Edited version of your private ruling

Authorisation Number: 1012588475145

Ruling

Subject: Deduction of interest expenses in relation to a partnership loan return capital

Question 1

In calculating the net income, within the meaning of that term in section 90 of the Income Tax Assessment 1936, of the partnership will interest incurred on the loan be an allowable deduction pursuant to section 8-1 of the Income Tax Assessment Act 1997?

Answer

Yes

This ruling applies for the following periods:

Income year ended 30 June 2014

Income year ended 30 June 2015

Income year ended 30 June 2016

The scheme commences on:

1 July 2013

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The taxpayer is a partnership which was formed under a formal Partnership Agreement. Partner A holds a minority partnership interest. Partner B holds a majority partnership interest.

On formation of the Partnership, the partners made capital contributions (all of which they are entitled to withdraw) in accordance with their partnership interest.

The Partnership owns and operates the business which was carried on solely to derive assessable income.

As at 30 June 2013, the Partnership had retained losses comprised of:

· accounting impairments to the value of certain intangible assets (jointly, "the assets")

· trading losses.

The Partnership proposes to return partnership capital to Partner B. To fund the return of partnership capital, the Partnership will obtain funding by way of external interest bearing loan ("the Partnership Loan"). The Partnership will incur interest on the loan ("the Partnership Loan interest").

The Partnership Loan amount will not be greater than the partnership capital amount returned to Partner B.

Accounting impairments of the assets are reflected and disclosed in the financial accounts of the Partnership which are consolidated into the audited consolidated financial accounts of its parent entity.

The Partnership adopts AASB 136 Impairment of Assets in accounting for impairments of the assets.

An impairment loss for the assets is recognised in the profit and loss immediately as an expense. At each reporting date, the carrying amounts of the assets are reviewed to determine whether there is any indication that these assets have suffered an impairment loss. An impairment loss is recorded against the gross value of the assets.

One of the assets is tested for impairment annually and whenever there is an indication that the asset may be impaired. Any impairment on that asset is not subsequently reversed. Another of the assets comprises indefinite-lived intangible assets. These are tested for impairment annually and whenever there is an indication that the asset may be impaired. Where it could be determined that the cash-generating unit's value were to increase, the impairment to that asset would be subsequently reversed. The reversal is limited to the lower of the current fair value or the original cost had no impairment loss been recognised for the licences in prior years.

The total accounting impairments for the assets as the end of the relevant income year is a retained loss of which is attributable to Partner A and Partner B in accordance with their partnership interest.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated.

In FC of T v. Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494 (Roberts and Smith), a loan was taken out by a partnership to enable the existing partners to receive a refund of capital, thereby facilitating the admission of new partners by reducing the amount of capital needed to buy into the partnership. The partnership account to which the payments to the partners were debited was described as a 'capital account'. The Court held that, to the extent that the payments to the partners represented the repayment of funds invested in the business, the borrowing had the necessary connection with the partnership's income-producing or business activities. Accordingly, interest on the borrowing was deductible under subsection 51(1) of the ITAA 1936 (now section 8-1 of the ITAA 1997).

In deciding that interest on the borrowings taken out by the partnership was deductible, Hill J commented (92 ATC 4380; 23 AT 494) that:

... let it be assumed that there are undrawn partnership distributions available at any time to be called upon by the partners. The partnership borrows from a bank at interest to fund the repayment to one of the partners who has called up the amount owing to him ... The funds to be withdrawn in such a case [are] employed in the partnership business; the borrowing replaces those funds and the interest incurred on the borrowing will meet the statutory description of interest incurred in the gaining or production by the partnership of assessable income ... In principle, such a case is no different from the borrowing from one bank to repay working capital originally borrowed from another; the character of the refinancing takes on the same character as the original borrowing and gives to the interest incurred the character of a working expense ... Similarly, where moneys are originally advanced by a partner to provide working capital for the partnership, interest on a borrowing made to repay these advances will be deductible ..

The Commissioner's views on the implications of Roberts and Smith for general law partnerships is set out in Taxation Ruling TR 95/25 Income Tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v Smith (TR 95/25).

Broadly, interest incurred on a loan may be deductible to a general law partnership if the loan is used to replace capital or working capital used in a business carried on by the partnership to derive assessable income, including where the working capital was advanced by a partner. This is known as the "refinancing principle".

TR 95/25 accepts the application of the refinancing principle emerging from Roberts and Smith in relation to general law partnerships provided the capital account reduced represents funds employed in the partnership business. Interest on borrowings to refinance funds employed in the partnership business will be deductible if the funds represent:

partnership capital in the Lord Lindley sense, undrawn profit distributions, advances by partners or other funds which have actually been invested in the partnership and which the partners were entitled to withdraw.

(paragraph 6 of TR 95/25)

The character of the refinancing gives the interest incurred the character of a working expense to the extent the provision of the funds returned to the partner constitutes a repayment of funds invested in the partnership business. It is therefore incidental and relevant to the partnership business and is deductible.

Paragraph 3 of TR 95/25 provides general principles relevant to whether the Partnership Loan interest will be deductible under section 8-1:

· there must be sufficient connection between the interest and the operation of business or income producing activities of the Partnership. The refinancing principle applies to demonstrate that such a connection exists.

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

· the extent to which the interest is not private or domestic in nature or is not incurred in relation to gaining or producing exempt income.

Here, the Partnership Loan interest is not private or domestic in nature, and is not incurred in relation to gaining or producing exempt income.

Interest on a borrowing by a partnership is not deductible to the extent that the borrowing is used to make payments to partners which do not comprise a return of moneys previously invested in the partnership businesses. For example, interest on borrowings to fund a return of capital which is represented by internally generated goodwill or an unrealised revaluation of assets (which are mere book entries) is not be deductible to a partnership (paragraph 7 of TR 95/25). A partnership is not entitled to describe what is, in effect a revaluation reserve as partnership capital.

The limitation on deductibility of interest is that partnership capital must be contributed and can never exceed the amount contributed. Similarly, if a partnership dissipates contributed partnership capital by making operating, trading or capital losses, only the remaining part of the original partnership capital can be returned to partners as partnership capital. It is not possible to reinstate the balance of that capital by revaluing assets (paragraph 36 of TR 95/25).

The deductibility of the Partnership Loan interest is limited to the extent that the Partnership Loan funds a return of partnership capital originally invested by Partner B to the Partnership, informed by the refinancing principle.

On formation of the Partnership, Partner B invested the relevant amount as capital contribution. The contribution comprised of relevant assets all of which Partner B is entitled to withdraw. The contribution was made solely for use in the Partnership business to gain or produce assessable income.

The Partnership Loan interest will be incurred in relation to the Partnership Loan. That loan will be used to fund a return of the Partnership capital contributed by Partner B (thus effectively replacing working capital). The objective purpose is to return an amount that was previously provided to the Partnership by Partner B as partnership capital and had been used in an assessable income earning activity, or business, carried on by the Partnership.

Consistent with the refinancing principle, to the extent the Partnership Loan is used to return partnership capital to Partner B the Partnership Loan interest satisfies the positive limb requirements of section 8-1. This requires determining the extent to which, in the particular circumstances here, the Partnership can return partnership capital to Partner B, as informed by that principle.

As at 30 June 2013, the Partnership had retained losses which comprised of trading losses and accounting impairments to the value of the assets. The trading losses at that date are realised losses and represent, in the relevant sense, a recognised reduction to the partnership capital account; that is, for the purposes of applying the refinancing principle, the partnership capital which was originally contributed by the partners has decreased by the trading loss.

From an evidentiary perspective the refinancing principle in Roberts & Smith relies on properly drawn partnership accounts, represented here by disclosure of the accounting impairments in the financial accounts of the Partnership which are consolidated into the audited consolidated financial accounts of its parent entity, and the Partnership's adoption of AASB 136 Impairment of Assets.

The accounting impairments to the assets as at 30 June 2103 relate to unrealised revaluations of the assets that simply represent book entries. The accounting impairments are mandated by AASB 136. They remain unrealised. The capital reduction does not represent funds employed in the Partnership business resulting from contributions applied to income-producing purposes. The accounting entries for the impairments are not, in the relevant sense, amounts that reduce the working capital provided to the Partnership by the partners. Though the accounting impairments to the assets may represent amounts attributable to a decrease to monetary value of partnership assets, they do not represent, for the purposes of applying the refinancing principle, a reduction to the amounts provided by a partner to the Partnership as working capital. Accordingly, the accounting impairments do not reduce the amount of the partnership capital that can be returned to a partner for the purpose of applying the refinancing principle.

It follows that in the particular circumstances here and consistent with the refinancing principle, the amount of partnership capital at the end of the relevant income year that can be returned to Partner B and to which the refinancing principle can apply (to allow interest deductions under section 8-1), is the original capital invested by Partner B reduced by the trading loss at that date attributable to its partnership interest.

Accordingly, in calculating the net income, within the meaning of that term in section 90 of ITAA 1936, of the Partnership, the Partnership Loan interest will be an allowable deduction pursuant to section 8-1 to the extent that the interest is incurred in relation to borrowed funds that do not exceed the original (contributed at the formation of the Partnership) capital amount invested by Partner B reduced by the trading loss attributable to its partnership interest.

The interest deduction allowable is not apportioned under section 8-1 as the Partnership Loan will not be greater than the amount of working capital that is replaced and that working capital is used in a business carried on by the Partnership solely to derive assessable income.