Edited version of private ruling

Authorisation Number: 1011771059761

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Ruling

Subject: Interest expenses

Question

Are you entitled to a deduction for the interest expenses incurred on the borrowed funds on lent to your relation?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commenced on

July 2007

Relevant facts

You and your spouse established a line of credit account.

The purpose of the line of credit account was that the money would be on lent to your relation to be used as capital in the establishment of their business.

Payments drawn down from the line of credit were made to your relation in July 20XX and August 20XX.

Through a verbal agreement, your relation intended to make regular monthly repayments of principal and interest on the loan.

Interest received from your relation would be equivalent to the interest incurred on the line of credit.

Your relation made two repayments in November 20XX and January 20XX.

You did not include any of these amounts on your 20XX-XX tax return and no deductions for the interest expenses have been claimed. You did not draw your tax agent's attention to the on lending arrangement when you had this tax return prepared.

In July 20XX your relation decided to cease trading and the company dissolved. At the time of dissolution no balance of the outstanding loan was recovered.

Your relation has made no further repayments. You have made all other monthly repayments. You consider the balance of the loan to your relation to be unrecoverable.

There was no agreement in relation to the non payment by your relation and no action was taken by you in relation to this.

As additional funds have become available, you have used this money to offset as much of the line of credit balance as possible.

In 20XX you made additional draw downs on the line of credit to fund other investments. You keep these draw downs as a separate loan with all repayments being apportioned over the balances of the original loan and the new investment loan.

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 on-lent to your relation. There is insufficient nexus between the interest expense and the income earning purpose of the borrowed money. The arrangement was largely private in nature and therefore no deduction is allowable.

Detailed 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, 

· 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, 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 (Munro's case) 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.

The issue of failing to derive interest income was considered in Munro's case. The principles established here were that neither the lending to the company in which Mr Munro was a shareholder, nor the financing of an acquisition of shares by his sons were regarded as sufficient to characterise the incurring of the interest as being directed to the gaining of the taxpayer's income.

Since Munro's case there have been a significant number of cases in which directors and shareholders of companies have provided benefits at their own expense to the companies with which they were associated which have not satisfied the characterisation test.

The exception is the decision of the Full Federal Court in FC of T v. Total Holdings (Australia) Pty Ltd 79 ATC 4279; (1979) 9 ATR 885 (Total Holdings). This case recognised the earning of dividends as a sufficient purpose to characterise interest on money borrowed to on-lend to another entity for the purpose of its business as falling within being a deductible expense.

Subsequent to this decision, the Commissioner published Income Tax Ruling IT 2606 to provide guidance as to how the principles concerning interest deductibility that were established in the Total Holdings decision should be applied.

IT 2606 clarified 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.

In Ure v. Federal Commissioner of Taxation 81 ATC 4100 (Ure's case) the derivation of assessable income was not the sole purpose of the loan, and a deduction was only allowed up to the amount of assessable income.

In Case 26/94 94 ATC 258, a director, who borrowed money to on-lend to his family company that had no capacity to borrow in its own name, was denied a deduction for interest as the purpose of the loan was to assist the company in avoiding liquidation. The connection between the lending and the derivation of future income by the director was too remote.

Although many of the above cases refer to directors of companies, the principles are relevant in your case.

Where a person lends money to a family member, a deduction for any interest or associated expense incurred will only be allowed where the money is lent on a commercial basis. That is, there must be a reasonable expectation that the person will receive a return.

It is considered that you have not lent funds to your relation on a commercial basis. The following factors were taken into account in arriving at this conclusion:

· The repayment terms under the verbal agreement between you and your relation were not enforced.

· The interest rate charged to your relation was the same as that charged to you by the financial institution.

· You did not pass on the borrowing costs to your relation, but paid them yourself.

· There is no end date for the loan.

· You have treated the payments to you as reimbursements of your interest expenses and not as income.

· You did not advise your tax agent of the on lending arrangement when you had your 20XX-XX tax return prepared even though you received payments from your relation in the 20XX-XX financial year. This indicates that you considered the arrangement to be a private one rather than a commercial arrangement with taxation consequences.

In your case there was no expectation of a profit being made by you by way of a higher interest rate charged on the loan to your relation than applied to the borrowed funds. That is you were not to receive any additional income or profit from the loans. Your purpose in lending the money cannot be seen as characterising the expenditure as incurred in gaining or producing assessable income. Rather it was incurred to help your relation and their financial position. That is, there is insufficient nexus between your interest outgoing and the derivation of your assessable income. Furthermore, as the loan was not made on a commercial basis, it is considered that the arrangement was more private or domestic in nature. Consequently no deduction is allowable for the expense on the funds on-lent to your relation under section 8-1 of the ITAA 1997.

We acknowledge that a loss or outgoing can be deductible even if it is incurred after the cessation of income earning activities, but in order to be deductible the occasion of the outgoing must be found in those income earning activities.

The issue of the deductibility of interest after the cessation of income earning activities has been examined by the courts in FCT v. Brown (1999) 43 ATR 1; 99 ATC 4600 (Brown's case) and Commissioner of Taxation v. Jones (2002) 117 FCR 95; (2002) 49 ATR 188; 2002 ATC 4135 (Jones' case ). In both these cases the taxpayers incurred interest on outstanding loans that were unable to be repaid after the income earning activities of the taxpayers had ceased. In both cases the courts held that the interest expense was deductible despite the interest having been incurred in a year after the year in which the relevant assessable income was earned, and despite the fact that the income earning activities of the taxpayers had ceased prior to the incurring of the interest expense.

In Placer Pacific Management Pty Limited v. FCT (1995) 31 ATR 253; 95 ATC 4459 the full Federal Court held that an expense will not cease to be deductible simply because the assessable income was earned in a year prior to the incurring of the expense. Therefore, the interest expense will be deductible under section 8-1 of the ITAA 1997 if there is a sufficient nexus or connection between the incurring of the interest expense and the assessable income produced.

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. The implications of the decisions in Brown's case and Jones' case were considered.

However, the above cases can be distinguished from your situation, in that at the time your borrowing was taken out there was not a sufficient nexus or connection between your assessable income and the interest incurred on the borrowing. This is because the borrowed funds were used to on lend to your relation. You only received two repayments from your relation since then. The interest repayments from your relation were more a reimbursement of expenses incurred rather than assessable income. As the funds were not used for income producing purposes and there was no associated income earning activity, the principles of TR 2004/4 have no application in your case.

Having regard to all your circumstances, it is considered that your loan is largely private in nature and therefore no deduction is allowable under section 8-1 of the ITAA 1997.

It also follows, that as borrowed money is not used for the purpose of producing assessable income, no borrowing expenses or loan fees are allowable under section 25-25 of the ITAA 1997.