Edited version of private ruling

Authorisation Number: 1011616431278

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Ruling

Subject: Deductibility of interest on funds on-lent

Are you entitled to a deduction for the interest incurred on a loan on-lent to a company for start up capital, where the funds were on-lent interest free under a profit-share agreement?

No.

This ruling applies for the following period

1 July 2005 to 30 June 2010

The scheme commenced on

1 July 2005

Relevant facts

You borrowed money and on-lent it to a company to provide start up capital for a new business.

The funds were used by the company to assist with the costs of setting up and fitting out the business premises.

The agreement included that the capital loan would be repaid in full over a period of five years in either monthly or quarterly instalments (dependent on cash flow) without interest.

In addition to the repayments, as an investor in the business, you were entitled to percentage share of the profits for the duration of the loan. This agreement was based on the financial outlook provided by the company accountants, which indicated a return on investment would be made.

Any profit received from the company would have formed part of your assessable income. You did not expect to derive any other income from the company.

Due to the nature of a new business and difficulties with cash flow in the early days of operation it was agreed with the directors of the company that repayments of the capital loan would be deferred until the business could afford it.

To date, no repayments have been made.

Since opening, the business has struggled, performing poorly (below expectations) and has not been profitable at any stage.

The company was placed under administration and has since entered into a Deed of Company Agreement (during the 2009-10 income year) with the administrators and the creditors.

Due to the extent of the debts and priorities placed on secured creditors, no funds were available to compensate investors.

In June 2010, the directors ceased operation of the business.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

We have determined in your circumstances that you are not entitled to a deduction for the interest incurred.

This is because the general impression gained is that your loan has the character of an investment, which is of a capital rather than revenue nature. Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) denies a deduction for losses that are of a capital nature.

However, you may declare a capital loss under section 104-25 of the ITAA 1997 because section 108-5 of the ITAA 1997 deems a debt owed to you to be a CGT asset. As the company entered into a Deed of Company Agreement in the 2009-10 income year, this is when you incurred the capital loss. Your capital loss may be offset against current and future capital gains but cannot be offset against your ordinary income.

Detailed explanation

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent that they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed to the extent that the losses or outgoings are of a capital, private or domestic nature or are necessarily incurred in gaining or producing exempt income.

Taxation Ruling TR 95/25 discusses deductions for interest under section 8-1 of the ITAA 1997. Whether a loss or outgoing satisfies the requirements of section 8-1 of the ITAA 1997 depends on all the facts and matters relating to the loss or outgoing.

Paragraph 3 of TR 95/25 includes the following general principles relevant to the deductibility of interest expenses:

· The interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be capital, private or domestic in nature, and

· The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put.

In AAT Case [2001] AATA 1249, Re Economedes and FCT 58 ART 1046, the AAT held that a taxpayer who borrowed money from a bank and on-lent it to a family company to purchase a takeaway food business was entitled to a deduction for the interest on the bank loan. This decision followed that in FC of T v. Total Holdings (Australia) Pty Ltd 79 ATC 4279; (1979) 9 ATR 885, where the funds were on-lent with the reasonable expectation of deriving income from the company in the form of dividends and interest. The claim arose in respect of interest payable to the bank after the business had failed and been wound up.

In this case, it was found that there was a sufficient nexus between the on-lending and the expectation of profit. Even though it was not relevant whether income was actually derived from the business, it was crucial that there was a reasonable expectation that income would be derived in the future.

In Case 26/94 94 ATC 258; (1994) 28 ATR 1133, the taxpayer was a shareholder and director of a family company. He borrowed money which he on-lent to the company. At that time the company had no capacity to borrow in its own name. Interest on the money would only be paid when the company was in a profit earning position. The taxpayer claimed the interest and other costs relating to the borrowings as a deduction under subsection 51(1) of the Income Tax Assessment Act 1936 (equivalent to section 8-1 of the ITAA 1997). He submitted that he had lent the money to the company to shore up its debts and ensure its future profitability which would enable him to derive assessable dividends in future.

The Administrative Appeals Tribunal held that the expenses were not deductible for the following reasons:

· The primary purpose of the taxpayer in borrowing the money was to temporarily assist the company to avoid liquidation by providing a short-term rescue package; and

· One of the taxpayer's objectives in lending the money to the company was to ensure its profitability so as to derive future dividends from the company. However, the connection between the lending and the future dividends was too remote.

In your case, you borrowed funds which were on-lent to the business. You did not make or enter any agreements to receive interest on your loan to the business when on-lending the funds, merely that you would receive a profit share if and when the business made a profit. Furthermore, you did not receive any shares and therefore did not expect to receive any dividends.

The business was not successful and never made a taxable profit. The weak cash flow meant that the company made no repayments to you in accordance with the agreement, although you continued to make interest payments to your bank in satisfaction of the moneys you borrowed and on-lent.

The fact that no income was ever derived does not preclude the interest expense from being deductible if the agreement was structured in such a way as to evidence a real intention or prospect of deriving assessable income.

It is considered that you did not reasonably expect to derive income from the funds you lent to the business. Although you hoped that the business would make a profit, there was always a risk that the business would fail, as it is common knowledge that a significant percentage of new businesses do fail. Therefore, a sufficient connection between the interest you incurred and the derivation of income does not exist.

Therefore, you are not entitled to a deduction for the interest expenses you incur in relation to the loan, under section 8-1 of the ITAA 1997, because there is not a clear nexus between that interest expense and the earning of your assessable income.

Timing of loss of capital

With regard to the capital amount of the loan, it is considered that you incurred the loss or outgoing when the company entered the Deed of Company Agreement in the 2009-10 income year. Up until this point, there was an expectation that the company would pay the loan back to you when it became profitable. Once the company entered the Deed of Company Agreement and the business ceased, the funds owed by the company to you were irrecoverable. It was at that time that the loss by you was crystallised since before that time there was an expectation that the company would pay you back when it became profitable.