Edited version of private ruling

Authorisation Number: 1011805095962

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Ruling

Subject: Interest expenses

Question 1

Can you claim a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for all of the interest expenses incurred on the loan money used to purchase investment units, after the sale of these units?

Answer

No.

Question 2

If you can not claim a deduction for all of the interest expenses under section 8-1 of the ITAA 1997, can you claim a deduction for any part of the interest?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commences on:

1 July 2010

Relevant facts and circumstances

We previously made a ruling but you have informed us of a change in your circumstances and asked for a replacement ruling.

You borrowed money from several financial institutions. One loan was an interest only loan, and you made regular and full payments during the period of this loan. The other loan was a line of credit attached to your mortgage. This loan was a separate account to your home mortgage.

The borrowing was taken out to finance the purchase of units in two investment products.

Both investments had potential income and capital growth.

You received no income from the investments. You understand from discussions with the financial advisers that the very disappointing performance was due to the global financial crisis.

You subsequently sold the investments at a loss on the recommendations of the financial advisers. One of the reasons for the sale was that the expected returns were not going to cover the interest paid over the life of the investments.

You have paid out one loan and have an amount outstanding on the other loan.

You have recently secured a new job, after a period of not working.

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 the next several years. The balance of the loans was not paid out earlier as you were out of work at the time and did not have the money.

You were expecting to incur interest at the time of purchase of the units.

Your decision to borrow and invest in the investments was based on the recommendation from your financial advisers and the returns projection they provided. The projection covers capital growth and annual income returns over the full term of the products.

You state that income was always a significant component of your decision to invest in the products.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 51AAA

Income Tax Assessment Act 1997 Section 8-1

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 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 of the ITAA 1936 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 of the ITAA 1936 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

Deductibility of interest

Interest is deductible under section 8-1 of the ITAA 1997 to the extent that it is incurred in gaining or producing assessable income or in carrying on a business for that purpose, except to the extent that the expense is of a capital, private or domestic nature, or is incurred in gaining or producing exempt income or non-assessable non-exempt income.

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 lists the following general principles to determine whether interest is deductible under section 8-1 of the 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 objection circumstances of the use to which the borrowed funds are put by the borrower. In some cases, the taxpayer's subjective purpose, intention or motive may be relevant in deciding the deductibility of interest.

· 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.

TR 95/25 specifies that to determine whether interest expenses are deductible, it is necessary to look at the use to which the borrowings are put. The 'use' test, established in the Federal Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, is the basic test for 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.

Apportionment

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 this general treatment, where only negligible income is expected to be produced by growth units, in which case the interest may only be deductible up to the extent of the assessable income actually received, and where apportionment of the interest expense is necessary. .

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 Tin NL v. FC of T (1949) 78 CLR 47 at 59; 8 ATD 431 at 437 (Ronpibon Tin); 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.

Paragraph 8 of IT 2684 states that in those cases where apportionment is required, interest is deductible in the same ratio as the assessable income component of any distributions for the particular income year bears to the total distributions (see Adelaide Racing Club Inc v. FC of T (1964) 114 CLR 517).

Paragraph 9 of IT 2684 also states that an interest expense is not fully deductible in those cases where the expected return from the units, both income and capital growth, does not provide an obvious commercial explanation for incurring the interest. This may arise in situations where the total amount of income and capital growth which can reasonably be expected from the units is less than the total interest expense, especially if the amount of assessable income expected is disproportionately less than the amount of the interest expense.

Paragraph 23 of IT 2684 states that if growth units in a split property unit trust are expected to produce only negligible income, the essential character of the interest expenses is for the gaining or producing of a capital gain rather than assessable income. The interest expenses in this situation are therefore deductible only up to the extent of the assessable income actually received.

If it can be concluded that the interest expense is incurred for dual or multiple purposes, including private or domestic purposes, it is necessary to apportion the expenses.

Taxation Ruling TR 95/33 considers the deductibility and apportionment of losses and outgoings where the 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 (for example, 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 (Fletchers Case).

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 Tin). In Fletchers 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.

Paragraph 15 of TR 95/33 states that if income is expected to be produced over a number of years from a single transaction it will be necessary to total the relevant assessable income reasonably likely to be produced during that period and compare it with the total expenditure reasonably likely to be incurred in order to produce that income.

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.

Interest incurred following cessation of the relevant income earning activities

Paragraphs 10 and 11 of TR 2004/4 state the following in relation to interest incurred after assessable income:

10. Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and 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.

11. 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 judgment about the nexus between the outgoing and the income earning activities.

This principle also applies to income earning activities that do not constitute a business, such as passive investments.

Section 51AAA of the Income Tax Assessment Act 1936 (ITAA 1936)

Section 51AAA of the ITAA 1936 ensures that interest is not deductible under section 8-1 of the ITAA 1997 by reason of the inclusion in assessable income of a capital gain.

Applying the above guidelines to your circumstances

In your case, your borrowed funds were used to invest in the investment products. You state that income was always a significant component of your decision to invest in the products. The information provided by you indicates that you would have had a reasonable expectation that the products would produce a reasonable amount of assessable income in the years in question. This means that the guidelines in TR 95/25 as discussed above are satisfied, and the interest incurred by you will be deductible to the extent that the borrowed funds are used to produce assessable income.

In this case, however, you also appear to have had other objectives in investing in these products, such as capital growth. Another factor which needs to be considered is the fact that the total amount of income and capital growth which could reasonably be expected to be received would have been less that the total interest expense.

The guidelines in IT 2684 and TR 95/33, as discussed above, therefore indicate that your interest expenses will need to be apportioned, as these expenses were incurred for dual or multiple purposes, that is, in order to gain or produce assessable income and non-assessable capital gains (by virtue of section 51AAA of the ITAA 1936). The apportionment method adopted must be 'fair and reasonable' in the circumstances.

In your case, the expected assessable income from the products was more than a 'negligible amount'. Limiting the interest deduction to the assessable income received would therefore not be 'fair and reasonable' in this case.

Following the apportionment principles referred to in IT 2684, we consider that the interest deductible should be calculated in accordance with the following formula for each product:

Total expected assessable income

Total expected assessable income x Total interest incurred = Deductible interest

+ non assessable income

The apportionment would apply equally to the years following the sale of your units as your economic inability to repay the loan would suggest that the loan is not being maintained for purposes other than for income earning activities.

Summary

You can not claim all of the interest expense incurred in relation to the acquisition of the investment units as a deduction under section 8-1 of the ITAA 1997 as all of the interest expense does not relate to the production of assessable income. You can only claim the portion of the interest expense that relates to the production of assessable income as determined by the above formula.