Edited version of private ruling

Authorisation Number: 1011759566921

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Ruling

Subject: Interest deduction and capital loss

Question 1:

Can you claim a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for interest expenses on money borrowed and on-lent to a trust, where the income earning activities have ceased and that trust is unable to repay any future interest expenses?

Answer:

No.

Question 2:

Do you have a capital loss if the trust is unable to repay the loan principle to you?

Answer:

No.

Question 3:

If you have a capital loss, can you also claim a deduction for the ongoing interest expenses on the loan?

Answer:

Not applicable.

This ruling applies for the following period

1 July 2009 - 30 June 2010.

The scheme commenced on

1 July 2009.

Relevant facts

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You are a Director of the trustee company of a trust.

You are not a beneficiary of the trust.

You borrowed money from the bank and on-lent it to the trust

You are not in the business of lending money. There was not loan contract between you and the trust. No amounts or payments were charged by you to the trust for the loans.

The terms of your loans to the trust are set out in the minutes of meetings between the directors of the trustee company. It was resolved that the money you on-lent to the trust be held on the same terms as those entered into by you with the bank.

The trust notionally allocated to you in their accounts the interest equivalent to that charged on the loans by the bank. However, the trust actually paid no amount out. Any monies generated by the trust from the investment were re-invested back into the scheme.

In the income year, the trust returned income from the investments as assessable income and claimed a deduction for the interest paid to you.

In the income year, you included the interest notionally allocated to you by the trust as assessable income and claimed a deduction for the same amount paid to the bank.

The trust used the money to invest and all returns on these investments were reinvested.

You were advised that the company the trust invested in were placed into administration and that there would be no return of the principle amount invested or the interest reinvested.

The trust does not have the ability to repay you the principle or interest amounts.

The loans have not been refinanced or extended in any way. The loans have not been maintained for any reasons unassociated with the original income earning activities.

You have not received any compensation for the loss.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997

Section 108-20 of the Income Tax Assessment Act 1997

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

The legislative references referred to herein are from the ITAA 1997

Question 1

Personal deductions for trust loan

Section 8-1 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.

Intrinsic in the operation of section 8-1 is the general rule that a loss or outgoing is not deductible under the section unless it is incurred in gaining or producing the assessable income of the person who incurs it.

Personal borrowing for on-lending to or buying units in a trust

Taxation Ruling No. IT 2606 is about borrowings to fund share acquisitions. It provides for the deductibility of interest on personal borrowings where it is expected that dividends or other assessable income will be derived from investing or on-lending those personal borrowings in or to an another entity, such as a trust or company.

In order for an interest expense to be deductible under section 8-1 the taxpayer must establish that the essential character of the interest incurred was to gain or produce assessable income. In determining the essential character of an interest outgoing, regard must be made to its connection with the income producing activities of the taxpayer.

The earning of either dividends or interest is considered sufficient to characterise interest on money borrowed to on-lend to another entity for the purpose of its business as falling within section 8-1.

If a taxpayer incurs a recurrent liability for interest for the purpose of furthering his/her present or prospective income producing activities, whether those activities are properly characterised as the carrying on of a business or not, generally the payment by him of that interest will be an allowable deduction under section 8-1.

The Commissioner published Taxation Ruling IT 2606 to provide guidance as to how the principles concerning interest deductibility should be applied. Paragraph 22(c) of IT 2606 clarifies that in circumstances where no income is derived directly by the taxpayer from the transaction to which the interest expense relates, and there is no obvious connection with the carrying on of a business or other income earning activity of the taxpayer, then the taxpayer's purpose may be relevant to the characterisation of the expenditure.

Paragraphs 22(d) and 23 of IT 2606 provide that in the process of characterisation all the relevant circumstances must be weighed. They indicate that when determining the essential character of the interest expense we consider factors such as the reasons for the borrowing, the actual use to which the borrowed moneys are put, and the connection between that use and the activities by which the taxpayer usually produces assessable income.

Your situation:

You borrowed money from the bank and on-lent it to the trust.

You are not in the business of lending money. You on-lent at the same interest rate you were required to pay.

You are not a beneficiary of the trust.

The trust notionally allocated interest to you in their accounts, equivalent to that charged on the loans by the bank.

The trust used the money to invest in a company and the trust reinvested the returns.

It was intended that the trust pay interest payments on the loan to you.

There was no expectation of a profit being made by you by way of a higher interest rate charged on the loan to the trust than applied to the borrowed funds.

There is no connection with your income earning activities and your loan to the trust. The essential character of your loan to the trust did not include income producing activities for you. It has the nature of a private or domestic loan to a trust.

The purpose of you incurring the interest expense cannot be seen as characterising the expenditure as incurred in gaining or producing assessable income.

Therefore, you are not entitled to a deduction under section 8-1 for the interest expense incurred for monies on-lent to the trust.

Question 2:

In working out your net capital gain or loss for an income year, any capital loss you make from a personal use asset is disregarded.

A personal use asset is:

(a) a CGT asset (except a collectable) that is used or kept mainly for your (or your associate's) personal use or enjoyment, or

(b) an option or right to acquire a CGT asset of that kind; or

(c) a debt arising from a CGT event in which the CGT asset the subject of the event was one covered by paragraph (a); or

(d) a debt arising other than:

(i) in the course of gaining or producing your assessable income; or

(ii) from your carrying on a business.

Your loan to the trust is considered a personal use asset as it is a debt arising other than in the course of gaining or producing your assessable income; or from your carrying on a business.

Therefore, an asset that is not used for business or profit making purposes is, by default, used or kept mainly for personal use and enjoyment. The two categories are mutually exclusive.

Question 3:

See answer in questions 1 and 2.