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Ruling

Subject: Interest deductions

Questions:

1. Can a business loan held in the name of a trust, remaining after the sale of the trust business, be restructured without affecting the deductibility of the interest on the residual loan to the trust?

Answer:

Yes.

2. Can the individual trustees/beneficiaries claim a tax deduction in their individual income tax returns for the interest incurred on the residual trust loan?

Answer:

No.

3. Can the loan be restructured in the name of the individual trustees of the trust now that the business has been sold?

Answer:

Invalid.

This ruling applies for the following periods

Year ending 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

The scheme commenced on

1 July 2012

Relevant facts

You and your spouse are trustees of a Family Trust (the trust).

You and your spouse are also named as primary beneficiaries of the trust, along with your children.

The trust is a discretionary trust.

The trust operated a franchise business (the business).

You were required to carry out renovations in order to meet the franchisor standards.

You and your spouse, as trustees of the trust, took out an additional business loan in order to carry out the renovations, using personal property as collateral.

The business struggled with this additional drain on cash flow and the business was sold in the relevant financial year.

The proceeds of the sale of the business have been fully expended on business related debts.

There is a residual bank loan debt in the name of you and your spouse as trustees of the trust.

The trust has no other assets and no other income.

The bank is currently reviewing the loan because the business has been sold and the trustees' ability to repay the loan has been reduced. They would like to refinance the loan into an all purpose loan, with a lower interest rate.

The new loan would be for the same amount and for the same term as the existing loan.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 8-1

Reasons for decision

Deductibility of interest expenses on refinanced loan after business has ceased

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a losses or outgoings to the extent that they are incurred in gaining or producing assessable income, except where the losses or outgoings are of a capital, private or domestic nature.

Taxation Ruling TR 95/25 considers the deductibility of interest. The basic test for deductibility of interest on borrowed money is the use to which the funds are put. In order for a deduction to be allowable under section 8-1 of the ITAA 1997 there must be a nexus between the incurring of the outgoing and the assessable income being derived, or a business being carried on for the purpose of deriving assessable income, of that taxpayer.

In your case, you and your spouse borrowed funds, as trustees of the trust, for use in the trust's franchise business; a business being carried on for the purpose of deriving assessable of the trust. The business has now been sold and there is a residual bank loan debt in the name of you and your spouse as trustees of the trust which continues to incur interest.

Taxation Ruling TR 2004/4 considers the deductibility of interest expenses incurred prior to the commencement of, or following the cessation of income earning activities.

In deciding whether a particular outgoing of interest incurred after the cessation of the relevant income earning activities is deductible, you need to determine if the continuing liability to interest is merely a burdensome legacy of the past (suggestive of a continuing nexus) or associated with present or future advantages (suggestive of a broken nexus) (paragraph 46 TR 2004/4).

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 un-associated with the former income earning activities.

In your case, the trust sold the franchise business and the proceeds of the sale of the business have been fully expended on business related debts. The trust has no other assets and no other income available to pay the remaining debt. Therefore, the interest expenses incurred on the monies borrowed in relation to the franchise business of the trust would continue to be deductible to the trust.

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.

In your case, the term of the refinanced loan will be the same as the remaining term of the old loan. Therefore, refinancing the outstanding debt to a loan product with a lower interest rate will not break the nexus between the ongoing interest expense and the prior income earning activities of the trust, and the interest expense will continue to be deductable to the trust.

Deductibility of interest to the trustees/beneficiaries in their individual returns

As discussed above, the basic test for deductibility of interest on borrowed money is the use to which the funds are put. As a general rule a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of a person other than the one who incurs it; FC of T v Munro (1926) 38 CLR 153.

In your case, you and your spouse borrowed the funds in your capacity as trustees of the trust, for use in a business being carried on for the purpose of deriving assessable of the trust. In order to be entitled to a deduction for the interest incurred on the loan, you need to show that the expense was incurred in gaining or producing your assessable income from the trust. You produced no assessable income as trustees of the trust, but did receive some distributions of trust income as beneficiaries of the trust.

Expenses incurred by beneficiaries of trusts, in relation to trust income, are not deductible unless it can be established that they were presently entitled to the trust income when the expenditure was incurred (Taxation Ruling IT 2385).

As a beneficiary of a discretionary trust, you are not presently entitled to any distribution from the trust until the trustee has exercised their discretion in your favour in any given income year. Until the discretion has been exercised, you have, at best, a mere expectancy of receiving income from the trust.

As the trust has now sold the business, there is no possibility that the trust will produce any income from this activity that could be available for distribution to beneficiaries of the trust.

Where no income is available for distribution, the trustee cannot exercise their discretion in your favour and there is no nexus between the interest expense incurred personally and the gaining or producing of assessable income from the trust. Therefore, you and your spouse are not entitled to claim a deduction for the interest expenses incurred in your personal returns.

This approach is consistent with the decision in Case U144 87 ATC 318, where the taxpayer was a beneficiary of a discretionary family trust and was also a director of the corporate trustee of that trust. In his return for the 1983 year, the taxpayer disclosed as assessable income a distribution from the trust, and claimed as deductions various trust expenses which he had met personally, including bank interest.

The Tribunal held that the expenses were not deductible on the basis that a sufficient nexus had not been shown between the expenditure on behalf of the trust and the derivation of the taxpayer's assessable income.

While we appreciate your situation, there is no provision available that would allow you to claim these expenses in the circumstances you describe.

Invalid question

A private ruling is a written expression of the Commissioner's opinion in respect of a relevant provision as defined in section 357-55 of Schedule 1 to the Taxation Administration Act 1953.

Your question, as to whether or not the loan can be restructured in the name of the individual trustees of the trust now that the business has been sold, is not in relation to a relevant provision and is, therefore, invalid.