable. Repayments are for principal and interest.

You intend to charge the entity the same X% interest.

If the variable interest rate on your mortgage changes, the relevant interest rate charged to the entity will also change. Any associated fees on the loan will also be passed on to the entity.

The entity will repay the loan over no more than two years.

You are lending the money in your own capacity.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 6-5(2)

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Assessable income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources during the income year. Ordinary income has generally been held to include interest income.

Interest received from money lent by one entity to another entity is generally considered to be part of the ordinary income of the lender of that money. However where the arrangement is not commercial in nature or not an arm's length arrangement or is purely a private or domestic arrangement, the interest income is not generally assessable income.

The test that should be considered in order to show whether the arrangement is at arm's length, is whether a reasonable person with no relationship to either party would enter into the arrangement using exactly the same terms and conditions to purchase the same (or similar) asset. If the answer is yes, then it would be an arms length arrangement.

Taxation Ruling TR 2002/2 considers the issue of arm's length. Whether parties are at arm's length in relation to a loan is a question of fact. The interest rate applied to a loan between related parties should be indicative of parties acting at arm's length and reflect the commercial and economic standing of the parties.

In your case, the moneys will be on-lent at the same rate that the financial institution is charging you. Having regard to the amount of the loan, the rate of interest payable, the duration of the loan and the capacity of the borrower to repay the loan, it is considered that the arrangement is at arm's length and the loan is commercially realistic. Therefore the interest income received is considered to be assessable income.

Allowable deductions

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, 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, 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 expense 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 of 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.

Taxation Ruling TR 95/33 considers the issue of whether the deduction would be an allowable deduction by considering the subjective purpose, motive or intention in making the outgoing. 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.

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.

Where a person lends money to a related entity, a deduction for any interest 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.

In your case, the borrowed funds will be on lent to a related entity. It is considered that you will lend the funds on a commercial basis. This is because:

· the interest rate charged is equal to the interest rate payable on the borrowed funds, and

· there will be a loan agreement between you and the entity.

As the loan is to be made on a commercial basis, it is considered that there is a sufficient nexus between your expenses and your assessable income. Therefore you are entitled to a deduction for the associated interest expenses incurred.

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