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Ruling

Subject: Deduction-interest

Question 1

Are you entitled to a deduction for the full interest expense incurred during an income year on the borrowings used to purchase a financial product?

Answer: No.

Question 2

Are you entitled to a deduction for a portion of the interest expenses incurred on the borrowings used to purchase a financial product up to the amount of assessable income received in an income year?

Answer: Yes.

This advice applies for the following periods:

Year ended 30 June 2010

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 2009

Relevant facts

You purchased a financial product from a financial institution.

You chose Strategy 1 which offers the potential for capital growth up to 70% above the Initial Reference Level of the S&P/ASX 200 index.

Coupon payments of 5.00% may be paid annually starting from Year 1.5 and are contingent on the performance of the S&P/ASX 200 Index reaching predefined levels above the Initial Reference Level.

Coupons are payable in arrears on a number of dates which we have outlined.

The financial product provides for 100% capital protection at maturity.

You funded the investment with a loan from a financial institution.

You have not received any receive a coupon payments to date.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5.

Income Tax Assessment Act 1997 section 8-1.

Reasons for decision

Deductibility of interest expenses

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows you a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing your assessable income, except where those outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. The essential character of the expense is a question of fact to be determined by looking at all the circumstances.

Taxation Ruling 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 was established in a Federal Court case and is the basic test for the deductibility of interest; it looks at the application of the borrowed funds as the main criterion.

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.

Taxation Ruling TR 95/33 considers the deductibility and apportionment of losses and outgoings where they are incurred for dual purposes. The ruling 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 each particular case, include an examination of the subjective purpose, motive or intention in incurring the expense. 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 (Fletcher's Case).

Taxation Determination TD 2008/21 discusses deferred purchase agreement (DPA) products. Paragraph 23 states that generally any gains or losses from DPAs would be on capital account and, in cases where the investor also has the potential to receive coupon payments, these payments are assessable income under section 6-5 of the ITAA 1997.

In your case, the funds you borrowed were applied to the delayed purchase of a capital asset (ASX listed shares) together with the possibility of receiving an annual coupon payment, subject to certain movements in the market. This means the borrowed funds have been applied partly to secure delivery of an asset at maturity of the investment and partly for the purpose of producing assessable income annually for the period of the investment.

Therefore, any deduction for the interest expenses you have incurred will need to be apportioned to reflect each of these purposes.

Apportionment

When you have 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 N L and Tongkah Compound NL v FC of T (1949) 78 CLR 47 at 59; 8 ATD 431 at 437). In Fletcher's case, it was deemed 'fair and reasonable' to limit the amount of the deduction to the amount of the assessable income actually received in that year.

In comparison, Taxation Ruling IT 2684 considers the circumstances in which interest on money borrowed to acquire units in a property trust is an allowable deduction. In that Ruling, the Commissioner considers that interest expenses incurred on borrowed funds used to purchase income units, capital growth units or combined units are an allowable deduction. However, the Commissioner considers that there are exceptions to the general rule.

Your case is somewhat comparable with a capital growth split property unit trust, in which the investor is entitled primarily to capital growth, but which may also produce some assessable income.

The Commissioner's view with respect to capital growth split property units is that where such units are expected to produce only negligible income, interest expenses incurred in borrowing money to purchase the units are deductible only to the extent of the assessable income actually received.

Conclusion

Having regard to all the circumstances, it is considered fair and reasonable to adopt the same approach in your case. If the market movements trigger the annual 5% coupon payment during an income year and you receive assessable income as a result, you will be entitled to a deduction for the interest expenses up to the amount of the assessable income (that is; the coupon payment) actually received in that financial year.