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Ruling

Subject: Loan expenses

Question

Are you entitled to a deduction for expenses incurred on monies borrowed to pay your PAYG instalment liability?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts

You have a share in a business, operated through a trust.

You receive unfranked dividends from a discretionary trust.

As a consequence of this trust income you are required to make quarterly PAYG instalments.

The timing of the payments sometimes creates cash flow problems.

You usually receive the bulk of your trust distribution X to Z months after the close of the financial year.

There is generally a delay of several months between having to make the PAYG instalment and the actual receipt of the cash.

To make the PAYG instalment payments you sometimes need to borrow funds.

You incur interest and fees in relation to the borrowed funds.

You also receive income as an employee.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 25-5.

Reasons for decision

Subsection 25-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for expenditure incurred in managing your tax affairs. However, paragraph 25-5(2) (c) of the ITAA 1997 specifically denies a deduction under subsection 25-5(1) of the ITAA 1997 for expenditure for borrowing money (including payments of interest) to pay a tax liability.

Loan fees and interest payable in respect of a bank loan taken out by an individual to pay their income tax or PAYG instalment liability are not deductible under subsection 25-5(1) of the ITAA 1997 (ATO Interpretative Decision ATO ID 2002/607).

A deduction for interest expenses is sometimes allowable under section 8-1 of the ITAA 1997. Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income or necessarily incurred in carrying on a business to gain or produce assessable income except where the outgoings are of a capital, private or domestic nature.

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 (Lunneys case)), 

· 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 (Ronpibon's case), 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).

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 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.

Taxation Ruling IT 2582 states that the interest incurred on moneys borrowed to pay income tax will be deductible provided that the taxpayer is carrying on a business for the purpose of gaining or producing assessable income and, in connection with the carrying on of that business; the taxpayer borrows money to pay income tax.

However, as highlighted in Taxation Determination TD 2000/24 and Case V48 88 ATC 380, interest on a loan taken out to pay personal income tax is not deductible.

An individual who is not carrying on business is not entitled to a deduction under section 8-1 of the ITAA 1997 for expenses incurred on borrowings taken out to pay income tax or a PAYG liability. This is because the expenses are not incurred in earning assessable income and are also private in nature.

In your case, where you borrow funds to pay your PAYG instalment liability, the PAYG instalment amount is not considered to be sufficiently connected to your employment income or trust distribution.

It is acknowledged that you have a share in a business; however it is not considered that you are carrying on a business for tax purposes. That is, your assessable income is not derived directly from carrying on a business. The nexus between your expenses and your assessable income is not sufficient, therefore, no deduction is allowed for the loan expenses incurred on moneys borrowed to meet your PAYG instalment tax obligations.