Edited version of your private ruling

Authorisation Number: 1012533658138

Ruling

Subject: Interest expenses

Question

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

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

You and your spouse were directors and shareholders of a company, which traded for several years.

The company went into administration and then into liquidation.

At that time the company had a number of outstanding debts.

You were a guarantor of the company loans and this was secured against your property.

You took out a further mortgage on your house to pay out these debts.

You have incurred interest on these borrowed funds in the 2010-11, 2011-12 and 2012-13 income years.

You are not in the business of providing guarantees.

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 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.

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.

Interest on a new loan used to repay an existing income producing loan will generally 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.

Although the borrowed funds of the company were used to produce assessable income for the business, your subsequent loan can not be said to be used for the same purpose. The funds you borrowed have not been used to produce assessable income.

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 taxpayers income earning activities.

You were guarantor for the company's loans. You were not in the business of providing guarantees. 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 went into liquidation. 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 used to pay out the company's debt.