Edited version of private ruling

Authorisation Number: 1011673650193

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Ruling

Subject: Interest deduction

1. Is the interest incurred on your loan used to purchase units in a property trust fully deductible?

No.

2. Is the interest incurred on your loan used to purchase units in a property trust deductible to the extent of income received from the trust?

Yes.

3. Does Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the arrangement?

No.

This ruling applies for the following periods:

Year ended 30 June 2007

Year ended 30 June 2008

Year ended 30 June 2009

The scheme commences on:

1 July 2006

Relevant facts and circumstances

The property trust (the trust) was established during the year ended 30 June 2007. You borrowed funds and purchased all of the units issued by the trust. The trust used the funds to purchase a property that includes a residence.

At the time the property was purchased there was an existing lease in place with tenants renting the residence. The lease ended during the year ended 30 June 2008.

Since the lease ended the residence has not generated rental income as no tenant could be found. An agreement to lease the residence has since been made.

You have not received any distributions of income from the trust in the 2006-07, 2007-08 or 2008-09 income years as the trust has not yet made an assessable profit.

The Deed of Settlement of the trust includes relevant clauses including the interest of unit holders, redemption of units, discretionary beneficiaries, distribution of net income and capital distributions.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1936 Section 177C.

Reasons for decision

Question 1

Summary

You have incurred interest on a loan used to settle moneys on trust to benefit yourself and others, therefore the interest is not fully deductible.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides a taxpayer with a deduction for a loss or outgoing to the extent to which it is incurred in gaining or producing the taxpayer's assessable income. A loss or outgoing is not deductible to the extent that it is of a private or domestic nature.

A loss or outgoing is not deductible where it is incurred to gain or produce benefits for other persons. This proposition was illustrated in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, where a taxpayer subscribed borrowed funds for shares in a company, 90% of which were issued to his sons.

For the purposes of section 8-1 of the ITAA 1997, the essential character of interest expense is derived from the purpose of the borrowing and the application or the use of the borrowed funds. The laying out of the borrowed money for the purpose of gaining assessable income 'furnishes the required connection between the interest paid upon it by the taxpayer and the income derived by him from its use' (Ure v. FC of T 81 ATC 4100; (1981) 11 ATR 484 (Ure)). Accordingly, interest expense is not deductible to the extent that the borrowed money has been used to benefit others.

Taxation Determination TD 2009/17 discusses that interest on a loan is not fully deductible when the borrowed moneys are settled by the borrower on trust to benefit the borrower and others. The arrangements addressed by TD 2009/17 typically display some or all of the following features:

The taxpayer arranges for the establishment of a trust. The trustee of the trust is either the taxpayer, or is controlled by the taxpayer and/or associates of the taxpayer.

The beneficiaries of the trust are the taxpayer and his or her associates (the other beneficiaries). The other beneficiaries are members of the taxpayer's family, and/or entities which the taxpayer and/or the taxpayer's associates control; they do not usually contribute any capital to the trust, nor do they provide money or property to the taxpayer.

The taxpayer borrows money at interest and settles it on the trust. The trustee issues units to the taxpayer. The units provide the taxpayer with particular rights to trust income and/or capital.

The trustee uses the money to purchase one or more income-producing assets. Typically, the assets comprise real estate or shares.

The trust deed, and/or the trustee acting under authority of the trust deed, determines how much of the income of the trust is available for distribution to beneficiaries.

The taxpayer's units do not give the taxpayer an entitlement to all of the benefits which may reasonably be expected to be produced by the asset(s) purchased by the trust. Alternatively, an objective implication to be drawn from the trust deed is that the taxpayer cannot reasonably expect to receive all such benefits. For example, the taxpayer's units:

· may carry no entitlement to share in realised capital gains of the trust

· may carry no entitlement to share in anything other than realised capital gains of the trust

· may carry an entitlement to share in only part of the income of the trust, or

· may be redeemable, at the trustee's discretion, for an amount which fails to reflect the taxpayer's contribution to the trust (for example the cost of the units or their market value, where such value reflects the limited nature of the rights which the units carry).

For a number of income years, the amounts included in the taxpayer's assessable income because of his or her unit holding are significantly less than the interest expense on the borrowing. The taxpayer claims that the interest expense is deductible in full under section 8-1 of the ITAA 1997.

In arrangements of the kind above, the objective facts indicate that borrowed money has been used for the purpose of benefiting both the taxpayer and other persons. As such, a portion of the interest payable on the borrowed money is not incurred in gaining or producing the taxpayer's assessable income or has a private or domestic nature. That portion of the interest is not deductible.

The conclusion that borrowed money is being used to benefit entities other than the taxpayer follows logically from the connection between the money spent and the rights the taxpayer and the others obtain. The terms of trust indicate that the taxpayer will not enjoy, or cannot reasonably expect to enjoy, all of the benefits flowing from the trust capital which he or she has funded with the borrowed money. A consequence of this is that the borrowed moneys the taxpayer settles on the trust are disproportionate to the benefits which might reasonably be expected to pass to the taxpayer under the trust deed. To that extent, the expenditure lacks an obvious commercial explanation but has an obvious private or domestic explanation.

In your case, you have borrowed money to purchase all of the units in the trust. The trust deed provides that the net income of the trust each income year, after recouping any losses in any prior income year, shall be held absolutely on trust for the unit holders. However, with regard to capital distributions, the trust deed provides that the Trustee may in its discretion determine that the capital of the trust be applied, firstly in accordance with any special rights attached to any units and then to the discretionary beneficiaries in any proportion as the Trustee in its discretion determines. In addition the units are redeemable for an amount that fails to reflect your contribution to the trust.

Therefore, the units do not give you an entitlement to all of the benefits which may reasonably be expected to be produced by the property purchased by the trust. The borrowed money has been used for the purpose of benefiting yourself and other persons. As such, the interest is not fully deductible.

We acknowledge that in Forrest v. FC of T 2010 ATC 20-163 (Forrest) the Full Federal Court found that the income of the trust, other than realised an unrealised capital gain, was held on a fixed trust for the unit holders and it followed that the interest payments were deductible. However, the Court did not consider whether the Commissioner was correct to contend that the interest expenses should be apportioned between their income producing and non-income producing purposes. Therefore, it is considered that the position in TD 2009/17 is not altered by the decision in Forrest.

Question 2

You have incurred interest on a loan used to settle moneys on trust to benefit yourself and others. As such, a portion of the interest payable on the borrowed money is not incurred in gaining or producing your assessable income or has a private or domestic nature. That portion of the interest is not deductible.

TD 2009/17 provides that where apportionment is required, what will be appropriate will be essentially a question of fact, to be determined in each case. Where the expenditure serves several objectives indifferently it may not be capable of arithmetical or rateable division.

As per Fletcher & Ors v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613 and Ure it is considered that the interest allowable would be no more than the assessable income derived by you from the trust.

Question 3

Your interest expense is not deductible in full under section 8-1 of the ITAA 1997. Therefore, the arrangement does not give rise to tax benefits within the meaning of section 177C of the ITAA 1936.