Edited version of your written advice

Authorisation Number: 1012908495289

Date of advice: 18 November 2015

Ruling

Subject: Interest expenses - investment

Question

Are you entitled to a deduction for interest expenses incurred on loan money used to purchase an income producing investment that has since collapsed?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 2015

The scheme commences on:

1 July 200X

Relevant facts and circumstances

You borrowed $XXX,XXX and invested in XYZ Pty Ltd.

You invested in XYZ Pty Ltd in 20XX.

The investment promised a X% return.

You received a return from the investment for four years.

In 20XX, the investment collapsed and you have not received any further return or income from the investment.

You still have an outstanding loan in relation to the investment.

You have paid off some of the loan. You wish to pay off the remainder of the loan as soon as possible.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Summary

You are entitled to a deduction for the interest incurred on the funds borrowed and used to purchase your income producing investment. The deduction still has the sufficient connection to your assessable income, even after the investment collapsed.

Reasoning

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 (Lunneys case)), 

• 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 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 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. That is, it is generally accepted that interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction.

Taxation Ruling IT 2684 considers the circumstances in which interest on money borrowed to acquire units in a property unit trust is an allowable deduction. In that Ruling, the Commissioner considers that, in general, interest expenses incurred on borrowed funds used to purchase income units, capital growth units or combined units (units offering returns of both income and capital growth) are an allowable deduction. However, the Commissioner considers that there are exceptions to the general rule.

The Commissioner's view on whether interest deductions are allowable after the cessation of the relevant income producing activity is outlined in Taxation Ruling TR 2004/4. Paragraph 10 of TR 2004/4 states that where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and the relevant income earning activities (whether business or non-business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing the assessable income if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

However, as highlighted in paragraphs 13 and 14 of TR 2004/4, if a taxpayer keeps the loan on foot for reasons unassociated with the former income earning activities or makes a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived that is not related to the original income earning debt, then the nexus between the outgoings of interest and the relevant income earning activities will be broken. A legal or economic inability to repay is suggestive of the loan not having been kept on foot for purposes other than the former income earning activities.

Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgement about the nexus between the outgoing and the income earning activities.

In your case, your borrowed funds were used to purchase an income producing investment. However, after a few years, the investment collapsed. You still have an outstanding amount on your loan. You have paid off some of the loan and hope to pay of the remainder of the loan as soon as possible.

As your borrowed funds were used to produce assessable income and in fact did produce income for you in the initial years, it is considered that the funds were used for income producing purposes. It is not considered that the loan is being kept for other non-income earning activities. As the investment is regarded as being an income earning activity, the principles of TR 2004/4 apply.

It is considered that your interest expenses on your loan are sufficiently connected to your prior income earning activity after the collapse of your investment. Therefore you are entitled to a deduction for the associated interest expenses incurred.

Additional information

It should be noted that if you do at any stage have the capacity to repay the loan and choose not to the Commissioner would generally consider that the nexus between the interest and the gaining of assessable income would be broken and further interest deductions would not be allowable.