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Ruling

Subject: Trust - Interest deduction

Question 1

Is the 2011 interest expense incurred by the trustee under the loan agreement deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in calculating the net income of the trust estate under section 95 of the Income Tax Assessment Act 1936 (ITAA 1936) for amounts borrowed to purchase land?

Answer

Yes.

Question 2

Is the 2011 interest expense incurred by the trustee under the loan agreement deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in calculating the net income of the trust estate under section 95 of the Income Tax Assessment Act 1936 (ITAA 1936) for amounts utilised to provide interest bearing loans to related parties?

Answer

Yes.

Question 3

Is the 2011 interest expense incurred by the trustee under the loan agreement deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in calculating the net income of the trust estate under section 95 of the Income Tax Assessment Act 1936 (ITAA 1936) for amounts borrowed to purchase shares in a related entity that have been subject to a share buyback?

Answer

No.

This ruling applies for the following periods:

Period ending 30 June 2011

The scheme commences on:

24 March 2005

Relevant facts and circumstances

The Trust borrowed funds from a related entity to purchase land which is used to generate rental income. At a later period the trust borrowed further funds through a bank facility to purchase shares which subsequently paid dividends.

The Trust then refinanced both of the amounts outstanding on these loans by borrowing funds from a beneficiary of the trust. The terms of the loan included interest and details are as per the loan agreement. An amount of the loan was also used to provide interest bearing loans to other entities.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1 and

Income Tax Assessment Act 1936 Section 95.

Reasons for decision

Summary

The amount of interest expense in relation to the land and the provision of interest bearing loans are a deduction under section 8-1 of the ITAA 1997 for the purposes of calculating net income under section 95 of the ITAA 1936. However the interest amount applicable for refinancing the purchase of the shares is no longer an allowable deduction.

Detailed reasoning

Section 95 of the ITAA 1936 defines net income of a trust estate as the total assessable income of the trust estate calculated under the Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions (excluding exceptions).

Interest is deductible under section 8-1 of the ITAA 1997 to the extent that it is incurred in gaining or producing assessable income or in carrying on a business for that purpose, except to the extent that the expense is of a capital, private or domestic nature or incurred in gaining or producing exempt income.

ATO Interpretative Decision ATO ID 2001/79 states that 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. The 'use' test, established in FC of T v Munro (1926) 38 CLR 153, 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 be deductible to the extent that the property is used to produce assessable income.

As per paragraph 42 of Taxation Ruling TR 95/25 interest on a new loan will be deductible if the new loan is used to repay an existing loan which, at the time of the second borrowing, was being used in an assessable income producing activity or used in a business activity which is directed to the production of assessable income (Roberts and Smith ATC at 4388; ATR at 504).

Taxation Ruling TR 2004/4, deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities is relevant to this case in particular paragraphs 40 to 50. Paragraph 45 states that the principles in Brown and Jones cases could apply to income earning activities that do not constitute a business, such as passive investments. In determining whether a particular outgoing of interest incurred after the cessation of the relevant income earning activities is deductible a number of factors are to be weighed to see if the continuing liability to interest is seen to be merely a burdensome legacy of the past (suggestive of a continuing nexus with prior assessable income) or if the liability is seen to be associated with present or future advantages (suggestive of a broken nexus). The factors to be considered are outlined in Paragraph 50 as:

The less the financial resources of the taxpayer, the more likely it is that an inference could be drawn that the existence of a continuing obligation to pay interest is a burdensome legacy of the past rather than a result of the taxpayer choosing to keep the loan on foot for reasons unassociated with the former income earning activities. Jones is an example of a case in which the limited financial capacity of the taxpayer was given considerable weight by the Court in determining whether interest incurred by the taxpayer after the cessation of the relevant income earning activities continued to be deductible;

The more liquid the resources of the taxpayer, the more likely the inference could be drawn that the loan is being kept on foot for reasons unassociated with the former income earning activities. For example, where there are sufficient funds held in cash or on deposit in a bank account that could relatively easily be applied in repayment of the principal, the refusal to make such repayment would suggest that the loan is being kept on foot for other reasons. However, the inference is unlikely to be drawn if it would be unreasonable in the circumstances to expect the taxpayer to apply their liquid resources against the loan;

The realisation or exchange of assets without a diversion of these resources in repayment of the principal will tend to indicate a breaking of any nexus that might previously have been maintained even after the cessation of the income earning activities. For example, the decision to realise shares and use the proceeds to purchase a leisure yacht rather than make a repayment would be highly suggestive of a break of any previously existing nexus. On the other hand, though, the sale of a taxpayer's residence and the use of the proceeds to purchase another closer to a new place of employment would typically not have that effect;

The greater the time since the cessation of the income earning activities, the more likely it is that an inference could be drawn that the continuing obligation to pay interest is a result of the taxpayer choosing to keep the loan on foot for reasons unassociated with the former income earning activities; and

Refinancing of a loan does not of itself break the nexus between outgoings of interest under the loan and the prior income earning activities. However the decision to refinance may, in all the circumstances, lead to the inference being drawn that the taxpayer has made a conscious decision to extend the loan, and has done this in order to derive an ongoing commercial advantage.

The Trust utilised the loan in the following ways:

· by lending funds at interest; and

· by repaying or refinancing existing interest bearing debt that had been utilised to purchase land which is rented and also to purchase shares which have been subsequently redeemed.

The land and the loan of funds at interest to other parties generate assessable income for the Trust. However the amount used to retire funds borrowed under commercial bills to acquire the shares which returned dividends at the time of the share buy-back needs to be considered as per paragraph 50 of TR 2004/4.

The loan for the purchase of the shares was refinanced indicating that there has been a conscious decision to extend the loan which in this case has provided a commercial advantage to the trust in accruing further interest deductions to the trust. Also there was a distribution made by the trust, part of which could have terminated the existing loan. There have been a number of years since the cessation of income earning activities in relation to the shares in that the last dividend was derived a number of years ago.

In addition funds have been directed to provision of other income producing investments with the loans to other parties that could have been utilised to terminate the loan amount for the shares. Therefore it is concluded that the taxpayer chose to keep the loan on foot for reasons unassociated with the former income earning activities of the shares.

Therefore the part of the funds utilised for refinancing purposes for the purchase of land and to provide interest bearing loans generate assessable income for the Trust. Interest expenses incurred for these purposes are an allowable deduction under section 8-1 of the ITAA 1997. However the amount used to refinance the purchase of shares a number of years ago which were subsequently subject to buy back no longer have the required nexus with the production of assessable income for the year of this ruling.