Edited version of private ruling

Authorisation Number: 1011806013659

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Ruling

Subject: Deduction - interest

Question

Are you entitled to a deduction for the interest expense incurred on borrowed funds on-lent to a private company?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 2008

The scheme commenced on:

1 July 2007

Relevant facts and circumstances

You and your spouse borrowed money which you on-lent to a private company of which you are one of the shareholders as well as a director.

Security for the loan was a residential property.

You advised that you still own this property and it is not a rental property. You also advised that there has been no refinancing of the loan.

You and your spouse borrowed the monies as the company did not have appropriate security to support the loan.

The monies were on-lent to the company for the purpose of commencing a business.

You advised as to how the loan monies were dispersed.

No other funds were provided to the company for the set-up of the business.

There is no formal agreement in place between yourself and the company regarding the terms of repayment, length of loan and interest payable on the loan monies.

There was a verbal agreement to the effect that the loan was to be repaid in priority over returns paid to the shareholders.

The loan was advanced with the expectation of making a small return in excess of the repayments, in terms of additional interest as well as dividend income from the company.

The company never made a repayment and the venture was ill effectively from commencement.

The company produced assessable income for a few years, though insufficient to cover operating expenses and pay for the debt funding provided by you.

The business never traded profitably and was placed into liquidation using a qualified liquidator.

No interest, dividends or other return was ever received by you from the company, however assessable income was derived by a related party.

You did not receive any monies in repayment of the loan monies from the company.

You did not pursue any action for the recovery of the loan monies from the company or through the business.

Reasons for Decision

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses or outgoings to the extent that they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed to the extent that the losses or outgoings are of a capital, private or domestic nature or are necessarily incurred in gaining or producing exempt income.

You were not carrying on a business as an individual, therefore, only the first limb of section 8-1 of the ITAA 1997 is applicable. In order for a deduction to be allowable, the interest expense must have sufficient connection with the operations or activities which more directly gain or produce your assessable income.

For an expense to be deductible under section 8-1 of the ITAA 1997, you must establish that the essential character of the expense incurred was to gain or produce assessable income. In determining the essential character of an outgoing, regard must be had to its connection with the income producing activities of the taxpayer (Federal Commissioner of Taxation v. Smith (1981) 147 CLR 578 at 586; 81 ATC 4114 at 4117; (1981) 11 ATR 538 at 542).

As a general rule, an expense will not be deductible if it is incurred in gaining or producing assessable income of a person other than the one who incurs it. Outgoings incurred personally by a director or shareholder in earning the company's assessable income are generally not deductible to that person (FCT v Munro (1926) 38 CLR 153) (Munro's case).

In Munro's case, the taxpayer, a shareholder, advanced certain money to the company without interest. In order to provide for the advance to the company, the taxpayer borrowed money. It was held that the interest on the borrowings was not deductible. The interest was paid, not for the purpose of gaining or producing assessable income of the taxpayer, but for the purpose of satisfying a debt which the taxpayer had incurred with a view, not to the production of his assessable income, but to the production of income by the company for the benefit of it's shareholders.

You and your spouse obtained a loan to on-lend to a private company of which you were a director and a shareholder. The loan monies were used to set-up the company business. The loan was made with the expectation of making a small return, in excess of the repayments, in terms of additional interest, as well as establishing a business with the capability of providing both employment and dividend income.

Interest is deductible to the extent to which it is incurred in gaining or producing assessable income.

The issue of failing to derive any interest income was first 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 Federal Commissioner of Taxation v. Total Holdings (Australia) Pty Ltd (1979) 79 ATC 4279; 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 being deductible.

Subsequent to this decision, the Commissioner published Taxation 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 your case, the loan monies were on-lent as start-up funds to the company. There was no formal agreement between yourself and the company concerning the terms of repayment of the loan monies, interest rate and default of the loan repayment. Based on this, it cannot be seen that there was an expectation of a profit being made by you by way of a higher interest rate charged on the loan to the company than applied to the borrowed funds.

The company did not make any repayment towards the loan monies or distribute income to you in your capacity as a director or shareholder. At the time of making the loan to the company, it cannot be said there was a foreseeable prospect that dividend income would eventuate as the funds were used primarily for the set-up of the company. At this time, the prospect of dividend income was too remote. As you have stated that the venture was ill effectively from the beginning, it would have been foreseeable within a short time that profits were unlikely. Considering this, you did not take steps to pursue the non-payment of the loan monies.

Where a director and/or shareholder of a company borrows money and on-lends it to their company, a deduction for the interest expense incurred will only be allowed where the money is lent to the company on a commercial basis. That is, there must be a reasonable expectation that the director will receive a return such as interest on the funds lent as well as the repayment of the original amount.

It is considered that you have not lent funds to the company on a commercial basis. This is because:

· You had no formal agreement between you and the company concerning the conditions and terms of the loan.

· You had an informal agreement which did not provide for any conditions and terms for the repayment of the loan monies which would include interest rate, length of time over which to repay the loan and default provisions.

· The informal agreement only provided that the loan was to be repaid in priority over returns paid to shareholders.

· You did not pursue the recovery of outstanding payments by the company towards the loan.

Based on this, the purpose in you lending the money to the company cannot be seen as characterising the expenditure as incurred in gaining or producing your assessable income. There is insufficient nexus between your interest outgoing and the derivation of your assessable income. As the loan was not made on a commercial basis, and there is no assessable income against which the expenses were incurred, no deduction is allowed for the interest expense on the loan monies on-lent to the company under section 8-1 of the ITAA 1997.