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Ruling

Subject: Deductible Interest Expenses

Question 1

Are you entitled to a deduction for interest expenses incurred on funds borrowed where the principal loan amount is on-lent to a trust under section 8-1 of the Income Tax Assessment Act (ITAA 1997)?

Answer

Yes, to the extent of income received from the trust in a particular year.

This ruling applies for the following periods:

Income year ending 30 June 2012 to Income year ending 30 June 2022.

The scheme commences on:

Income Year ending 30 June 2012

Relevant facts and circumstances

You are proposing to:

§ establish a Trust (the Trust);

§ borrow funds from an external lender - at arm's length; and

§ advance the full amount of the external loan to the Trustee of the Trust as a loan under the arrangement described in a Loan agreement and the deed.

The loan to the Trust will be interest free.

The Trustee of the Trust will use this loan to for an investment.

The investment will be long term investments.

The Trust deed defines you as the Primary Beneficiary.

The Secondary Beneficiary is a Family Trust related to you.

In consideration for making the loan to the Trust, the Primary Beneficiary will become absolutely entitled to the lesser of:

§ The Distribution Amount: or

§ The total net income of the Trust plus any capital gain not included in the net income of the Trust for that year.

The Distribution Amount is defined in the Trust deed as follows:

The Distribution Amount in each financial year is the amount equal to the interest payable on the External Loan in that financial year plus the Margin (if any) provided that, if the Priority Distribution for a financial year is less than the Distribution Amount for that financial year, the shortfall will be added to and form part of the Distribution Amount for the following financial year.

The Priority Distribution is defined as the amount the Primary Beneficiary must receive pursuant to the Trust deed.

The Secondary Beneficiaries are absolutely entitled to the balance of the Net Income and any Net Capital Gain not otherwise included in Net Income for each year.

The Net Income of the Trust is defined in the Trust deed as follows:

The amount determined in accordance with section 95 of the Income Tax Assessment Act 1936 (Cth) excluding any Notional Amounts unless the Trustee declares that the Net Income for a period will be determined in some other way.

No distributions of capital may be made to Secondary Beneficiaries while the loan remains unpaid.

The Trust deed states that clauses relating to the distribution of income and capital cannot be amended while there is an amount of the loan owing or there is an unpaid distribution amount.

The Trustee cannot enter into another loan unless the first loan (and all Priority Distributions in respect to that loan) has been repaid in full.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent that they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed to the extent that the losses or 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.

For the purposes of section 8-1 of the ITAA 1997, the essential character of 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' (Ure v. Federal Commissioner of Taxation (1981) 50 FLR 219; 81 ATC 4100 at 4104; (1981) 11 ATR 484 at 488 (Ure)). Accordingly, interest expense is not deductible to the extent that the borrowed money has been used to benefit others.

Importantly, for a beneficiary to achieve an unapportioned deduction under section

8-1 of the ITAA 1997, in relation to the settlement of funds provided by them on a trust, a beneficiary has to establish that they reasonably expect to receive all income from the trust that is derived using the funds they provided. It is not enough for the beneficiary to establish that they expect to receive some income, or that the total amount of income they expect to receive is likely to exceed the total amount of their interest expense. A loss or outgoing is not deductible where it is incurred in order to gain or produce assessable income of another entity. This proposition does not cease to apply if a beneficiary can show that he or she expects to recoup his or her expense from assessable income (Federal Commissioner of Taxation v Munro (1926) 38 CLR 153; (1926) HCA 58; 32 ALR 339).

If interest expense is designed to fund the income of both the relevant beneficiary who has provided funds that were settled upon the trust and other beneficiaries, that expense has a dual aspect. If part of the expenditure has a private or domestic nature, then a fair apportionment to each object of the actual expenditure is required.

Taxation Determination TD 2009/17 Income tax: is interest on a loan fully deductible under section 8-1 of the Income Tax Assessment Act 1997 when the borrowed moneys are settled by the borrower on trust to benefit the borrower and others? (TD 2009/17) discusses cases where the objective facts indicate that the borrowed money has been used for the purpose of benefiting both the taxpayer and other persons. To the extent that it is used to benefit others, it has the characteristics of a gift. A transfer of property may bear 'all the marks of a family settlement' even though it is done under an arrangement which may produce assessable income for the taxpayer. As such, where a portion of the interest payable on the borrowed money is not incurred in gaining or producing the taxpayer's assessable income, or has a private or domestic nature, that portion of the interest is not deductible.

The conclusion that borrowed money is being used to benefit entities other than the taxpayer follows logically from the connection between the money spent and the rights the taxpayer and the others obtain. The terms of the trust indicate that the taxpayer will not enjoy, or cannot reasonably expect to enjoy, all of the benefits flowing from the trust capital which they have funded with the borrowed money. A consequence of this is that the expenses incurred on borrowed moneys the taxpayer settles on the trust are disproportionate to the benefits which might reasonably be expected to pass to the taxpayer under their rights to trust income. To that extent, the expenditure lacks an obvious commercial explanation but has an obvious private or domestic explanation.

To illustrate these principles, TD 2009/17 contains an example at paragraphs 13-20, where a taxpayer borrows money and uses this loan to acquire units in a trust. The taxpayer's spouse and children are also beneficiaries of the trust. The trust uses the money to purchase a rental property.

The Trust deed provides that where there is income of the trust available for distribution, the trustee is to hold an amount for the benefit of the unitholder, equal to the lesser of:

a) the total income of the trust available for distribution

b) the unit holder's interest expense plus a nominal amount.

Any excess of the (a) amount over the (b) amount is carried forward and is cumulative. Any excess of the (b) amount over the (a) amount is distributable to the other beneficiaries at the trustee's discretion. The units are redeemable for an amount equal to the amount originally settled. Any remaining trust capital is held for the benefit of the other beneficiaries.

In this example, the interest expense is not deductible in full, as the terms of the trust indicate that the taxpayer borrowed money, in part, to create a fund for the benefit of their family. Accordingly a portion of this interest expense is not incurred in gaining or producing the taxpayer's assessable income, notwithstanding the method of calculation of the income entitlement may lead to the total income from the units exceeding the total interest expense. In this case, the interest expense will be apportionable between these purposes.

The extent of any apportionment is a question of fact, to be determined in each case. There must be 'a fair apportionment to each object of the … actual expenditure' (Ronpibon Tin NL & Tongkah Compound NL v Federal Commissioner of Taxation (1949) 78 CLR 47 at 60).

To relate to your specific situation, the Trust deed describes the determination and distribution of income of the Trust.

The Trust deed states that in consideration for making the loan to the trust, the Primary Beneficiary will become absolutely entitled to the lesser of:

§ The Distribution Amount: or

§ The total net income of the Trust plus any capital gain not included in the net income of the Trust for that year.

The trust deed explains that the Secondary Beneficiaries are absolutely entitled to the balance of the Net Income and any Net Capital Gain not otherwise included in Net Income for each year.

The trust deed states that no distributions of capital may be made to Secondary Beneficiaries while a Stakeholder Loan remains unpaid.

The Distribution Amount as follows:

The Distribution Amount in each financial year is the amount equal to the interest payable on the External Loan in that financial year plus the Margin (if any) provided that, if the Priority Distribution for a financial year is less than the Distribution Amount for that financial year, the shortfall will be added to and form part of the Distribution Amount for the following financial year.

The Trustee can not enter into another loan unless the first loan (and all Priority Distributions in respect to that loan) has been repaid in full.

The Trust deed states that clauses relating to the distribution of income and capital cannot be amended while there is an amount of the loan owing or there is an unpaid distribution amount

In your case, you will borrow money to on-lend to the Trust to enable the Trustee of the Trust to invest. The trust deed provides that the Primary Beneficiary will be absolutely entitled to the net income of the Trust each income year, after recouping any losses in any prior income year, to the extent of the Distribution Amount or Priority Distribution.

However, the Trust deed provides that the Secondary Beneficiaries are absolutely entitled to the balance of the Net Income and any Net Capital Gain not otherwise included in Net Income for each year.

Therefore, the Trust will not give you an entitlement to all of the benefits which may reasonably be expected to be produced by the investment purchased by the Trust, using the funds you have forwarded. The borrowed money has been used for the purpose of benefiting yourself and other persons. As such, the interest is not fully deductible and must be apportioned.

We note that the examples in TD 2009/17 relate for the most part to trusts in which a beneficiary invests in the trust by application for units in exchange for monies which are settled upon the trust. We further note that in your case you have not applied for units in the trust but purport to enter into a lending arrangement with the Trustee. TD 2009/17 was not intended to apply to pure on-lending arrangements with trusts. However, as noted, your situation is not viewed as a pure on-lending arrangement with a trust. No interest is payable by the trust under the draft loan agreement. Rather, the proposed arrangement gives you an entitlement to a portion of the Trust income as the Primary Beneficiary. However, an entitlement to Trust income derived from the funds provided is also available to the Secondary Beneficiaries, who carry no expense or risk associated with the provision of those funds. Therefore the principles that underpin TD 2009/17 apply to the proposed arrangement you have sought advice on.

TD 2009/17 provides that where apportionment is required, what the appropriate level of apportionment is will be essentially a question of fact, to be determined in each case. Where the expenditure serves several objectives indifferently it may not be capable of arithmetical or rateable division.

As per Fletcher v. Federal Commissioner of Taxation [1991] HCA 42; (1991) 173 CLR 1; (1991) 22 ATR 613; 91 ATC 4950 and Ure it is considered that the interest allowable would be no more than the assessable income derived by you from the trust in a particular year.