Edited version of your written advice

Authorisation Number: 1013082257108

Date of advice: 31 August 2016

Ruling

Subject: Deductibility of interest expense

Question

If you as an individual increase the loan on the investment properties you hold as an individual by an amount, to pay down an investment loan held by your discretionary trust, will you be able to claim the interest expense on the extra amount?

Answer

No

This ruling applies for the following period

Year ended 30 June 2017

The scheme commences on

1 July 2016

Relevant facts and circumstances

The discretionary trust has investment properties and a loan associated with these.

You and your spouse have investment properties and a loan associated with these.

The current loan structure is set up in a manner where all the properties are cross co- lateralised for both loans.

You are looking at simplifying the loan structure. This would also simplify the process if you decided to sell a property.

To allow this to happen it would mean moving part of the loan from the trust loan to the individual loan to meet the 70% LVR that the bank requires.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

If you increased the loan held by you as an individual to pay down the loan that the trust has, you would not be able to claim a deduction for the interest expense on this extra amount.

You and the trust are separate entities for income tax purposes. In effect you as an individual are borrowing an amount to pay down the discretionary trust loan. The investment properties are just being used as security for the loan. The increase in the loan does not relate to the purchase of the properties.

There is not sufficient nexus between the interest expense on these extra borrowings you will incur and the potential income you may receive from the trust. As a beneficiary there is a mere expectancy of receiving income from the trust.

The interest expense on this extra amount will not be incurred in your earning assessable income; therefore it is not a deductible expense to you.

Detailed reasoning

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 interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income.

The issue of failing to derive interest income was considered in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339. The principles established here were that neither the lending to the company in which Mr Munro was a shareholder, nor the financing of an acquisition of shares by his sons were regarded as sufficient to characterise the incurring of the interest as being directed to the gaining of the taxpayer's income.

Income Tax Ruling IT 2385 discusses the deductibility of expenses incurred by beneficiaries of discretionary trusts. As highlighted in IT 2385, a beneficiary of a discretionary trust is not entitled to a deduction against their trust distribution income as the expenditure is not incurred in gaining or producing their assessable income. There is not a sufficient nexus between the expenditure incurred and the receipt of income. A beneficiary has a mere expectancy of receiving income from the trust.

We need to apply these established principles to your set of facts.

You are looking at borrowing an amount as individuals to pay down the outstanding loan that the discretionary trust has in relation to their investment properties. For section 8-1 of the ITAA 1997 to be applicable, you have to incur the expense in relation to you deriving assessable income.

The borrowing of the amount does not relate to the purchase of the properties they are just being used as security over this extra amount on the loan. Therefore it does not relate to the rental income from these properties. For the amount to be deductible you would have to show that the interest expense on this amount is incurred in deriving your assessable income from the trust. As set out above there is only a mere expectancy of receiving income from the trust. The Commissioner considers that there is insufficient nexus between the expenditure incurred and the receipt of income for section 8-1 of the ITAA 1997 to apply. A deduction for this portion of the interest expense would not be allowable.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).