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Ruling

Subject: interest expenses

Question

Are you entitled to a deduction for the interest expenses incurred on the borrowed funds used to purchase shares?

Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commenced on

1 July 2008

Relevant facts

The arrangement that is the subject of the ruling is described below. This description is based on the following documents. These documents form part of and are to be read with this description. The relevant documents are:

o the application for private ruling,

o additional information, and

o company's information memorandum.

You are an Australian resident.

You purchased shares in an Australian company, (the company).

The shares were acquired a few years ago.

You initially purchased shares in the company with your own funds.

You borrowed money from the bank to purchase further shares in the company. The shares cost $1 each. This loan was fully repaid in the 2010-11 financial year.

You acted in the capacity as the company's chairperson for a few years.

You were also one of many directors of the company and resigned as director of the company after a few years, due to ill health.

You did not receive director's fees or any salary and wages from the company.

When in Australia, you would spend between 10 and 15 hours per week on your duties as director with the company. When you travelled overseas as part of your director duties (for six to eight weeks per year) you would work on a full-time basis for the company for that period.

The company was carrying on a business.

You invested in the company with the expectation of receiving a return in the form of dividends. You advised you expected to receive dividends annually to assist you in your retirement.

You have not received any dividends from the company.

You expected to receive a return once the venture had stabilised its initial operations. You anticipated receiving a dividend in year three, based on the original information memorandum provided to prospective investors.

You did not expect to receive any other benefits from the company.

The company has not made a profit.

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.

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, 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).

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, it is necessary to examine 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 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

Accordingly, it follows that if a loan is used for investment purposes from which assessable income is to be derived, the interest incurred on the loan will generally be deductible. 

The fact that a taxpayer does not derive any assessable income as a result of incurring the interest expenses to purchase shares does not necessarily prevent a deduction as long as the incurring of the interest expenses is expected to produce assessable income.

As stated in paragraph 9 of Income Tax Ruling IT 2606, generally interest on money borrowed to acquire shares will be incurred in gaining or producing assessable income where it is expected that dividends or other assessable income will be derived from the investment. Such an expectation will usually exist as shares, by their very nature, are inherently capable of generating dividends, whether in the short or long term. However, such an expectation must be reasonable and not a mere theoretical possibility. That is, there must be a prospect of dividends or other assessable income being received.

A deduction for interest will generally not be allowable where shares are acquired solely for the purpose of capital profit on their resale.

IT 2606 provides that where purpose or subjective intention is relevant to the characterisation of the interest expense, matters such as the dividend policy of the company, the reasons for the borrowing, the use to which the borrowed moneys were to be put and the connection between that use and the income producing activities of the taxpayer may be considered.

Your decision to purchase shares in the company was to gain dividends. There were no special conditions attached to your shares. From the company information provided and its dividend policy, it was reasonable to accept that the company would pay dividends when it made a profit. As a shareholder in the company, you had an expectation to receive dividends from the company when it made such a profit. The reason that prevented you from deriving dividends from the shares is the company's failure to make a profit.

You borrowed the funds and used them to acquire shares for the purpose of gaining assessable income. There is no evidence to show that you had another purpose or intention in acquiring the shares other than to derive assessable income. Therefore it is considered that the expectation to gain or produce assessable income was reasonable and was more than a mere theoretical possibility. Therefore a deduction is allowable under section 8-1 of the ITAA 1997.