Edited version of private ruling

Authorisation Number: 1011876998632

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Ruling

Subject: Interest incurred after the cessation of the business

Question 1

Are you entitled to claim a deduction for the full amount of interest incurred on a loan after your business has ceased where the funds borrowed had been used for working capital of your business, to pay income tax and GST arising from your business and to pay your spouse's PAYG tax instalments?

Answer

No.

Question 2

Are you entitled to claim a deduction for the portion of interest incurred on a loan after your business has ceased that relates to the funds borrowed that had been used for working capital of your business, and to pay income tax and GST arising from your business?

Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2011
Year ending 30 June 2012
Year ending 30 June 2013
Year ending 30 June 2014
Year ending 30 June 2015

The scheme commenced on

1 July 2010

Relevant facts

You operated a business as a sole trader. However, the business has now ceased.

When the business was operating you incurred interest expense on a loan which was used in the business for working capital, and to pay your income tax and GST arising from the earnings of the business.

You also used the loan proceeds to pay your spouse's PAYG tax instalments. These payments had no connection with the operation of the business. The amount that had been used for this purpose has since been deposited into the loan account.

The proceeds of the loan have not been re-drawn for any other purpose.

You intend to make additional repayments that will see the loan repaid in full in several years. You have other financial obligations and do not have the capacity to pay the loan out any sooner.

Assumptions

Nil

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1
Income Tax Assessment Act 1997 Paragraph 25-5(2)(a)
Income Tax Assessment Act 1997 Subsection 25-5(1)
Income Tax Assessment Act 1997 Section 27-15

Reasons for decision

Summary

A deduction will be allowed under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for interest incurred after your business has ceased on funds borrowed, where the funds were used for working capital, and to pay income tax and GST arising from your business. It is accepted in your case that the occasion of the expense is to be found in your previous income earning activity and the nexus between the expense and the activity has not been broken.

The interest that relates to the borrowed funds that were used to pay your spouse's PAYG tax instalments is not allowed. The interest on the loan cannot be claimed in full as a tax deduction even after the amounts drawn down to pay your spouse's PAYG tax instalments have been repaid into the loan account. This is because repayments to a loan used for business and private purposes cannot be directed towards repaying only either the business or private component of the loan. Any repayment is applied proportionately against both components of the loan.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for expenses necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowable if the expense is of a private, domestic or capital nature.

In general the character of interest is determined with reference to the use to which the borrowed funds are put (Commissioner of Taxation v. Roberts; Commissioner of Taxation v. Smith (1992) 37 FCR 246; 92 ATC 4380; (1992) 23 ATR 494).

Funds borrowed for use as working capital

Interest on funds borrowed for use as working capital of a business is an expense incurred in carrying on a business for the purpose of producing assessable income and therefore would generally be deductible.

Funds borrowed to pay income tax

Paragraph 25-5(2)(a) of the ITAA 1997 provides that expenditure on money borrowed to pay tax cannot be deducted as a tax related expense under subsection 25-5(1) of the ITAA 1997. Therefore, the deductibility of the interest expense will need to be determined under section 8-1 of the ITAA 1997.

Taxation Ruling IT 2582 states that where a taxpayer carries on a business and, in connection with that business, borrows money to pay income tax, then it is considered that the interest incurred is a normal incident of conducting a business and is therefore deductible. While the taxation ruling has a reference to companies carrying on a business, the same approach is applicable to an individual carrying on a business as a sole trader.

Funds borrowed to pay GST

GST is not an allowable deduction by virtue of section 27-15 of the ITAA 1997. However, this section does not deny a deduction for interest incurred on funds borrowed to pay GST. Therefore, the deductibility of the interest expense will also need to be determined under section 8-1 of the ITAA 1997.

As stated above, interest takes it character from the use to which the borrowed funds are put. The obligation to pay GST arises from the provision of goods and services by a taxpayer in the course of carrying on its business. As such, the GST expense is incurred in carrying on the business. Therefore, the interest on funds borrowed to pay this expense will also be incurred in carrying on the business and would generally be an allowable deduction under section 8-1 of the ITAA 1997.

Interest incurred after cessation of the business

As discussed above, interest relating to funds borrowed that are used for working capital and to pay the income tax and GST arising from a business would be deductible as an expense incurred in carrying on a business. However, in your case the further issue that must be addressed is whether the interest continues to be deductible after the business has ceased.

Taxation Ruling TR 2004/4 states:

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.

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.

An outgoing of interest in such circumstances will not fail to be deductible merely because:

·  the loan is not for a fixed term;

·  the taxpayer has a legal entitlement to repay the principal before maturity, with or without penalty; or

·  the original loan is refinanced, whether once or more than once.

However, if the taxpayer:

·  keeps the loan on foot for reasons unassociated with the former income earning activities; or

·  makes 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 nexus between the outgoings of interest and the relevant income earning activities will be broken.

A legal or economic inability to repay is suggestive of the loan not having been kept on foot for purposes other than the former income earning activities.

In application to your case you are making extra payments and intend to have the loan fully paid out in several years. You do not have the financial capacity to pay the loan out sooner because of other financial obligations. Therefore the nexus between the outgoings of interest and the relevant income earning activity has not been broken.

As proceeds of the loan were used to pay for expenses which were incurred in carrying on a business, you are entitled to claim a deduction for the interest incurred on the loan for that purpose after the business ceased. That is, you can claim a deduction for the portion of the interest incurred after the business ceased that relates to the borrowed funds that were used for working capital and to pay for income tax and GST arising from the operation of the business.

Funds borrowed to pay spouse's PAYG tax instalments

You are not however, entitled to claim the interest on the portion of the loan which was used to pay PAYG tax instalments for your spouse as this is considered private in nature. You are not entitled to a deduction for the full amount of the interest on the loan even though you repaid into the loan account the amount borrowed that was used for to pay your spouse's PAYG tax instalments.

Taxation Ruling TR 2000/2 states that repayments to a loan used for business and private purposes cannot be directed towards repaying only either the business or private component of the loan. Any repayment must be applied proportionately against both components of the loan.

The following example is provided to demonstrate this principle:

Bob borrowed $100,000. He used $80,000 for business purposes and $20,000 for private purposes. Therefore, Bob was entitled to claim a deduction for 80% of the interest. He now wishes to convert the loan into a 100% business loan so that he can claim the full amount of interest on the loan. He has not as yet paid off any of the principal of the loan.

Bob makes a repayment of $20,000 which he claims repays the $20,000 used for private purposes. However, the repayment must be applied proportionately against both components of the loan. Therefore, only $4000 is applied against the private component and $16,000 is applied against the business component. Consequently, Bob is still only entitled to claim a deduction for 80% ($64,000/$80,000 x 100) of the interest on the loan.

More comprehensive examples are provided in TR 2000/2. Please refer to this taxation ruling to assist you in calculating the apportionment between deductible and non-deductible interest in your case.