Edited version of private ruling

Authorisation Number: 1011695720136

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 fact 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 expense

Question 1

Is an ongoing interest expense incurred by a non resident deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) after becoming an Australian resident?

Answer:

No.

This ruling applies for the following period:

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

The scheme commences on:

The scheme has commenced.

Relevant facts and circumstances

The taxpayer was a non-resident for Australian tax purposes at the time of borrowing the relevant funds.

The taxpayer subsequently became an Australian resident for tax purposes several years after borrowing the relevant funds.

The taxpayer had an existing loan through commercial lender number one.

The taxpayer refinanced and increased his borrowings through commercial lender number two.

A few days later the taxpayer transferred funds ('the Funds') to an Australian resident company (Company Y).

Neither the taxpayer nor his associates are shareholders or directors of Company Y.

The taxpayer states he expected to earn interest from Company Y from the Funds, however no loan documentation was produced to support this claim.

The taxpayer provided no details in respect of a repayment plan nor any interest rates applicable to the Funds.

Documentation from Company Y describes the Funds as 'investment monies' or 'investing funds'.

No interest income was ever received by the taxpayer in relation to the Funds.

Approximately two years later the taxpayer refinanced his loan with commercial lender number two. The existing loan was substantially reduced.

Approximately 18 months later the taxpayer refinanced and increased his borrowings through commercial lender number three.

A few months later the taxpayer borrowed an additional amount from commercial lender number three.

Approximately two years later, after becoming an Australian resident for tax purposes, the taxpayer refinanced the total borrowings with commercial lender number four.

Voluntary administrators were appointed to Company Y approximately three years after receiving the Funds from the taxpayer.

Approximately 12 months later, creditors and investors of Company Y were given notice by the liquidators that Company Y was in liquidation and informed that 'it is unlikely that sufficient funds will be realised in liquidation to enable a dividend to be paid to any class of creditor'.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 128A(1AB)

Income Tax Assessment Act 1936 subsection 128B(2)

Income Tax Assessment Act 1936 subsection 128B(5)

Income Tax Assessment Act 1936 section 128D

Income Tax Assessment Act 1997 subsection 6-5(2)

Income Tax Assessment Act 1997 section 8-1

International Tax Agreements Act 1953

Reasons for decision

Interest is deductible to the extent to which it is incurred in gaining or producing assessable income or it is necessarily incurred in carrying on a business for that purpose and is not of a capital, private or domestic nature (section 8-1 of the ITAA 1997)).

Paragraph 8-1(2)(c) of the ITAA 1997 states you cannot deduct a loss or outgoing if it is incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

Subdivision 11-B of the ITAA 1997 lists particular kinds of non-assessable non-exempt income which includes interest subject to withholding tax.

Non-resident

Non-residents are liable to Australian income tax on all assessable income derived directly or indirectly from Australian sources.

Section 128D of the Income Tax Assessment Act 1936 (ITAA 1936), provides that income upon which withholding tax is payable is non-assessable non-exempt income.

Under subsection 128B(5) of the ITAA 1936, a non-resident withholding tax is imposed at a rate of 10% of the gross amount of interest which is derived by a non-resident where that interest is paid by a resident of Australia.

'Interest' is defined in section 128A(1AB) of the ITAA 1936 to include an amount in the nature of interest and an amount that is a dividend paid in respect of a non-equity share.

In determining liability to tax on Australian sourced income, it is necessary to consider not only the income tax laws but also any applicable tax treaty contained in the International Tax Agreements Act 1953 (the Agreements Act).

The relevant Schedule to the Agreements Act contains the tax treaty between Australia and Country X (the Country X Agreement). The Country X Agreement operates to avoid the double taxation of income received by Australian residents and residents of Country X.

Under the relevant article of the Country X Agreement, interest derived in Australia by a resident of Country X may be taxed in Australia at a rate not exceeding 10% of the gross amount of interest.

In these circumstances, the taxpayer borrowed money from a commercial lender, which he then on-lent an amount to Company Y.

Although the taxpayer states that his intention in lending money to Company Y was to enable him to derive assessable income in the form of interest payments on the loan, no formal loan agreement was entered into and no interest rate was set to determine the interest payable by Company Y. Further, no interest income was ever received by the taxpayer.

Withholding tax under subsection 128B(2) of the ITAA 1936 is imposed on the gross amount of interest derived by a non resident, therefore any expenses incurred in deriving that interest income are not deductible against the non-resident's assessable income in Australia, pursuant to section 128D of the ITAA 1936 and paragraph 8-1(2)(c) of the ITAA 1997.

Australian resident

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident includes ordinary income derived from all sources whether in or out of Australia during the income year.

The taxpayer is not carrying on a business, therefore only the first limb of section 8-1 of the ITAA 1997 is applicable in these circumstances, being an expense incurred in gaining or producing assessable income.

In order for a deduction to be allowable, the expense incurred must have sufficient connection with the gaining or producing of the taxpayer's assessable income.

At the time the taxpayer became an Australian resident for tax purposes, there was no reasonable expectation that the taxpayer would derive any interest income (nor receive repayment of the loan to Company Y) based on prior official notification by the liquidators.

Therefore, any residual expenses in relation to the taxpayer's initial borrowings in order to on-lend to Company Y, could not reasonably be characterised as being incurred in gaining or producing the taxpayer's assessable income as an Australian resident for tax purposes. Accordingly, those interest expenses will not be deductible under section 8-1 of the ITAA 1997.

Cessation of relevant income earning activities

The issue of deductibility of interest on borrowed funds is covered in Taxation Ruling TR 2004/4 Income Tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities (TR 2004/4).

Paragraph 6 of TR 2004/4 states, 'the deductibility of interest is typically determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put.'

'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 between the nexus between the outgoing and the income earning activities' (paragraph 11 of TR 2004/4).

At the time of the loan to Company Y, when the taxpayer was a non-resident, the operation of section 128D of the ITAA 1936 would have precluded the taxpayer from establishing the required nexus between the outgoing of interest on the initial borrowed funds and the production of Australian assessable income.

Paragraph 13 of TR 2004/4 states that the nexus between the outgoings of interest and the relevant income earning activities will be broken where an inference can be drawn that:

(a) the taxpayer 'has kept the loan on foot for reasons unassociated with the former business'; or

(b) the taxpayer has made a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred.

The taxpayer has refinanced the borrowed funds several times since the original borrowing.

Paragraph 50 of TR 2004/4 provides a number of general observations in weighing the factors of a case including:

(a) The greater the time since the cessation of the income earning activities, the more likely it is that an inference could be drawn that the continuing obligation to pay interest is a result of the taxpayer choosing to keep the loan on foot for reasons unassociated with the former income earning activities; and

(b) Refinancing of a loan does not of itself break the nexus between outgoings of interest under the loan and the prior income earning activities. However the decision to refinance may, in all the circumstances, lead to the inference being drawn that the taxpayer has made a conscious decision to extend the loan, and has done this in order to derive an ongoing commercial advantage.

The loan the taxpayer made to Company Y will, in a legal sense, remain in existence unless extinguished either by the taxpayer formally forgiving the debt; a full repayment of the debt is made by Company Y; or Company Y is wound up and deregistered. None of which to date has occurred.

However in practical terms, Company Y has ceased being a 'relevant income earning activity', at least from the time the liquidators gave formal notice.

In view of the circumstances of this case, with regard to the guidelines set out in TR 2004/4, after the time when the taxpayer became an Australian resident for tax purposes, the Commissioner does not accept that the taxpayer has established the required nexus between the outgoing of interest on the initial borrowed funds and the production of assessable income.

Accordingly, any residual interest expenses which relate to funds borrowed to on-lend to Company Y, will not be deductible amounts to the taxpayer under section 8-1 of the ITAA 1997.