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Ruling

Subject: interest expenses

Question

Are you entitled to a deduction for interest expenses incurred on loan money used to repay a company's loan?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

The scheme commenced on

1 July 2010

Relevant facts

A loan was originally held in the name of a company.

You and your spouse were the two original shareholders in the company.

You and your spouse owned one ordinary share each in the company, representing a 100% ownership of the company.

You received wages and dividends from the company.

The company struggled with cashflow and profitability due to poor economic conditions and closure of large industry operations in the surrounding area.

The company was eventually put into voluntary liquidation and liquidated. The relevant income earning activities of the company had ceased on liquidation.

In the same month as the company's liquidation you obtained a loan from a bank at commercial rates with the intention and purpose of repaying the company's business loans that were originally used as working capital and business investment funding in the business.

You and your spouse were the guarantors for the company's loans.

You were not in the business of providing guarantees.

Your loan was at a lower interest rate than the company's loan. You also obtained minimum repayments.

You did not receive any dividend, distribution or capital return from the company in liquidation.

You are currently repaying the loan from other sources of income.

You were declared bankrupt in connection with these matters.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Interest expenses

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 (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).

Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that it is 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.

TR 95/25 lists the following general principles to determine whether interest is deductible under section 8-1 ITAA 1997: 

· the interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature

· the character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower 

· a tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity

· interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets, and

· interest on borrowings will not continue to be deductible if the borrowed funds cease to be employed in the borrower's business or income producing activity.

In your case, you borrowed funds to pay out the company's loan. As a general rule, a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of an entity other than the one who incurs it (Munro's case ). For taxation purposes, the company is a separate entity.

Although the borrowed funds of the company were used as working capital and business investment funding for the business, your subsequent loan cannot be said to be used for the same purpose. The funds you borrowed have not been used to produce assessable income.

Thus a deduction for paying the company's debt will not be allowable under section 8-1 of the ITAA 1997 as it relates to the earning of the company's assessable income and not your assessable income.

Interest incurred following the cessation of the business

The Commissioner's view on whether interest deductions are allowable after the cessation of the relevant income producing activity is outlined in Taxation Ruling TR 2004/4.

Paragraph 10 of TR 2004/4 states that where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and the relevant income earning activities (whether business or non-business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing the assessable income if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgement about the nexus between the outgoing and the income earning activities.

In your case, the original loan was taken out by the company to produce its assessable income. Your subsequent loan is regarded as a new loan. You borrowed money to pay out the company's loan.

It is therefore considered that your loan is not sufficiently connected to any prior income earning activity of yours. That is, the connection between the incurring of the interest expense and the earning of assessable income by the company is too remote.

As your borrowed funds were not used to produce any assessable income, the principles of TR 2004/4 have no application in your case.

It is acknowledged that the company was previously earning assessable income and you were the original shareholders in the company, however this connection is not sufficient to allow a deduction.

Shareholders of a company would not ordinarily be expected to guarantee business debts. Debts are normally incurred by a business in relation to their operations and, thus, the earning of the assessable income of the business.

We also acknowledge that interest on a new loan used to repay an existing income producing loan will generally also be deductible as the character of the new loan is derived from the original borrowing. However, where separate entities are involved and the purpose of the loan changes, this principle does not apply.

The fact that you were guarantors of the company's debt also does not change the above principles.

Taxation Ruling TR 96/23 discusses the deductibility of payments made under guarantee. The ruling states that liabilities arising under contracts of guarantee will not be deductible under section 8-1 of the ITAA 1997 if the provision of guarantees and the losses or outgoings under the guarantees are not regular and normal incidents of the taxpayer's income earning activities.

You were guarantors for the company loan. You were not in the business of providing guarantees. Although you may not have borrowed the money directly as being a guarantor, the principles outlined in TR 96/23 are relevant.

The purpose of your loan was not to produce any assessable income for yourself but to pay out the company's debt and indirectly or directly fulfil your commitment as guarantor.

Your loan only came about after the company ceased trading. The associated expenses therefore arose when there was no possibility of the company deriving assessable income.

The fact that you were guarantor for the company's loan does not have a connection with your income producing activities. As the interest takes on the same character as the use of the borrowed funds, it too would be regarded as having a non-income producing character.

You are therefore not entitled to a deduction under section 8-1 of the ITAA 1997 for the expenses incurred on your loan.