Edited version of your written advice

Authorisation Number: 1012921585902

Date of advice: 15 February 2016

Ruling

Subject: Deductibility of Interest Payments

Question 1

Does the Commissioner agree that the amounts paid by the Trust to the Beneficiary during the relevant income years were interest? If so, can the Trust amend its income tax returns and financials for the relevant income years (and lodge the Trust's income tax return for the following income year) to instead treat the payments made to the Beneficiary (which were erroneously reported as trust distributions in the relevant income tax returns) as interest payments?

Answer

Yes.

Question 2

If the Commissioner does not agree that the amounts paid by the Trust to the Beneficiary during the relevant income years were interest, does the Commissioner agree that interest has been capitalised under the Loan Agreement?

Answer

Not applicable.

Question 3

Can the Trust claim a deduction in the relevant income years for the interest payments either paid and/or capitalised under the Loan Agreement?

Answer

Yes - only for the amounts of interest actually paid by the Trust (and not capitalised) during each of the relevant income years.

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 Beneficiary 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 Beneficiary, 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 Beneficiary 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 Beneficiary and the Trust, interest-only payments were due by the Trust to the Beneficiary 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 Beneficiary. The Beneficiary contends that they borrowed the funds from the Third Party Lender in their 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 Beneficiary 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 Beneficiary, 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 Beneficiary 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 Beneficiary and the Trust as described above, interest-only payments were due by the Trust to the Beneficiary 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 Beneficiary).

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

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

Following a review on the Beneficiary's tax returns for the relevant income years, the Commissioner disallowed the Beneficiary'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 Beneficiary and the Trust, the Beneficiary as lender may capitalise any amounts of interest due by the Trust which have not been paid.

The Beneficiary and the Trustee for the Trust wish to correct the records to treat the amounts paid by the Trust to the Beneficiary as interest (instead of a trust distribution) so that the Trust can claim a deduction for the interest paid to the Beneficiary.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Question 1

Does the Commissioner agree that the amounts paid by the Trust to the Beneficiary during the relevant income years were interest? If so, can the Trust amend its income tax returns and financials for the relevant income years (and lodge the Trust's income tax return for the following income year) to instead treat the payments made to the Beneficiary (which were erroneously reported as trust distributions in the relevant income tax returns) as interest payments?

Summary

The Commissioner accepts that there is a Loan Agreement in place between the Trust and the Beneficiary, and that the amounts paid by the Trust to the Beneficiary in each of the relevant income years constituted payments of interest (and not trust distributions).

The Trust may therefore amend its income tax returns and financials for each of the relevant income years (and lodge its income tax return for the following income year) to reflect the true nature of the payments made by the Trust to the Beneficiary during each of those income years as interest.

Question 2

If the Commissioner does not agree that the amounts paid by the Trust to the Beneficiary during the relevant income years were interest, does the Commissioner agree that interest has been capitalised under the Loan Agreement?

Summary

As per the response to Question 1 above, the Commissioner agrees that the amounts paid by the Trust to the Beneficiary during the relevant income years were interest. Therefore, Question 2 is not applicable.

Question 3

Can the Trust claim a deduction in the relevant income years for the interest payments either paid and/or capitalised under the Loan Agreement?

Summary

The Trust may claim a deduction in each of the relevant income years only for the amounts of interest actually paid to, and not capitalised by, the Beneficiary during the relevant income year.

The Trust is not entitled to a deduction for the interest amounts owing by the Trust to the Beneficiary that were unpaid in each of the relevant income years, which were purportedly capitalised by the Beneficiary under the Loan Agreement. This is because a loss or outgoing cannot be deducted to the extent that it is a loss or outgoing of capital, or of a capital nature.

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 Beneficiary owes a present money debt that the Beneficiary cannot escape.

A liability will be a loss or outgoing 'incurred' under section 8-1 of the ITAA 1997 even though it remains unpaid, provided the Beneficiary is 'definitively committed', or has 'completely subjected' itself to the liability (FC of T v James Flood Pty Ltd (1953) 10 ATD 240 at p 244; (1953) 88 CLR 492 at p 506).

In the Full High Court decision of Nilsen Development Laboratories Pty Ltd & Ors v FC of T 81 ATC 4031, Barwick CJ stated: '[T]here can be no warrant for treating a liability which has not 'come home' in the year of income, in the sense of a pecuniary obligation which has become due, as having been incurred in that year.' Gibbs J said, at p 4037: '[W]hat is clearly necessary is that there should be a presently existing liability'. The Federal Court has since added: 'An outgoing is incurred for the purposes of section 8-1 [of the ITAA 1997] at least where the Beneficiary is subject to an immediate obligation to pay the sum referred to, notwithstanding that payment is not in fact made in the year in question' (De Simone & Anor v FC of T [2009] FCA 446).

An outgoing may be incurred notwithstanding that, at the end of the year of income, it represents a present liability then due but payable in the future (FC of T v Australian Guarantee Corporation Ltd 84 ATC 4642).

It is therefore considered that the amounts of interest payable by the Trust to the Beneficiary during the 2011 to 2015 income years - in respect of the loans provided by the Beneficiary to the Trust - were 'incurred' by the Trust. This is because, regardless of whether such interest amounts were actually paid by the Trust or were unpaid and capitalised, each interest amount constituted a presently existing liability of the Trust to the Beneficiary in the applicable income year. In terms of the unpaid interest amounts that were capitalised and added to the principal loan amounts, the capitalised interest amounts reflected a present liability (in the applicable income year) that is payable in the future (being the time the principal loan amounts are payable which - according to the Loan Agreement - is a period of XX years after the date in which the original loan was provided).

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, at p 4117, 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). That is, 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 Beneficiary and the income derived by him from its use' (Ure v Federal Commissioner of Taxation (1981) 50 FLR 219; 81 ATC 4100 at 4104; (1981) 11 ATR 484 at 488).

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

With specific regard to the amounts of interest that were actually paid by the Trust, these expenses were incurred due to borrowing funds to purchase investment properties. The subjective purpose in incurring the interest on the borrowed funds has been for income producing purposes in the form of rental properties and not for private or non-income-producing purposes. As such, it is considered that the interest expense/outgoing is incidental and relevant to gaining or producing the Trust's assessable income. There is a sufficient nexus between the Trust's payment of interest and the earning of assessable income. The Trust did not have a purpose for incurring the expense that is not related to the earning of assessable income.

Therefore, as the amounts of interest that were actually paid by the Trust (and not capitalised) in each of the relevant income years were incurred on the funds borrowed from the Beneficiary in deriving assessable income, the Trust is entitled to a deduction for those amounts of interest pursuant to section 8-1 of the ITAA 1997.

Capitalised Interest

In terms of the amounts of interest that were unpaid by the Trust in each of the relevant income years, which were capitalised in each of those years as per a clause in the Loan Agreement, the Trust is not entitled to a deduction for those unpaid, capitalised amounts of interest.

The capitalisation of interest is the process of adding unpaid interest charges to an existing, principal loan balance. Generally, future interest accrues on this new principal, such that as the loan balance increases, so do future interest charges.

Once an amount of unpaid interest is capitalised, the Beneficiary is exchanging interest income from the Trust for a capital investment. Such a capital investment is a capital amount. Pursuant to section 8-1 of the ITAA 1997, a loss or outgoing of capital, or of a capital nature, is not an allowable deduction.

Conclusion

The Trust may claim a deduction in each of the relevant income years only for the amounts of interest actually paid to the Beneficiary during the relevant income year. However, the Trust cannot claim a deduction for the interest payments that were capitalised in each of the relevant income years.