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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 a related entity?

Answer

Yes.

This ruling applies for the following period

Year ending 30 June 2012

The scheme commenced on

I July 2011

Relevant facts

You borrowed money from a relation in 2011. You entered into a written agreement with your relation. Under the loan agreement you are paying the current variable interest rate charged by the lender's bank for the loan. The loan term is 30 years.

The borrowed funds were on lent to a company. You are the controlling and only shareholder of the company.

The loan to the company is an 'at call' loan with no fixed term and is repayable on demand by you. You intend to call the loan and demand repayment within five years. You are charging the same rate of interest as you are paying to your relation. You don't have a written loan agreement with the company.

The company has used the funds to purchase listed shares.

You haven't received any dividends as yet, but hope to receive dividends when the company sells some shares at a profit in the near future.

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. That is, it is generally accepted that interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction.

Income Tax Ruling IT 2606 clarifies the circumstances where no income is derived directly by the taxpayer from the transaction to which the interest expense relates, and there is no obvious connection with the carrying on of a business or other income earning activity of the taxpayer, then the taxpayer's purpose may be relevant to the characterisation of the expenditure. If the borrowed moneys had been laid out solely for the purpose of gaining assessable income, the interest would be wholly deductible.

Taxation Ruling TR 95/33 considers various issues in determining the deductibility of losses and outgoings. TR 95/33 states that 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.

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 on-lent the borrowed funds to the company on a commercial basis. This is because

· you are charging the company a commercial interest rate on the funds, and

· the demand for repayment of the loan is to be made in a reasonable time.

In your case, your borrowed funds were used to on lend to the company. Although you haven't derived any assessable income to date, there is reasonable expectation that you will receive dividends from the company in the near future.

As the loan was made on a commercial basis, it is considered that the arrangement was made for the purpose to produce assessable income. Therefore you are entitled to a deduction for the associated interest expenses incurred.

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