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Ruling

Subject: interest deduction

Question

Is the total interest expense necessarily deductible where this relates to a loan taken out to invest in a private company with different share classes and a dividend policy that may limit your entitlement to dividends?

Answer

No

This ruling applies for the following periods:

Year ending 30 June 2012

Year ending 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

The scheme commences on:

1 July 2011

Relevant facts and circumstances

A proprietary limited company (the company) will be registered as an Australian proprietary limited company through the Australian Securities and Investments Commission (ASIC) issued share structure.

Once registered with ASIC, the company will commence investing activities.

The company will have two classes of issued shares, A and B.

It is intended that the company's constitution will provide that defined quantum of declared dividend must be paid to class A shareholders; thereafter the dividend policy of the company will be governed by the replaceable rules.

The company will have at least two directors who will be responsible for its day to day investment operation. You will be one of those directors.

The company will raise, at the discretion of its directors, debt financing to supplement its income producing activities.

The profits generated by the company will be distributed to both classes of shareholders as dividends.

The directors will determine the class and quantity of dividends to be distributed.

The directors may not immediately commence declaring dividends in order to strengthen the balance sheet of the company. It is expected that the directors of the company will begin declaring dividends within 2-3 years.

One class of shares, B, will be controlled by a trust (the trust) which has a corporate trustee which will be controlled by you.

The beneficiaries of the trust are family members and are related to you.

You will enter into an arm's length loan arrangement with a financial institution for investment purposes.

The loan funds will be used to acquire class A shares in the company.

You will pay interest to the financial institution on this loan.

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.

Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. Where a borrowing is used to acquire an income producing asset or relates to an income producing activity, the interest on this borrowing is considered to be incurred in the course of producing assessable income.

Paragraph 9 of Taxation Ruling IT 2606 states:

As a general rule, interest on money borrowed to acquire shares will be deductible under the first limb of subsection 51(1) 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; there must be a prospect of dividends or other assessable income being received.

Due to the unusual nature of this proposed arrangement other matters need to be considered, such as the theoretical possibility of the company paying dividends to shareholders in a manner that is disproportionate to the funds invested by those shareholders.

A loss or outgoing is not deductible where it is incurred to gain or produce benefits for other persons. This proposition was illustrated in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153; [1926] HCA 58; (1926) 32 ALR 339, where a taxpayer subscribed borrowed funds for shares in a company, 90% of which were issued to his sons. The borrowed funds were clearly spent to benefit other people, and the taxpayer's interest expense was not deductible.

The essential character of an interest expense is derived from the purpose of the borrowing and the application or the use of the borrowed funds. The laying out of the borrowed money for the purpose of gaining assessable income 'furnishes the required connection between the interest paid upon it by the taxpayer and the income derived by him from its use'. Accordingly, an interest expense is not deductible to the extent that the borrowed money has been used to benefit others.

Taxation Determination TD 2009/17 examines whether interest is fully deductible where borrowed monies are settled by the borrower on trust to benefit the borrower and others. The view espoused on this matter is that the taxpayer's interest expense can only be deducted to the extent to which the taxpayer has used the borrowed moneys to gain or produce assessable income of the taxpayer.

In relation to apportionment, TD 2009/17 notes:

Apportionment

If apportionment is required, what will be appropriate will be essentially a question of fact, to be determined in each case. There must be 'a fair apportionment to each object of the… actual expenditure'.

Where the borrowing is used to fund trust entitlements with distinct and severable parts, the deduction can be determined on a proportionate basis (see Example 1 at paragraphs 8 to 12 of this Determination).

In other cases, the expenditure may serve several objectives indifferently and may not be capable of arithmetical or rateable division. In these cases the result will depend to an even greater degree upon a finding of fact as to the extent to which the expenditure is incurred in gaining or producing assessable income. If income production appears to be a minor object of the taxpayer in borrowing the money upon which interest is incurred (and the benefiting of other persons a main or prevailing purpose) only a small part of the interest will be fairly and reasonably attributable to gaining the assessable income of the taxpayer: as a rule of thumb, generally no more than the assessable income derived by the taxpayer in a particular year and in some cases less.

Application to your circumstances

You intend to borrow funds from a third party and use those funds to acquire class A shares in a private company. The company will have at least two directors and you will be one of those directors. Those directors will determine the class and quantity of dividends to be distributed. There are two classes of shares in the company, of which one class (A) you will control (own) and the other class (B) will be controlled by a trust.

The beneficiaries of the trust are family members of yours. You will borrow funds and incur interest expense on those funds. The funds will be used by the company for investment purposes. Ultimately any dividends flowing from the activities of the company will be distributed by the directors, of which you are one. Despite the fact that it is your intention that the company's constitution will provide that the first portion of any declared dividend must be paid to one class of shareholders, you have also stated that thereafter, the dividend policy of the company will be governed by the replaceable rules. The replaceable rules are parts of the Corporations Act 2001 (CA) and include the following:

Section 254U of the CA, which states:

"The directors may determine that a dividend is payable and fix the amount, the time for payment, and the method of payment.
The methods of payment may include the payment of cash, the issue of shares, the grant of options and the transfer of assets."

Also, subsection 254W(2), which states:

"Subject to the terms on which shares in a proprietary company are on issue, the directors may pay dividends as they see fit."

You have not stated specifically how the directors will pay any declared dividends.

Under the above arrangements, it may be the case that: you provide all or the majority of the company's capital; these funds are invested to generate income for the company; but the majority of that income is distributed as dividends to the ordinary shareholders who may have provided only a small portion of the capital.

Objectively, it must be concluded that your borrowing to invest in the company may be used for the benefit of others, namely the beneficiaries of the trust (as the B class of shareholders). Accordingly the interest you will incur on the borrowing is not deductible in full and must be apportioned to exclude that portion of interest referable to the income it generates for others rather than yourself.

Apportionment must be reasonable in all the circumstances. However, if the share capital contributed by yourself as the owner of the company's A class shares far exceeds capital contributed by B class shareholders, it is considered that unless another apportionment can be justified, the interest on your loan would only be allowed to the extent to which dividend income might reasonably be expected (the guaranteed defined sum) or the income actually derived by you from the investment.