Edited version of your written advice

Authorisation Number: 1051436995879

Date of advice: 8 October 2018

Ruling

Subject: Interest deductions

Question 1

Are interest expenses incurred deductible under section 8-1 of the Income Tax Assessment Act 1997?

Answer

Yes

Question 2

Can you claim the full amount of interest charged to you by the Bank?

Answer

No

Question 3

Can you claim an apportionment of interest charged to you by the Bank, being the X.X% charged to the Company?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

Year ended 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

You are a Dentist

You set up a company (Company), on XX/XX/20XX

You are one of two Directors and shareholders in the Company

You borrowed $XX from a Bank in your personal name

You then lent those funds to your Company, on an interest only basis until XX/XX/20XX

You had a Loan Deed drawn up between yourself and the Company dated XX/XX/20XX

The Bank charge you X.X% interest on the funds borrowed

You charge the Company less than X.X% on the borrowed funds

The Company plans to pay you dividends in the future

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

Section 8-1 of the Income Tax Assessment Act 1997 will not operate to deny you a deduction for the interest expense you incur on the monies borrowed from your discretionary trust.

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.

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).

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, it is necessary to examine 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.

Accordingly, it follows that if a loan is used for investment purposes from which income is to be derived, the interest incurred on the loan will be deductible. However, it will only be deductible to the extent that it is used to produce assessable income.

Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings considers various issues in determining the deductibility of losses and outgoings.

TR 95/33 requires an examination of all the circumstances surrounding the expenditure to ensure that the interest expense could be properly characterised as genuinely, and not colourably, incurred in gaining or producing assessable income.

If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective (for example, to derive exempt income or derive income for another entity or the obtaining of a tax deduction), then the outgoing must be apportioned between the pursuit of assessable income and the other objective: see Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 (Fletcher’s case).

When it is necessary to apportion a loss or outgoing, the appropriate method of apportionment will depend on the facts of each case. However, the method adopted in any particular case must be both 'fair and reasonable' in all the circumstances (Ronpibon’s case).

Income Tax Ruling IT 2167 Income Tax: rental properties - non-economic rental, holiday home, share of residence, etc. cases, family trust cases discusses arms-length arrangements with rental properties and relatives. Although your investments do not relate to rental properties, the principles in this ruling are relevant. The essential question in relation to arrangements with family members is whether the arrangements are consistent with normal commercial practices. If the arrangement is commercial, the owner of the property would be treated no differently for income tax purpose from any other owner in a comparable arms-length situation.

The test that should be considered to show whether the arrangement is at arm’s length, is whether a reasonable person with no relationship to either party would enter into this arrangement using exactly the same terms and conditions. If the answer is yes, then it would be an arm’s length and commercial arrangement.

Where a person lends money to a related entity or takes responsibility for their loan, a deduction for any interest or associated expense incurred will only be allowed where the arrangement is a commercial basis. There must be a reasonable expectation that the person will receive a return.

The Company is a related entity and the interest rate being charged to the Company is X.XX% lower than the commercial rate being charged to you by the bank. You have argued that there is an expectation that dividends will be received from the Company, however, the prospect of receiving a dividend at a future point in time does not justify claiming the full deduction of interest now especially given the payment of dividends is controlled by yourself as director of the Company.

The loan arrangement is not made on a commercial basis and it is considered that the arrangement was made for some other purpose other than to produce assessable income for you. The purpose in the arrangement cannot be seen as characterising the expenditure as incurred solely in gaining or producing your assessable income. Therefore, any deduction for the interest expenses you have incurred will need to be apportioned.

As such you will only be entitled to deduct an amount of interest expense up to the amount of interest you have received from the Company.

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