Edited version of your written advice

Authorisation Number: 1012724556043

Ruling

Subject: Interest

Question

Are you entitled to a deduction for interest expenses incurred?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

Year ended 30 June 2017

Year ended 30 June 2018

The scheme commenced on

1 July 2013

Relevant facts

You were guarantor for a relation's business loan.

Your relation's business went into liquidation.

The loan was partly paid out after selling the business assets; however there is still an outstanding amount on the loan.

As the business could not pay out the loan, you became responsible for the debt.

You have refinanced and are incurring interest expenses in relation to the loan.

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 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), 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).

Interest expenses may be deductible under section 8-1 of the ITAA 1997 where there is a sufficient connection to the earning of assessable income and the expense 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 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 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.

Debts are normally incurred by a business in relation to their operations and, thus, the earning of the business's assessable income. As highlighted in Munro's case, 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. For example, where expenses are incurred by a company and paid for by a director or someone else, a deduction is not allowable to the director or that other person.

Taxation Ruling TR 96/23 Income tax: capital gains: implications of a guarantee to pay a debt, discusses the deductibility of payments made under guarantee. The ruling states that liabilities arising under contracts of guarantee will not be deductible if the provision of guarantees is not regular and normal incidents of your income earning activities. The ruling further states that if the provision of guarantees is not a regular and normal incident of the taxpayer's income earning activities, any payments made under those guarantees will be capital in nature.

Only if a taxpayer acts as guarantor to such a degree as to amount to his or her usual practice, say, as a solicitor, in the ordinary course of business will the payments be deductible as a revenue outgoing and not of a capital nature: Jennings (Inspector of Taxes) v. Barfield & Barfield [1962] 2 All ER 957; 40 TC 365.

In your case, you provided a guarantee to your relation's business which has since gone into liquidation. The purpose of your action was not to directly produce any assessable income for yourself, but to fulfil your commitment as guarantor. You were not in the business of entering into contracts of guarantee. It is not considered that the provision of guarantees was undertaken by you as a regular and normal incident of your income earning activities.

It is acknowledged that you incur interest expenses in relation to your relation's previous business. However, such expenses do not sufficiently relate to your income earning activities. They more directly belong to your relation's previous business. That is the expenses belong to the business and you paid the expenditure on behalf of the business. Therefore a deduction for paying the business's debt will not be allowable under section 8-1 of the ITAA 1997 as it relates to the business's affairs and not your assessable income.

The Commissioner acknowledges that interest expenses may be still deductible after the cessation of a relevant income earning activity. However, as your interest expenses do not relate directly to your assessable income and more to your relation's business, the principles in Taxation Ruling 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities do not apply.

After considering your specific circumstances and the requirements of section 8-1 of the ITAA 1997, no deduction for the associated interest expenses is allowable to you as the expenses do not directly relate to your assessable income.