Edited version of private ruling

Authorisation Number: 1011690051296

This edited version of your ruling will be published in the public Register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fac sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. Contact us at the address given in the fact sheet if you have any concerns.

Ruling

Subject: Interest deduction

Question

Are you entitled to a deduction for the interest expenses incurred on the loan money used to purchase the investment units after the sale of these units?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commenced on

1 July 2010

Relevant facts

The arrangement that is the subject of the private ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

· correspondence received,

· the product disclosure statements (PDS), and

· fact sheets for the investments.

You invested in units.

The PDS in relation to the investments included the following information:

Both investments had potential capital growth.

The units were capital guaranteed if held to expiry date.

They had potential for income of up to 8% and 10% per annum. This income is generated by reference to an exposure independent from the Equity Asset.

Where the Coupon Dynamic Portfolio Value is less than the Notional Coupon Dynamic Portfolio Value no Coupon Amount is payable.

You would probably not consider an investment in these units if you need certainty of an income stream.

Investors should review the terms of the borrowing together with the investment to ensure that it is reasonably likely that the expected assessable income (other than capital gains) from their investments will exceed the interest expense. If this is the case, the interest expense should be deductible.

If the deductible expenditure exceeds the assessable income derived (excluding capital gains), the Commissioner may focus on the investor's purpose for undertaking the investment. If the deficit can only be explained by reference to factors such as the reduction of tax or the making of capital gains, the excess expense may not be deductible.

You received no income from the units. You purchased the investment for capital growth.

This investment was funded by loans from banks. These loans were in your name only and the total funds were used on the investment.

As a result of the downturn in 2009 you sold your holdings and incurred a capital loss.

You received no money on the sale of your units and had to pay a significant shortfall to redeem.

You have paid out part of your loan.

You have approximately $100,000 outstanding on the loan.

You have recently secured a new job.

You intend to make contributions to pay off the loan as soon as possible.

You have not purchased any other investments.

You hope to have paid off the loan in three to five years.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

You are not entitled to a deduction for the interest incurred on the funds borrowed and used to purchase the investment units. There is insufficient nexus between the interest expense and the income earning purpose of the investment. The investment was largely capital in nature and therefore no deduction is allowable.

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, or relate to the earning of exempt income.

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 (Lunneys case)), 

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).

Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that it is not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances.

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, regard must be given to all the circumstances including 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. The interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income. That is, it is generally accepted that interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction.

TR 95/25 lists the following general principles to determine whether interest is deductible under section 8-1 ITAA 1997: 

· 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 of a capital, private or domestic nature

· 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 by the borrower 

· a tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity

· interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets, and

· interest on borrowings will not continue to be deductible if the borrowed funds cease to be employed in the borrower's business or income producing activity.

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 (see Ronpibon's case at 59; 8 ATD 431 at 437; Kidston Goldmines Ltd v. FC of T 91 ATC 4538 at 4544-46; (1991) 22 ATR 168 at 175-177). This is a question of fact.

Regarding apportionment it has been stated (Brennan J in Ure v. FC of T 81 ATC 4100; 11 ATR 484)

If the borrowed moneys had been laid out solely for the purpose of gaining assessable income, the interest would be wholly deductible; but as they were laid out in part for that purpose, and in part for other purposes, the interest charges must be apportioned.

Taxation Ruling TR 95/33 considers the deductibility and apportionment of losses and outgoings where expenses are incurred for dual purposes. TR 95/33 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 the particular case, include an examination of the taxpayer's subjective purpose, motive or intention in making the outgoing.

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 (e.g., 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 objective: see Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 (Fletcher's case)

In your case, your borrowed funds were used to acquire the investments. These investments were for potential capital growth with the possibility of receiving an annual coupon payment, contingent on certain movements in the market. This means the borrowed funds have been applied partly to secure a capital gain 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.

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). In Fletcher's case, it was 'fair and reasonable' to limit the amount of the deduction to the amount of the assessable income actually received in that year.

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

Your case is somewhat analogous 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 up to the extent of the assessable income actually received (IT 2684 at paragraph 6).

The Commissioner's view on whether interest deductions are allowable after the cessation of the relevant income producing activity is outlined in Taxation Ruling TR 2004/4.

Paragraph 10 of TR 2004/4 states that where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and the relevant income earning activities (whether business or non-business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing the assessable income if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgement about the nexus between the outgoing and the income earning activities.

As your borrowed funds did not guarantee an annual income and in fact did not produce any assessable income while you held the investments, it is not considered that the funds were used mainly for income producing purposes. As the investments are not sufficiently regarded as being an income earning activity, the principles of TR 2004/4 have no application in your case.

In your situation, you borrowed money to purchase units and later sold these units. An outstanding amount of approximately $100,000 remains on your investment loan.

It is considered that the loan is not sufficiently connected to any prior income earning activity. That is, the connection between the incurring of the interest expense and the earning of assessable income from the investments which are now sold is too remote.

It is acknowledged that there was potential for an annual income return on your investment. However, this did not result. The relevant values required to trigger an annual payment did not occur while you held the investments, therefore, no assessable income was produced from the investment for that period. Furthermore, you advised that you purchased the investments for capital growth. Having regard to all your circumstances, it is considered that your investment was largely capital in nature and therefore no deduction is allowable under section 8-1 of the ITAA 1997. That is, no portion of the interest expenses incurred to purchase your investments is deductible.