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Ruling

Subject: Deduction-interest

Question 1:

Are you entitled to a deduction for interest incurred on a loan on-lent to a company that has ceased trading?

Answer: Yes.

Question 2:

Is a deduction allowed for the portion of the interest on loan B that is attributable to the income producing purpose?

Answer: Yes.

This ruling applies for the following periods:

Year ended 30 June 2009
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 2008

Relevant facts

The company purchased and operated a business.

To fund the purchase of the business you and your spouse took out loan A and on-lent the funds to the company.

You and your spouse were directors and shareholders of the company.

One spouse was employed as the manager of the business and was paid a salary for their services during the period of business operation.

The other spouse worked for a period to set up the business and was paid a salary for their services.

Your purpose for lending the funds to the company was to set up the business with the expectation of receiving a distribution from the company in the form of dividends or interest payments.

The letter of agreement between you and the company outlined the terms of the loan agreement which were:

· the funds have been on lent to the company at the exact prevailing interest rate pursuant to the source under loan A's agreement

· the company is expressly and solely responsible for the repayment of the loan, and associated expenses during the period of the loan period.

The company treated the funds borrowed to purchase the business as loans to the shareholders.

The business ceased and was sold.

The interest expense on loan A was paid by the company until the business ceased.

You and your spouse didn't have the financial capacity to repay loan A at the time the business ceased.

You opened up a loan facility (loan B) with a financial institution.

You drew down funds from loan B to repay loan A.

You drew down funds from loan B for private purposes.

You used the proceeds from the sale of the business to reduce loan B to an outstanding balance.

You and your spouse have made repayments to loan B loan since the company cease trading.

You currently have other debts to repay.

You intend to make repayments on loan B in future financial years from your salary and wages and from a line of credit facility.

You and your spouse have not refinanced or drawn down additional funds on loan B.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1.

Reasons for Decision

Interest deduction
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 or are necessarily incurred in carrying on a business for the purposes of gaining or producing such income, except where the outgoings are of a capital, private or domestic nature.

The deductibility of interest expenses incurred by shareholders on borrowings on-lent to associated family companies for the purpose of gaining or producing their assessable income where they are the sole shareholders is generally held to be an allowable deduction under section 8-1 of the ITAA 1997.

This view is supported by the Full Federal Court case of Federal Commissioner of Taxation v Total Holdings (Aust) Pty Ltd (1979) 79 ATC 4279,9 ATR 885, Taxation Ruling IT 2606 and the Administrative Appeals Tribunal case of Economedes v Federal Commissioner of Taxation 2004 ATC 2353; 2004 58ATR 1046; [2005] ALMD 4478; [2004] AATA 1249 (Economedes case). In the Economedes case, the Tribunal held:

The taxpayer had an expectation, when on-lending the borrowings to the company, the borrowing would result in interest and dividend income being received from the company at least equal to the interest expense incurred in repaying the loan.

It was common commercial practice for small business clients to borrow funds from a bank and to on-lend them to a family company to enable the company to operate a business. It was common commercial practice for such loans to be undocumented.

There was a sufficient nexus between the on-lending and the expectation of profit. As per the Total Holdings case, it was not relevant whether income was actually derived from the business but rather whether there was a reasonable expectation that income would be derived in the future. Moreover it was clear from the nature of the relationship between the taxpayer and the company that the purpose of the on-lending was to manage an income-producing enterprise.

The judgment in Munro centred not on the fact that the loan was inherently capable of being categorised as having been made for the purpose of gaining or producing assessable income of the taxpayer, but rather on the fact that nine-tenths of the money was applied directly or indirectly for the benefit of third parties.

Your circumstances are similar to Economedes case in that you were the shareholders of your private company and you borrowed funds which you on-lent to the company with no expectation of deriving income by way of higher interest rates charged on the original borrowing. While the interest on loan A was paid directly to the financial institution by the company there was a reasonable expectation that you would earn assessable income by way of dividends. Therefore there is sufficient nexus between the outgoing of the interest and the expectation of deriving income. Accordingly, a deduction is available for the interest expenses incurred in relation to unrecouped amounts on-lent to the company under section 8-1 of the ITAA 1997.

Loan Refinancing
In examining the use of borrowings, there may be instances where the loan has a mixed purpose. Where there is a mixed purpose, only the interest of the portion of the borrowing which is attributed to an income producing purpose is deductible. Apportionment must be made on a fair and reasonable basis. The onus is on the taxpayer to show that the method they have used is fair and reasonable in their circumstances. 

Taxation Ruling TR 2000/2 (enclosed) provides information which can be used as a guide in relation to the calculation of the apportionment of interest on line of credit facilities (paragraphs 19 to 21, TR 2000/2).

Further, interest on a new loan used to repay an existing investment loan will generally also be deductible as the character of the new loan is derived from the original borrowing. That is, when a loan is refinanced, the new loan takes on the same character as the previous loan. Refinancing a loan does not in itself break the nexus between the outgoings of interest under a loan and the income earning activities.

In your case, you on-lent funds to the company for income producing purposes until the company ceased operating and the business was sold. You secured loan B to payout the outstanding debt on loan A and for other private purposes. Loan B is considered a mixed purpose loan. You are entitled to a deduction under section 8-1 of the ITAA 1997 for a portion of the interest on loan B that is attributed to an income producing purpose.

Deductibility of interest with the cessation of income producing activity
Taxation Ruling TR 2004/4 provides the Commissioner's view on the deductibility of interest where the income-producing asset has been disposed of and the taxpayer is still liable for the balance of the loan.

In general, the interest expense will continue to be deductible where:

· the taxpayer borrowed money to acquire an income-producing asset

· the income-producing asset has been disposed of

· the proceeds from the disposal have been applied against the loan and not used for personal or non-income producing purposes

· the taxpayer does not have the legal power to repay the loan (FC of T v. Brown 99 ATC 4600, (1999) 43 ATR 1) or does not have the financial resources to repay the loan fully (FC of T v. Jones 2002 ATC 4135, (2002) 49 ATR 188), and

· is unable to avoid incurring ongoing interest liabilities.

In this situation, a nexus will continue to exist between the interest outgoings and the relevant income earning activities at least until the end of the period during which the interest cannot be avoided.

However, where it can be inferred that a taxpayer has:

· kept the loan on foot for reasons unassociated with the former income earning activities, or

· made 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 and relevant income-earning activities will be broken.

We have determined that you and your spouse are entitled to claim the interest expenses related to loan A.

Your obligation to pay the interest expenses arose from your former investment in the business. The connection with the income earning activities has not been broken because the business was sold and the outstanding debt was refinanced by loan B.

Currently you and your spouse do not have the financial resources or means to pay out the income producing portion of loan A. Therefore, you are not keeping the income producing portion of the loan on foot for reasons unassociated with the former income earning activities, nor have you made a conscious decision to extend the income producing portion of the loan B to gain an ongoing commercial advantage.

As your original purpose and use of the borrowed funds was to purchase a business, we consider the nexus with prior income earning activities and your ability to claim a deduction for the relevant interest expense incurred on loan B has not ceased.

You are entitled to claim the income producing portion of the interest expenses incurred on the outstanding balance of loan B under section 8-1 of the ITAA 1997.