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Ruling

Subject: interest expenses

Question

Are you entitled to a deduction for any interest expenses incurred?

Answer

No.

This ruling applies for the following periods

Year ending 30 June 2010

Year ending 30 June 2011

Year ending 30 June 2012

Year ending 30 June 2013

Year ending 30 June 2014

The scheme commenced on

I July 2009

Relevant facts

You borrowed money from a bank in 2007 and lent the same amount to a Trust (the Trust).

The Trust then lent the same amount to a company (the company).

The loan to the company was a precursor to the Trust possibly becoming a shareholder in the company and was used as working capital in the company's business.

The intention of the Trust was to acquire up to X% of the equity in the company.

Your loan was secured over your family home held in joint names of you and your spouse.

Under the terms of the loan agreement between the company and the trust, interest was paid for the 2007-08 and 2008-09 financial years to the Trust.

The Trust paid the same amount of interest to you. You declared this interest income as assessable income on your 2008 and 2009 tax returns and claimed a deduction for the associated interest expenses incurred.

Due to trading difficulties, the company became insolvent and was put into voluntary liquidation in during 2009. The company paid no interest to the Trust for the 2009-10 financial year. The liquidation of the company has been completed and the Trust recovered none of the outstanding funds on lent to the company.

The loan between you and the Trust was not in writing, however it was on the same terms as the loan from the Trust to the company. Interest was payable at X%. Repayments of principal and interest made by the Trust to you were to be the same amount of principal and interest received by the Trust from the company.

The loan repayments were made monthly from June 2007 to June 2009, but then ceased when the company could no longer make payments.

You received less interest repayments from the Trust than interest expenses incurred on your loan.

Your loan remains in place and continues to incur interest. Interest was incurred in the 2009-10 financial year.

Your loan had no set date for full repayment. There was no repayment schedule from the bank for the loan. The master loan had a portfolio limit of over $1,000,000.

The original interest rate charged by the bank when the loan was taken out was $X% per annum. There was no change to the terms of the loan from you to the Trust when the bank's interest rates changed. Also the repayment amounts from the Trust to you did not change. The interest on your loan has changed frequently to various rates between X% to X%.

You did not pass on the loan fees or other costs to the Trust.

As your spouse was the sole director of the trustee company of the Trust, you were aware that when the Trust ceased payments to you, it was not possible for the Trust to make any further payments as it was not receiving any payments from the company and it had no other resources from which payments could be made. It was not feasible to take any further action in relation to the outstanding repayments in the circumstances.

The original loan agreement between you and the Trust did not anticipate that the company would cease making payments to the Trust.

There was no security for the loan from you to the Trust.

The loan has not been refinanced.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

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 (Ronpibon's case) , 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 the above circumstances are different to your circumstances and you are not a director or shareholder, the principles are relevant.

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's case at 59; 8 ATD 431 at 437; 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.

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.

Taxation Ruling TR 95/33 considers the deductibility and apportionment of losses and outgoings where 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 derive income for another entity 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).

Where a person lends money to a related entity, 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 did not lend the funds to the Trust on a commercial basis. This is because

· there was no written loan agreement between you and the Trust,

· there was no security for the loan,

· there was no provision in relation to the repayments not being made,

· the loan fees were not passed on to the Trust,

· the initial interest rate charged by you to the Trust was less than the interest rate being charged by the bank to you, and

· the interest rate charged to the Trust did not change when your bank loan interest rates increased or decreased.

In your case, your borrowed funds were used to on lend to the Trust. The amount of assessable income derived from the loan was less than the associated interest expenses and loan fees incurred by you. That is, an overall loss was made during the initial years of the loan. Furthermore, there is no evidence to show that the funds were borrowed for a profit making purpose either now or in the future.

As the loan was not made on a commercial basis, it is considered that the arrangement was made for some other purpose other than to produce assessable income for you. Although the bank interest rate was less than X% at times, the purpose in lending the money to the Trust cannot be seen as characterising the expenditure as incurred solely in gaining or producing assessable income. Therefore, any deduction for the interest expenses you have incurred will need to be apportioned.

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's case). In Fletcher's 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.

As in Ure's case and Fletcher's case, it is considered fair and reasonable in your circumstances to allow a deduction only up to the amount of assessable income derived. No assessable income has been derived after June 2009. Consequently no deduction is allowable after this date for the expenses on the funds on-lent to the Trust 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 (Browns 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.

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 the borrowed funds were not solely used for income producing purposes. The borrowed funds were used to on lend to the Trust in a non-commercial arrangement. As the funds were not used solely for income producing purposes, the principles of TR 2004/4 have little application in your case. Therefore no interest deduction is allowable for the 2009-10 financial year or future years.