Edited version of private ruling

Authorisation Number: 1011594404879

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Ruling

Subject: Deductibility of interest expenses

1. Are you entitled to a deduction for the full interest expenses incurred during an income year on the borrowings used to purchase your investment?

No.

2. Are you entitled to a deduction for a portion of the interest expenses incurred on the borrowings used to purchase your investment up to the amount of assessable income received in an income year?

Yes.

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on:

1 July 2009

Relevant facts and circumstances

You purchased an investment scheme from a bank which is a deferred purchase agreement.

You chose an investment which offers the potential for capital growth above the Initial Reference Level of the S&P/ASX 200 index.

Coupon payments may be paid annually and are contingent on the performance of the S&P/ASX 200 Index reaching predefined levels above the Initial Reference Level.

Coupons are payable in arrears at specified intervals.

100% capital protection at maturity is also provided.

You funded the investment with a 100% funding via an investment loan.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 115-1.

Income Tax Assessment Act 1997 Section 115-100

Reasons for decision

Please note that all references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Deductibility of interest expenses

Section 8-1 allows you a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing your assessable income, except where those outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. The essential character of the expense is a question of fact to be determined by looking at all the circumstances.

Taxation Ruling TR 95/25 specifies that to determine whether interest expenses are deductible, it is necessary to look at the use to which the borrowings are put. The 'use' test was established in a Federal Court case and is the basic test for the deductibility of interest; it looks at the application of the borrowed funds as the main criterion.

If the money is borrowed for the purpose of, or applied in, producing both assessable and non-assessable income, rather than producing only assessable income, the interest expense may need to be apportioned.

Taxation Ruling TR 95/33 considers the deductibility and apportionment of losses and outgoings where they are incurred for dual purposes. The ruling states that if an outgoing produces an amount of assessable income greater than the amount of the outgoing, there would normally be no need to examine the taxpayer's motives and intentions when determining the deductibility of the expenditure.

However, if the outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is wholly deductible.

This may, depending on the circumstances of each particular case, include an examination of the subjective purpose, motive or intention in incurring the expense. If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained to derive exempt income or the obtaining of a tax deduction, then the outgoing must be apportioned between the pursuit of assessable income and the other purpose.

Taxation Determination TD 2008/21 discusses deferred purchase agreement (DPA) products. Paragraph 23 states that generally any gains or losses from DPAs would be on capital account and, in cases where the investor also has the potential to receive coupon payments, these payments are assessable income under section 6-5.

In your case, the funds you borrowed were applied to the delayed purchase of a capital asset (ASX listed shares) together with the possibility of receiving an annual coupon payment, subject to certain movements in the market. This means the borrowed funds have been applied partly to secure delivery of an asset at maturity of the investment and partly for the purpose of producing assessable income annually for the period of the investment.

Therefore, any deduction for the interest expenses you have incurred will need to be apportioned to reflect each of these purposes.

Apportionment

When you have 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. In a Federal Court case, it was deemed 'fair and reasonable' to limit the amount of the deduction to the amount of the assessable income actually received in that year.

In comparison, Taxation Ruling IT 2684 considers the circumstances in which interest on money borrowed to acquire units in a property trust is an allowable deduction. In that Ruling, the Commissioner considers that interest expenses incurred on borrowed funds used to purchase income units, capital growth units or combined units are an allowable deduction. However, the Commissioner considers that there are exceptions to the general rule.

Your case is somewhat comparable with a capital growth split property unit trust, in which the investor is entitled primarily to capital growth, but which may also produce some assessable income.

The Commissioner's view with respect to capital growth split property units is that where such units are expected to produce only negligible income, interest expenses incurred in borrowing money to purchase the units are deductible only to the extent of the assessable income actually received.

Conclusion

Having regard to all the circumstances, it is considered fair and reasonable to adopt the same approach in your case. If the market movements trigger the annual coupon payment during an income year and you receive assessable income as a result, you will be entitled to a fair and reasonably apportioned deduction of interest expenses for that year.

Alternatively, if the market movements required to trigger the annual coupon payment do not occur and no assessable income is produced from the investment, no portion of the interest expenses incurred to purchase your investment is deductible.

Other information

It is noted that you asked for your private ruling to apply until the year ended 30 June 2015. Due to the possibility of change to the law, the possibility of changes in your circumstances, and the risk that a subsequently issued public ruling might override a private ruling the Commissioner has issued, the Commissioner has provided you with a private ruling until the year ended 30 June 2013 in this instance. You can request a further ruling to determine the deductibility of your interest expenses after that time.