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Ruling

Subject: Deduction of interest expense

Question 1

Are you entitled to a deduction of interest expenses for the years ended 30 June 2010 and 30 June 2011?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commences on

01 July 2009

Relevant facts and circumstances

In 2009 you borrowed funds from a bank to facilitate the purchase of a business by a company of which you are a 50% shareholder.

You have not made provision for the repayment of the money you gave the company and you do not have a loan agreement or an arrangement in place to cover this.

The company has not made any loan payments for the funds that you provided. You have not received a dividend or directors fee from the company.

You are making loan repayments from your personal account.

The prime purpose of you obtaining the loan was to allow the company to purchase a business.

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.

Generally, interest expenses incurred for income producing purposes is deductible under section 8-1 of the ITAA 1997, to the extent that they are not capital, private or domestic in nature.

In order for the interest expense to be deductible under section 8-1 of the ITAA 1997 an individual must establish the essential character of the interest incurred was to gain or produce assessable income. In determining the essential character of an interest outgoing, regard must be had to its connection with the income producing activities of the taxpayer (Federal Commissioner of Taxation v. Smith (1981) 147 CLR 578 at 586; 81 ATC 4114 at 4117; (1981) 11 ATR 538 at 542).

Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. TR 95/25 specifies that to determine whether the associated interest expenses are deductible under section 8-1, it is necessary to look at the use to which the borrowings are put.

The 'use' test, established in the Federal Court case FC of T 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.  Accordingly, it follows that if a loan is used for investment purposes from which income is to be derived, the interest incurred on the loan will be deductible.

The issue of failing to derive any interest income was first considered in Munro's Case where the principles established were that neither the lending to the company in which Mr Munro was a shareholder, nor the financing of an acquisition of shares by his sons were regarded as sufficient to characterise the incurring of the interest as being directed to the gaining of the taxpayer's income.

Since Munro's Case there have been a significant number of cases in which directors and shareholders of companies have provided benefits at their own expense to the companies with which they were associated which have not satisfied the characterisation test.

Taxation Ruling IT 2606 clarified that in circumstances where no income is derived directly by the taxpayer from the transaction, to which the interest expense relates, and there is no obvious connection with the carrying on of a business or other income earning activity of the taxpayer, then the taxpayer's purpose may be relevant to the characterisation of the expenditure.

In your case, you have used your borrowed funds to allow your company to make a capital investment that being the purchase of a business. You did not borrow the money to generate an income directly and the company has not reimbursed you for the funds you provided.

Therefore, consistent with the principles established in TR 95/25, you will not be entitled to claim a deduction for the interest expenses on the loan.