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Ruling

Subject: Interest expenses

Question

Are you entitled to a deduction for the interest expenses incurred in respect of borrowed funds used to pay out your former spouse as part of a court-approved settlement?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts

Pursuant to Family Court orders in respect of a divorce settlement, you are directed to pay to your former spouse a sum ('the payment') together with interest.

At the time of the court order, you were self-employed and your former spouse was otherwise employed.

The payment represents one-half of the current value of your business and was to be made upon settlement of the sale of the business.

The terms of the agreement included that your former spouse agreed to 'lend' you the money required for the settlement with interest. You advise that there was no actual 'loan agreement' required as the Court consented to this agreement.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Interest is deductible under section 8-1 of the ITAA 1997 to the extent that it is incurred in gaining or producing assessable income or in carrying on a business for that purpose, except to the extent that the expense is of a capital, private or domestic nature, or incurred in gaining or producing exempt income or non-assessable non-exempt income.

Whether an interest expense has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. The 'use' test, established in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153; [1926] HCA 58; (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.

A loss or outgoing is not deductible where it is incurred to gain or produce benefits for other persons.

To be deductible, the interest expenses must be sufficiently connected with an assessable income-earning activity, or business, you carry on. The onus rests on you to show that a sufficient connection exists. The interest expenses will be sufficiently connected if your purpose in borrowing the funds, when viewed objectively, is to refinance the business for the purposes of earning assessable income.

The interest expenses will not be sufficiently connected if your objective purpose in borrowing funds is merely to discharge an obligation to make a settlement as ordered by a Court. Interest on a loan used for a non-deductible purpose (e.g. funding a Court-ordered settlement) is not deductible under section 8-1 of the ITAA 1997 even though the loan avoided the need for using other income-producing funds or for selling off income-producing assets.

In Hayden v. FC of T (1996) FCR 19; 96 ATC 4797; (1996) 33 ATR 352, interest on moneys borrowed to satisfy a Supreme Court order under testator family maintenance provisions was not deductible, even though the loan enabled the executor to retain the income-producing assets of the estate without encumbrance.

In holding that the interest incurred was not deductible, Spender J stated:

Here, the borrowed funds were used to discharge an obligation by the estate [to pay an amount ordered by a court under family maintenance provisions]. I can see no difference in the present case from a case where an individual taxpayer, in order to discharge an obligation such as school fees, borrows funds on which interest is paid rather than sell income-producing assets and from the proceeds discharge the obligation. The paying of school fees requires funds, on which interest might be otherwise earned; that fact does not make interest on funds borrowed for the purpose of paying school fees deductible. The discharge of the obligation is a purpose quite independent of the property.

In your case, you essentially borrowed funds to pay a court ordered divorce settlement. The divorce settlement did not specify that the funds were to be paid to your former spouse for relinquishing a share of your business. The quantum of the settlement merely took the value of the business into account.

A taxpayer's marital arrangements are regarded as being private in nature. The interest you incur on this loan is not an expense incurred in gaining or producing your assessable income from the business as it is considered an expense relating to your marriage settlement.

Accordingly the interest is regarded as being of a private or domestic nature and you are not entitled to a deduction for this expense.

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