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Ruling

Subject: Deductibility of interest expenses to individuals/guarantors after cessation of business conducted by a company

Question 1

Is the interest on a portion of a consolidated loan taken out to acquire shares in the company that was conducting the now ceased business operation, deductible?

Answer: Yes.

Question 2

Is the interest on a portion of a consolidated loan taken out to meet your obligation of going guarantor for a loan taken out by the company that was conducting the now ceased business operation, deductible?

Answer: No.

Question 3

Is the interest on a portion of a consolidated loan taken out to meet your obligation of going guarantor for rent owing by the company that was conducting the now ceased business operation, deductible?

Answer: No

This ruling applies for the following period

Year ended 30 June 2010

The scheme commenced on

1 July 2009

Relevant facts

You conducted a franchise business through a company of which you were shareholders. Shares in the company were also held by the franchisor.

Loans used to purchase a part of the business, run the business and meet guarantor obligations were secured against the family home. To stop the liquidators of the company from attacking the family home to recover on securities, you entered into a new consolidated loan to repay the debt owing on the company/business and other debts. You did not on-lend money to the company.

You have provided a break up of how the consolidated loan was disbursed to pay out the various debts of a business and private nature. The consolidated loan was obtained by refinancing your house.

A portion of the loan relates to the purchase of shares in the company and two other portions of the loan relate to meeting your obligations for going guarantor on a company loan and guaranteeing the rent on the company business premises.

Relevant legislative provision

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

The interest on the portion of the loan used to purchase shares in the company is deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) as it was incurred in deriving assessable income in the form of dividends from the company. The liability arose at a time when the company was conducting the business and there was the potential to derive income.

The interest on the portions of the loan arising from the obligations of going guarantor is not deductible as it is not incurred in deriving assessable income and would be of a capital nature. The liability arises at a time when the business has ceased and the company has gone into liquidation. There is no potential to derive any income from these related sources.

Detailed reasoning

Loan taken out to buy share in business

To be deductible under section 8-1 of the ITAA 1997, the expense must be incurred in the gaining or producing of assessable income or necessarily be incurred in carrying on a business for the purpose of gaining or producing assessable income. The interest must also not be of a capital, private or domestic nature, relating to the gaining or producing of exempt income or rendered non deductible by a specific provision of the Act.

In determining the deductibility of interest, the courts and tribunals have looked at the purpose of the borrowing and the use to which the borrowed moneys have been put (Taxation Ruling TR 2004/4). Interest on borrowed moneys may be deductible where the moneys are used to acquire income-producing assets (for example, property for rental, shares for dividends), to finance business operations (for example, as working capital) or to meet current business expenses (for example, overdraft moneys used to pay business outgoings such as wages, purchase of trading stock or materials). The security given for the borrowed money is totally irrelevant (Taxation Determination TD 93/13).

In accordance with general principles interest on funds used to purchase a business or shares in a business remains deductible if the occasion of the outgoing is found in the taxpayer's income producing activities.

The shares in the company were acquired with the expectation of deriving income in the form of dividends. The interest expense is a liability from the time of taking out the loan to acquire the shares. The interest expense will remain deductible after the company has gone into liquidation and the business has ceased.

Interest expenses arising out of loans to meet obligations as guarantor

You have gone guarantor in relation to the overdraft taken out by the company and also for the rent for the premises the company leased to conduct the business.

Payments made under a guarantee as well as interest expenses incurred in respect of the guarantees fall for consideration under section 8-1 of the ITAA 1997.

Accordingly it is the relationship between the outgoing and the gaining of the taxpayer's assessable income that determines whether the section permits a deduction or not. The act of going guarantor on these two occasions for a company in which you hold shares could not qualify you as carrying on a business of providing guarantees. You do not meet any of the general criteria used in determining whether a business is being carried on of providing guarantees. It is a one off event to allow the company to borrow money and enter into a lease agreement.

In Ronpibon Tin NL v. FC of T; Tongkah Compound NL v. FC of T (1949) 78 CLR47; 4 AITR 236; 8 ATD 431 the Full High Court found that for expenditure to form an allowable deduction as an outgoing incurred in gaining or producing the assessable income it must be relevant and incidental to that end. It has to be both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the taxpayer's assessable income or, if none be produced, would be expected to produce assessable income. What matters is their connection with the operations which more directly gain or produce the taxpayer's assessable income. Where an outgoing has been incurred in gaining assessable income it will be deductible provided it is not an outgoing 'of capital or of a capital, private or domestic nature'.

The legal system has held firmly, for most purposes, to a distinction between a company as one legal entity, and its promoters or shareholders. As a shareholder in the company you can potentially derive income through the company conducting the business. The potential to derive income does not come about because you have gone guarantor. At the time of going guarantor you have not incurred any liability, you only have a potential future liability.

In Willersdorf-Greene v FC of T 2009 ATC 10-102; 76 ATR 688 it is noted at paragraph 78 and 79:

Generally;

"…. A guarantee is essentially a promise to answer for the debt, default or miscarriage of another, and it does not include as such the case of a person incurring an additional liability in respect of a sum of money for which he is already liable."

Therefore, it is a promise that is dependant upon the occurrence of specified events at some future time. Those events may not occur.

You do not incur any liability until the company goes into liquidation, the business has ceased and you are called upon to meet your obligation under the guarantee. At the time of incurring these interest expenses you cannot potentially derive any income from the activities of the company business. The expenses of making the payments and the associated interest are not incurred in deriving assessable income and therefore are not deductible.

Also, the loan repayments and associated interest would be considered to be capital in nature and therefore not deductible.

In FC of T v. South Australian Battery Makers Pty Ltd (1978) 78 ATC 4412; 8 ATR 879, supported the proposition that it was the advantage which the expenditure was intended to gain directly or indirectly, for the taxpayer, that is relevant in determining the character of the expenditure. Thus the relevant advantage or benefit sought and the nature of which falls to be examined will be the advantage or benefit, directly or indirectly, to the person who claims to have expended the money on revenue account.

The Federal Court has confirmed in Bell & Moir Corporation Pty Ltd v. FC of T (1999) 99 ATC 4738; 42 ATR 421 that payments made under guarantees, given to a bank and finance company on behalf of a company in which the taxpayer had a one-third stake, were capital in nature and not deductible. It was found that the advantage sought by the taxpayer in providing the guarantees was the extension of credit facilities to the company. This served to strengthen the base from which the company carried on business so that the taxpayer could continue to trade with it. Such an enduring benefit was ordinarily capital in nature.