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Edited version of your written advice
Authorisation Number: 1013102267260
Date of advice: 25 October 2016
Ruling
Subject: Deductions for interest expenses
Question
Is the Family Trust entitled to a deduction for the interest paid on a loan taken out to satisfy a deed of settlement?
Answer
No
This ruling applies for the following period
Year ending 30 June 20XY
The scheme commences on
1 July 20XX
Relevant facts and circumstances
The testator left various assets in their will. A family member contested the will and thereafter a Deed of Settlement and Release was entered into. The terms of the settlement were that an amount (Settlement Sum) was to be paid to the family member in consideration for releasing the estate from any and all claims they may have to family provision.
The family member was initially entitled to property. The property will now be transferred to the Trust and is expected to produce rental income.
The payment of the Settlement Sum will be partially funded by a loan in the name of the Trust.
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) broadly allows a deduction for any losses or outgoings to the extent to which they are incurred in gaining or producing assessable income except to the extent outgoings are of a capital, private or domestic nature.
The general principles relevant to the deductibility of interest expense are set out in Taxation Ruling 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. The test is one of characterization and the essential character of an expense is a question of fact to be determined by reference to all the circumstances.
Where a loan is taken out, the use test is applied to determine the deductibility of the interest. This is the basic test of deductibility of interest and looks to the application of the borrowed funds as the main criteria. This 'use' test was established in the case of FC of T v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 (Munro's Case).
Essentially, it is the use to which the borrowed funds are put that will determine the deductibility of the interest. If the borrowed funds are used to produce assessable income, then the interest will be deductible. If the funds are used for non-income producing purposes, then the interest will not be deductible.
Paragraph 3(e) of TR 95/25 states that interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets.
In the case of Hayden v. FC of T 96 ATC 4797 at 4801; (1996) 33 ATR 352 (Hayden's Case), a son, after the death of his father, commenced proceedings in the Supreme Court of Queensland claiming that his father had failed to make adequate provision from his estate for the proper maintenance and support of his son. The Court ordered that the estate pay the son $150,000. In order to pay the son, the executor borrowed $150,000. By borrowing the sum of money, the executor was able to comply with the court's order without selling the income producing assets of the estate (two properties). The executor argued that the interest incurred on these borrowings was deductible.
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.
Application to your circumstances
In this case, the Trust has taken out a loan to finance part of the payment required under the Deed of Settlement. By making the payment, the terms of the Deed of Settlement will be satisfied and the properties will remain in the estate. The Trust intends to acquire these properties and used them to produce rental income.
We do not consider that the loan monies will be used for the purpose of maintaining an income-producing asset. Instead they will be applied to a non-income producing purpose, that is, to discharge the obligations of the estate under the Deed of Settlement. Therefore the Trust is not entitled to a deduction for interest expenses under section 8-1 of the ITAA 1997.
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