Edited version of your written advice

Authorisation Number: 1012921572956

Date of advice: 15 February 2016

Ruling

Subject: Deductibility of Interest Payments

Question 1

Can the Taxpayer claim a deduction in each of the relevant income years for the interest he/she paid to the Third Party Lender during those income years?

Answer

Yes. However, the deduction that the Taxpayer is entitled to claim in each of the relevant income years is limited to the amount of interest the Taxpayer actually received from the Trust during each income year. The amounts of interest unpaid by the Trust that were capitalised by the Taxpayer in those income years are not deductible.

Question 2

Can the Taxpayer claim a partial deduction in each of the relevant income years for the interest he/she paid to the Third Party Lender up to the amount of interest payments he/she received from the Trust during those income years?

Answer

Refer to the response to Question 1 above.

Question 3

When is the capitalised interest assessable to the Taxpayer?

Answer

As the unpaid amounts of interest owing to the Taxpayer by the Trust - which were capitalised - were added to the balance of the principal loans provided by the Taxpayer, the capitalised interest will be assessable to the Taxpayer in the relevant income year in which the Trust pays to the Taxpayer the principal loan amounts (for each of the loans or advances provided by the Taxpayer to the Trust).

Each respective principal loan amount will incorporate the original loan amount the Taxpayer provided to the Trust, as well as the applicable, accumulated amounts of interest that had been capitalised throughout the life of each of those loans/advances.

According to the Loan Agreement in place between the Taxpayer and the Trust, the principal loan amounts/advances are payable XX years after the date in which the original loan was provided, or a later date as determined by the Taxpayer.

The periods to which this ruling applies

1 July 2010 to 30 June 2011

1 July 2011 to 30 June 2012

1 July 2012 to 30 June 2013

1 July 2013 to 30 June 2014

1 July 2014 to 30 June 2015

Date in which the scheme commences

1 July 2010

Relevant facts and circumstances

The Taxpayer is a beneficiary of the family trust (the Trust).

The Taxpayer borrowed an amount of $XXX from the Third Party Lender at an interest rate of X% per annum. According to the terms of the Third Party Lender's loan to the Taxpayer, repayments were on an interest-only basis for the first XX months only, with principal and interest repayments payable thereafter. On the same day as receiving this loan from the Third Party Lender, the Taxpayer on-lent the same amount to the Trustee of the Trust at the same interest rate to enable the Trust to purchase an investment property. According to the terms of the Loan Agreement between the Taxpayer and the Trust, interest-only payments were due by the Trust to the Taxpayer each month, with payment of the principal loan amount not payable until XX years from the abovementioned Commencement Date.

The Trust derived rental income from the property and paid interest to the Taxpayer. The Taxpayer contends that he/she borrowed the funds from the Third Party Lender in his/her own name and on-lent those funds to the Trustee of the Trust because the Trust was unable to obtain a loan from a bank due to it having no borrowing history and limited income.

The Taxpayer later borrowed a further amount of $XXX from the Third Party Lender at an interest rate of X% per annum. According to the terms of the Third Party Lender's loan to the Taxpayer, repayments were on an interest-only basis for the first XX months only, with principal and interest repayments payable thereafter. On the same day as receiving this loan from the Third Party Lender, the Taxpayer on-lent the same amount of $XXX to the Trustee of the Trust at the same interest rate to enable the Trust to purchase a second investment property. According to the terms of the same Loan Agreement between the Taxpayer and the Trust as described above, interest-only payments were due by the Trust to the Taxpayer each month, with payment of the principal loan amount not payable until XX years from the abovementioned Commencement Date (or a later date as determined by the Taxpayer).

The Trust derived rental income from the second investment property and paid interest to the Taxpayer.

The Trustee for the Trust and the Taxpayer inadvertently treated the interest paid by the Trust to the Taxpayer for the relevant income years as trust distributions. The Taxpayer also claimed a deduction for the interest he/she paid to the Third Party Lender in each of those income years.

Following a review on the Taxpayer's tax returns for the relevant income years, the Commissioner disallowed the Taxpayer's interest deductions for each of those income years on the basis that there was no nexus between the deductibility of the interest and the receipt of trust distributions.

Pursuant to a clause in the Loan Agreement between the Taxpayer and the Trust, the Taxpayer as lender may capitalise any amounts of interest due by the Trust which have not been paid.

The Taxpayer and the Trustee for the Trust wish to correct the records to treat the amounts paid by the Trust to the Taxpayer as interest so that the Taxpayer can claim a deduction for the interest he/she has paid to the Third Party Lender.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Question 1

Can the Taxpayer claim a deduction in each of the relevant income years for the interest he/she paid to the Third Party Lender during those income years?

Summary

Yes. However, the deduction that the Taxpayer is entitled to claim in each of the relevant income years is limited to the amount of interest the Taxpayer actually received from the Trust during each income year. The amounts of interest unpaid by the Trust that were capitalised by the Taxpayer in those income years are not deductible.

Detailed 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.

Were the interest outgoings 'incurred'?

To be deductible in a particular year under section 8-1 of the ITAA 1997, a loss or outgoing must generally have been 'incurred' in that year. 'Incurred' is not defined in the Act. In general terms, an outgoing is incurred at the time a taxpayer owes a present money debt that the taxpayer cannot escape.

In accordance with the terms of the loans provided by the Third Party Lender to the Taxpayer, the Taxpayer made interest payments to the Third Party Lender in the relevant income years respectively.

It is therefore considered that the amounts of interest paid by the Taxpayer to the Third Party Lender during the relevant income years - in respect of the loans provided by the Third Party Lender to the Taxpayer - were 'incurred' by the Taxpayer. This is because each interest amount constituted a presently existing liability of the Taxpayer to the Third Party Lender in the applicable income year.

Were the interest outgoings incurred for an income producing purpose?

The High Court of Australia in Ronpibon Tin NL v FC of T (1949) 78 CLR 47; 4 AITR 236; 8 ATD 431 said that for expenditure to constitute an allowable deduction as an outgoing incurred in gaining or producing assessable income pursuant to the former subsection 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936) - which, as of 1 July 1997, was replaced with section 8-1 of the ITAA 1997 - it must be incidental and relevant to that end.

In Lunney v FC of T (1958) 100 CLR 478; 7 AITR 166; 11 ATD 404, the High Court pointed out that expenditure must be more than an essential prerequisite to the earning of the assessable income for it to be incidental and relevant to the derivation of that income.

In FC of T v Smith 81 ATC 4114, Gibbs C.J. Stephen, Mason and Wilson JJ - in referring to the requirement that the expenditure be incidental and relevant to the operations or activities regularly carried on for the production of income - said that:

What is incidental and relevant in the sense mentioned falls to be determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character, and generally to its connection with the operations which more directly gain or produce the assessable income.

Such a principle is also encapsulated in paragraph 6 of Taxation Ruling TR 2004/4 ('Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities'), which stipulates that the deductibility of interest is typically determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put (Fletcher & Ors v FC of T 91 ATC 4950; (1991) 22 ATR 613, FC of T v Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52, and Steele v FC of T 99 ATC 4242; (1999) 41 ATR 139).

If borrowed money is laid out for the purpose of gaining assessable income then the interest on the borrowed money will be incidental and relevant to the gaining of that income (FC of T v Munro (1926) 38 CLR 153 at 170). Similarly, as provided in Ure v Federal Commissioner of Taxation (1981) 50 FLR 219; 81 ATC 4100 at 4104; (1981) 11 ATR 484 at 488 (Ure), the laying out of the borrowed money for the purpose of gaining assessable income 'furnishes the required connection between the interest paid upon it by the taxpayer and the income derived by him from its use'.

Therefore, provided there is a nexus between the expenditure or outgoing and the production of assessable income or activities productive of assessable income, a taxpayer will not be precluded from being entitled to a deduction for the expenditure or outgoing even if no assessable income is derived.

The Taxpayer has borrowed money from an external lender, which the Taxpayer has on-lent to the (Trustee of the) Trust on an interest-only basis for XX years (or a later date as determined by the Taxpayer), after which time the principal loan amount will need to be repaid, in addition to any amounts of unpaid interest that were capitalised during the course of the loans. Therefore, the interest payable on the external loan is, at least in part, incidental and relevant to the gaining of assessable income from the Trust. The interest outgoing has a connection with the gaining or production of assessable income.

In Ure's case, an employed solicitor took out three loans at commercial rates of interest (being 10%, 7.5% to 8.5%, and 12.5%) and on-lent the principal at 1% interest either to his wife or their family company. The borrowed funds were used by the family company to discharge a mortgage over a residential property it beneficially owned and by a family trust to purchase a new home which was then leased to the solicitor and his wife at a nominal rent. The proceeds of the third loan were placed by the family company trust on interest-bearing deposits with public companies.

The taxpayer in Ure's case returned as assessable income $660 received by him from on-lending the borrowed moneys. He sought to deduct an amount of $8,736, representing the whole of the interest on the borrowed funds and some other finance costs. The Commissioner allowed a deduction only to the extent of the assessable income generated, i.e. $660. The Full Federal Court (Deane, Sheppard and Brennan JJ) unanimously held that, in relation to the claim for an interest deduction, an apportionment was called for and, on the facts of the case, allowed a deduction only to the extent of the assessable income of $660 generated by the on-lending.

In particular, Deane and Sheppard JJ stated:

In considering the deductibility, pursuant to sec. 51(1) [of the ITAA 1936, which is the former section 8-1 of the ITAA 1997], of the interest paid by the taxpayer, it is important to be mindful of the fact that an outgoing which is claimed to have been incurred in earning assessable income is only deductible, pursuant to the subsection, "to the extent to which" it was so incurred and "to the extent to which" it cannot properly be characterized as being of a private or domestic nature. Where an outgoing was partially so incurred or should be partially so characterized, the subsection requires apportionment between what, not being of a private or domestic nature, should properly be regarded as incurred in earning the assessable income and what should not.

…

One of the most difficult aspects of the problem of characterizing an outgoing is the assessment of what, if any, weight is to be given to indirect objects which a taxpayer had in mind in incurring the outgoing. Such objects form part of the relevant circumstances by reference to which the problem of characterization must be resolved. There is, however, no rigid principle which can be applied in determining what, if any, weight should be given to them. In the ordinary case, such as, for example, where the immediate object achieved by the outgoing is the production of assessable income which is commensurate with the amount of the outgoing…, indirect objects or motives of a personal or domestic character will plainly not prevent the characterization of the outgoing as having been incurred in earning assessable income ... In other cases, the immediate object or effect of an outgoing will not suffice either to explain or to characterize it. In such cases, indirect objects or motives can assume a sometimes decisive importance.

The Court held in Ure's case that the interest outgoings were incurred in part with the taxpayer's object of deriving assessable income, and in part due to less direct objects and advantages that were not of an income-earning character.

The Court perceived these indirect objects to be the financial benefit to the taxpayer's wife and family trust, provision of accommodation for the taxpayer and his family and the obtaining of a tax deduction. The claim was apportioned accordingly and the amount allowed as a deduction equalled the amount returned by the taxpayer as assessable income.

While the objective of the taxpayer in Ure's case was predominantly private in nature due to on-lending to his spouse at a discounted interest rate, there is no disparity in the interest rates in the present circumstances between the Taxpayer and the Trust, as the Taxpayer on-lent to the Trust at the same interest rate that the Taxpayer is paying to the Third Party Lender.

However, there is instead disparity in the repayment terms between the loans the Taxpayer obtained from the Third Party Lender and the repayment terms of the Loan Agreement between the Taxpayer and the Trust. The terms of each of the two principal loans (and subsequent refinancing of those loans) were that monthly interest-only repayments be made by the Taxpayer to the Third Party Lender in the first XX months only, with monthly repayments of principal and interest thereafter. As per the terms of the Loan Agreement between the Taxpayer and the Trust, the Trust was to pay the Taxpayer monthly interest-only repayments, with no repayment of the separate, principal loan amounts (or advances) required until XX years after the 'Commencement Date' stipulated in the Loan Agreement (or a later date as determined by the Taxpayer).

Having regard to such a disparity in line with the principles in Ure's case, it cannot be considered in the present circumstances that the object which the Taxpayer had in mind or the advantage which he/she sought in incurring the interest payments to the Third Party Lender (in accordance with the terms of the loans) was the derivation by him of income being amounts that do not include elements of the principal loans/advances and amounts well below the interest payments he paid to the Third Party Lender during the relevant income years. It is considered to have been an object which the Taxpayer had in mind. In the circumstances, however, characterisation of the outgoing cannot properly be effected by reference to that object alone. The incurring of the outgoing is also considered to be attributable by reference to less direct objects of the Taxpayer. These indirect objects are not considered to be of an income-earning character in that they reasonably involved a non-commercial/independent objective. Such an objective facilitated a delay in the Trust having to make repayments against the principal amounts of the loans/advances provided to it by the Taxpayer for at least XX years after the initial loans were provided, in addition to enabling the Trust to delay the payment of interest owing to the Taxpayer through capitalising any unpaid interest amounts (thus also delaying payment of the capitalised interest amounts until such time the principal loan amounts are paid).

The Commissioner therefore considers it reasonable to adopt/apply the same approach taken in Ure's case to the present case. To this end, it is necessary to apportion the Taxpayer's outgoings in respect of interest between what can properly be regarded as incurred in gaining or producing assessable income and as not being of a private or domestic nature, and what cannot be regarded as such. The method of apportionment applied in Ure's case - where a borrowing is partly for the purpose of producing assessable income and partly for non-allowable purposes - was to limit the taxpayer's deduction for interest to an amount equal to the amount received from his investment of the borrowed funds.

Hence, the Taxpayer is entitled to deduct - pursuant to section 8-1 of the ITAA 1997 - interest only up to the amount of interest that the Taxpayer actually received as interest income¹ for each of the relevant income years.

Conclusion

The Taxpayer is entitled to claim a deduction in each of the relevant income years for the interest he/she paid to the Third Party Lender. However, the amount of the deduction for each of these income years is limited to the amount of interest the Taxpayer actually received from the Trust during each income year (the amounts of interest unpaid by the Trust that were capitalised by the Taxpayer in those income years are not deductible).

Question 2

Can the Taxpayer claim a partial deduction in each of the relevant income years for the interest he/she paid to the Third Party Lender up to the amount of interest payments he/she received from the Trust during those income years?

Summary

Refer to the response to Question 1 above.

Question 3

When is the capitalised interest assessable to the Taxpayer?

Summary

As the unpaid amounts of interest owing to the Taxpayer by the Trust - which were capitalised - were added to the balance of the principal loans provided by the Taxpayer, the capitalised interest will be assessable to the Taxpayer in the relevant income year in which the Trust pays to the Taxpayer the principal loan amounts (for each of the loans or advances provided by the Taxpayer to the Trust).

Each respective principal loan amount will incorporate the original loan amount the Taxpayer provided to the Trust, as well as the applicable, accumulated amounts of interest that had been capitalised throughout the life of each of those loans/advances.

According to the Loan Agreement in place between the Taxpayer and the Trust, the principal loan amounts/advances are payable XX years after the date in which the original loan was provided (i.e. the 'Commencement Date stipulated in the Loan Agreement), or a later date as determined by the Taxpayer.