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Ruling

Subject: interest expenses

Question 1

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

Answer

No.

Question 2

Are you entitled to a deduction for the interest expenses incurred on the borrowed funds used to purchase your relative's land?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commenced on

1 July 2007

Relevant facts

You purchased a block of land in 2007.

Your relative also purchased a block of land.

You have paid money in relative to your block of land.

You agreed to loan your relative money for the deposit to enable him to pay for the land.

You withdrew money from your home loan account to pay for both blocks of land.

You paid money to the vendor.

The vendor was engaged to market and sell future lots to be subdivided.

You paid your relative some money to reimburse him for the expression of interest fee he had paid on your behalf for the land.

You purchased the land to build a rental property.

Settlement date for the land was to be in 2009. The balance of the purchase price was to be paid on the settlement date.

The special conditions in the contract of sale stated that if you had not been issued with the land title by the agreed date in 2009, then the deposit monies shall be repaid without deduction to you.

You first became aware that the sales deposits had been misappropriated and lost when you were informed by a notice to creditors that a related entity had been placed into liquidation.

The vendor has not given the possession of the land to you.

You and your relative and other buyers filed a court case against the vendor in 2009 for possession of the land or recovery of the money.

You believe it is unlikely that you will be able to get possession of the land or recover your money from the vendor. You believe the vendor will probably be declared bankrupt.

Your relative intended to repay the money with interest once the land subdivision had been completed and you and your relative had settled on both blocks of land.

Interest to be paid from your relative would be equivalent to the interest incurred on the money.

Your relative has not made any repayments.

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, or relate to the earning of exempt income.

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).

Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that they are not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances.

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, regard must be given to all the circumstances including 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 (Munro's case) is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. The interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income. That is, it is generally accepted that interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction.

Taxation Ruling TR 93/32 states that the income/loss from a rental property must be shared according to the legal interest of the owners except in those very limited circumstances where there is sufficient evidence to establish that the equitable interest is different from the legal title.

Taxation Ruling TR 2004/4 considers deductions for interest expenses incurred prior to the commencement of income earning activities and the implications of the decision of the High Court in Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 (Steele's case) as well as the decisions in the Full Federal Court .

The deductibility of interest is generally determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put.

In Steeles case, the High Court considered the deductibility of interest expenses incurred on borrowings to purchase land intended to be developed for income production. Taxation Ruling TR 2004/4 concludes that interest incurred in a period prior to the derivation of relevant assessable income will be incurred in gaining or producing the assessable income in the following circumstances:

· the interest is not incurred too soon, is not preliminary to the income earning activities, and is not a prelude to those activities,

· the interest is not private or domestic,

· the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost,

· the interest is incurred with one end in view, the gaining or producing of assessable income, and

· continuing efforts are undertaken in pursuit of that end.

In your case, the vendor has not given you possession of the land, that is, you are not the legal owner of the property until the transfer has been completed. There is no other agreement that gives you an equitable interest in the property.

We acknowledge that you purchased the land for an income producing purpose, however, as you are not the legal or equitable owner of the land, the principles of Steele's case do not apply. Any interest expenses incurred on the land on which you never became the legal owner are not sufficiently connected to the earning of your assessable income. Furthermore, the expenses are more capital in nature. Therefore no deduction is allowable under section 8-1 of the ITAA 1997.

Interest incurred on funds lent to your relative

In Case 26/94 94 ATC 258, a director, who borrowed money to on-lend to his family company that had no capacity to borrow in its own name, was denied a deduction for interest as the purpose of the loan was to assist the company in avoiding liquidation. The connection between the lending and the derivation of future income by the director was too remote.

Although the above case refers to a director of a company, the principles are relevant in your case.

Where a person lends money to a family member, a deduction for any interest or associated expense incurred will only be allowed where the money is lent on a commercial basis. That is, there must be a reasonable expectation that the person will receive a return.

It is considered that you have not lent funds to your relative on a commercial basis. This is because:

· the interest rate your relative was to pay is the same as that charged to you by the financial institution, and

· the payments were to be reimbursements of your interest expenses and not actual income.

In your case there was no expectation of a profit being made by you by way of a higher interest rate charged on the loan to your relative than applied to the borrowed funds. That is you were not to receive any additional income or profit from the loans. Your purpose in lending the money cannot be seen as characterising the expenditure as incurred in gaining or producing assessable income. Rather it was incurred to help your relative and his financial position. That is, there is insufficient nexus between your interest outgoing and the derivation of your assessable income. Furthermore, as the loan was not made on a commercial basis, it is considered that the arrangement was more private or domestic in nature. Consequently no deduction is allowable for the expense on the funds on-lent to your relative under section 8-1 of the ITAA 1997.