Edited version of your private ruling

Authorisation Number: 1012544882197

Ruling

Subject: Interest expenses

Question

Are you entitled to a deduction for the interest expenses incurred on funds on lent to the family trust?

Answer

No.

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

Year ending 30 June 2017

The scheme commenced on

I July 2012

Relevant facts

You and your spouse jointly borrowed money from a bank a few years ago.

You proceeded to execute a loan agreement in your capacity as individuals and as individual trustees of your family trust.

The agreement stipulated that the discretionary family trust will be liable for the interest costs of the loan and the repayments of the borrowed capital.

You and your spouse on lent all the loan funds to the family trust. You charged the trust the same interest rate that the bank was charging you.

The family trust used the borrowed funds to acquire units in a unit trust.

It was anticipated that the unit trust would receive fully franked dividends along with a capital return over a few years. Part of this dividend would flow through to the family trust.

The family trust made loan repayments to you.

The interest income derived from the loan and the interest expense incurred from the investment loan netted off to $0 for both you and your spouse. The $0 net amount has not been recorded in your personal tax returns.

You as trustees of the family trust reviewed the investment in the unit trust as at 30 June 20XX and determined that investment will not return any of the invested capital nor will any income be received.

The family trust can no longer fund the interest liabilities with the loan.

You are not expecting to receive any further loan repayments from the family trust.

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.

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, 

§ 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 interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income.

Taxation Ruling TR 95/33 also considers factors relevant in determining the deductibility of losses and outgoings. TR 95/33 states that if an outgoing produces an amount of assessable income greater than the amount of the outgoing, there would normally be no need to examine the taxpayer's motives and intentions when determining the deductibility of the expenditure.

However, if the outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is deductible. If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective (for example, to derive exempt income or derive income for another entity or the obtaining of a tax deduction), then the outgoing must be apportioned between the pursuit of assessable income and the other objective: see Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613.

In Case 26/94 94 ATC 258, a director, who borrowed money to on-lend to his family company that had no capacity to borrow in its own name, was denied a deduction for interest as the purpose of the loan was to assist the company in avoiding liquidation. The connection between the lending and the derivation of future income by the director was too remote.

The issue of failing to derive interest income was considered in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339. The principles established here were that neither the lending to the company in which Mr Munro was a shareholder, nor the financing of an acquisition of shares by his sons were regarded as sufficient to characterise the incurring of the interest as being directed to the gaining of the taxpayer's income.

Income Tax Ruling IT 2385 discusses the deductibility of expenses incurred by beneficiaries of discretionary trusts. As highlighted in IT 2385, a beneficiary of a discretionary trust is not entitled to a deduction against their trust distribution income as the expenditure is not incurred in gaining or producing their assessable income. There is not a sufficient nexus between the expenditure incurred and the receipt of income. A beneficiary has a mere expectancy of receiving income from the trust.

Although the above circumstances are different to your circumstances, the principles are relevant.

Where a person lends money to a related entity, a deduction for any interest expense incurred will only be allowed where the money is lent on a commercial basis. That is, there must be a reasonable expectation that the person will receive a return. The test that should be considered is whether a reasonable person with no relationship to either party would enter into this arrangement using exactly the same terms and conditions. If the answer is yes, then it would generally be a commercial arrangement.

It is questionable in your case whether you would enter into such an arrangement with an unrelated party. Generally for a commercial loan, the amount being charged for on lent funds is at a rate higher than that being incurred. That is, a profit is planned.

It is considered that you did not lend the funds to the trust on a commercial basis. This is because

§ the repayments made by the trust were at the same rate of the interest expenses incurred by you for the borrowed funds,

§ there is no evidence that a profit would be made, and

§ you have treated the payments to you as reimbursements of your interest expenses and not as income.

It is considered that you entered into the loan arrangement for some other purpose other than to produce assessable income. The arrangement is regarded as being private in nature. There is insufficient nexus between your interest outgoing and the derivation of your assessable income. As such, no deduction for the associated expenses incurred is allowed under section 8-1 of the ITAA 1997.

We acknowledge that a loss or outgoing may be deductible even if it is incurred after the cessation of income earning activities, but in order to be deductible the occasion of the outgoing must be found in those income earning activities.

In your case, the loan arrangement with the trust is not regarded as an income producing activity or a commercial arrangement. As the expenses are not incurred in earning your assessable income, the decisions in Federal Commissioner of Taxation v. Brown 99 ATC 4600; (1999) 43 ATR 1 and Federal Commissioner of Taxation v. Jones 2002 ATC 4135; (2002) 49 ATR 188 are not relevant in your circumstances. Similarly, the principles found in the High Court in Steele v. FC of T (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 and in Taxation Ruling TR 2004/4 have no application.

Accordingly, the interest you incur on the loan is not deductible under section 8-1 of the ITAA 1997 for the relevant income year or future years.