Edited version of your private ruling

Authorisation Number: 1012475441179

Ruling

Subject: Deductibility of interest on a loan

Question

Is entity 2 entitled to claim a deduction for interest incurred on a loan taken out to satisfy a guarantee provided by a director in relation to a loan which entity 1 had taken out from a financial institution?

Answer

No

This ruling applies for the following period

Year ended 30 June 2012

Year ending 30 June 2013

Year ending 30 June 2014

The scheme commenced on

1 July 2011

Relevant facts

While entity 1 was operating it had loan amounts on foot with a financial institution. Entity 1 claimed a deduction for interest on the loans in previous years.

The directors of entity 1 gave personal guarantees on the loan amount as outlined in the signed Guarantee and Indemnity document.

Entity 1 operated until a certain date when liquidators were appointed.

Entity 1 was liquidated and deregistered with ASIC.

The majority shareholders in entity 1 were entity 2 and entity 3. There were minority shareholders but they lost everything when entity 1 was liquidated.

Loans for the outstanding amounts to the financial institution were split and transferred to entity 2 and entity 3.

One of the guarantors is a director of entity 2.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

Entity 2 is not entitled to claim a deduction for interest incurred on a loan taken out to satisfy a guarantee provided by its director in relation to a loan which entity 1 had taken out with the financial institution as it was not incurred in producing assessable income for entity 2.

Detailed reasoning

Taxation Ruling TR 95/25 discusses deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997).

Paragraph 2 states the deductibility of a loss or outgoing comprising interest under section 8-1 of the ITAA 1997 (formerly subsection 51(1) of the Income Tax Assessment Act 1936) depends upon satisfying the words of the section, that is, being able to show that the loss or outgoing (or the part of the loss or outgoing in an appropriate case of apportionment) is:

(a)   incurred by the taxpayer in gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature ('first limb'); or

(b)   necessarily incurred by the taxpayer in carrying on a business for the purpose of gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature ('second limb').

Paragraph 3 in part states the cases (in TR 95/25) clearly indicate that whether or not a loss or outgoing incurred by a taxpayer satisfies the requirements of section 8-1 is dependent on all the facts and matters relating to the loss or outgoing incurred by the taxpayer in question. However, the following general principles are relevant to the question whether interest is deductible under section 8-1:

(a) 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 test is one of characterisation and the essential character of an expense is a question fact to be determined by reference to all the circumstances.

(b) 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. However, regard must be had to all the circumstances, including the character of the taxpayer's undertaking or business, the objective purpose of the borrowing, and the nature of the transaction or series of transactions of which the borrowing of funds is an element. In some cases, the taxpayer's subjective purpose, intention or motive may be relevant in deciding the deductibility of interest.

(c) 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. Normally this would be the case for non-business taxpayers. It might also be the case where a business makes a specific borrowing which goes to the structure of the business - for example, where a business makes a large borrowing to fund an offshore acquisition.

In this case the directors of entity 1 gave personal guarantees by signing a guarantee and indemnity document that they would personally undertake to pay an amount under the guarantee. The guarantee was in relation to a debt of entity 1 which was owed to a financial institution.

Before entity 1 was liquidated, the directors made the decision, on behalf of entity 2 and entity 3, to take out loans which were used to pay down the loan owed by entity 1.

Entity 2 which took over part of the loan owed by entity 1 incurred interest expense on the new loan. The loan was used to pay a personal debt owed by the director as guarantor to a loan incurred by entity 1.

The new loan taken out by entity 2 was not used in producing assessable income for entity 2 as it was used to pay a personal debt incurred by its director. Therefore entity 2 is not entitled to a deduction for any interest incurred under section 8-1 of the ITAA 1997.