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Edited version of your written advice
Authorisation Number: 1012832300877
Date of advice: 8 July 2015
Ruling
Subject: Interest expenses
Question
Are you entitled to a deduction for your portion of the interest expenses incurred on loan money used to purchase a business after the sale of the business?
Answer
Yes.
This ruling applies for the following period:
Year ended 30 June 2015
Year ended 30 June 2016
Year ended 30 June 2017
Year ended 30 June 2018
Year ended 30 June 2019
The scheme commenced on:
1 July 2014
Relevant facts
You and your spouse took out a loan to purchase a business.
The business was later sold.
The funds from the sale were used to pay debts owing to creditors. There were no funds left over to pay any of the original loan taken out to purchase the business.
No payments from the proceeds of the business sale were in respect of private debts.
You did not have the financial capacity to repay the original debt at the time the business ceased.
Later, the original loan was refinanced for the purposes of consolidating debts for repayments.
You are employed full time.
You are currently making monthly repayments on the loan. You are hoping to double the repayments in the near future to help pay off the debt quicker.
No additional funds been drawn down on the loan.
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, 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 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 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.
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 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities.
Paragraph 10 of TR 2004/4 states that where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and the relevant income earning activities (whether business or non-business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing the assessable income if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.
Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgement about the nexus between the outgoing and the income earning activities.
As highlighted in paragraphs 13 and 14 of TR 2004/4, if a taxpayer keeps the loan on foot for reasons unassociated with the former income earning activities or makes a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived that is not related to the original income earning debt, then the nexus between the outgoings of interest and the relevant income earning activities will be broken. A legal or economic inability to repay is suggestive of the loan not having been kept on foot for purposes other than the former income earning activities. Where a taxpayer has the capacity to repay the loan and chooses not to, the Commissioner would generally consider that the nexus between the interest and the gaining of assessable income would be broken and further interest deductions would not be allowable.
In your case, your borrowed funds were used to purchase an income producing business. You subsequently sold the business, however you did not have funds to repay the loan. That is the loan remained after the sale of your business.
As your borrowed funds were used to produce assessable income while you had the business, it is considered that the funds were used for income producing purposes. As the business was regarded as being an income earning activity, the principles of TR 2004/4 apply.
It is considered that the interest expenses on your loan are sufficiently connected to your prior income earning activity after the sale of your business. Therefore you are entitled to a deduction for the associated interest expenses incurred.
Please note that as the business was operated jointly, you are only entitled to a deduction for your share of the interest expenses.
Additional information
It should be noted that if you do at any stage have the capacity to repay the loan and choose not to, the Commissioner would generally consider that the nexus between the interest and the gaining of assessable income would be broken and further interest deductions would not be allowable.
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