Edited version of your written advice

Authorisation Number: 1013139792721

Date of advice: 22 December 2016

Ruling

Subject: Repaid income

Question 1

Are you entitled to a deduction for the amount paid to entity A?

Answer

No

Question 2

Are you entitled to reduce your assessable income by the amount paid to entity A?

Answer

Yes.

Question 3

Are you entitled to a deduction for the interest expenses incurred on borrowed funds used to repay entity A?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 201X

Year ended 30 June 201X

The scheme commenced on:

1 July 200X

Relevant facts

You were employed as a professional with entity A.

Under the terms of your contract you are paid a base amount. Amounts in excess of the base amount, were apportioned between you and entity A.

The total amount of the money collected by you were paid to you and included in your tax returns for the relevant years.

Recently, entity A advised that an amount is payable to them. You paid the amounts in the 201X-1X financial year.

In order to repay the amount you borrowed money. The loan is in your name only and is being repaid over a term of 1X years.

You advised that the money was not paid previously as you never fully understood the terms of the relevant agreements.

Relevant legislative provisions

Income Tax Assessment Act 1997 - Section 6-5

Income Tax Assessment Act 1997 - Section 8-1

Reasons for decision

Allowable deductions

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 or are necessarily incurred in carrying on a business for the purpose of 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, or a provision of the ITAA 1997 prevents it.

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).

The essential character of the expense is a question of fact to be determined by reference to all the circumstances.

In Case D19 72 ATC 113, having been awarded a teacher training studentship, the taxpayer entered into an agreement with the Education Minister. One condition of the agreement was that upon the termination of the course, he was to perform teaching services in any school/s to which he might be appointed, for a certain number of days. In the event of breach or non-observance of the conditions, the taxpayer would become liable to pay to the Minister a sum equal to the total of all the allowances paid to him. The taxpayer failed to observe the agreement and was liable to repay the total amount of the allowances he had been paid. His claim for a deduction for the amount so repaid was disallowed. It was held that the liability to make the payment arose from the breach of the agreement, and was not incidental to the gaining or producing of assessable income. The most that could be said for the payment was that it was expenditure incurred by the taxpayer in choosing between two possible avenues of employment (as a teacher or otherwise).

Although your situation is not the same as the above, the principles are relevant.

In your situation, you were required to repay an amount to entity A. This amount is not considered to be an expense incurred in the course of earning your assessable income as a professional. It is a payment required to be made under the contract agreement you had with entity A. The expenses were not incurred to produce income, but to repay a debt under the contract. The liability to repay would not have arisen had you previously distributed the relevant amounts to entity A as per the agreement.

Although the amount was declared as assessable income, this does not automatically entitle you to a deduction for expenses incurred in relation to the payment. The expenses must meet the criteria for deductibility under section 8-1 of the ITAA 1997.

Your expenditure for repaying the amount is not deductible, even though the expenditure had a causal connection with the earning of income. The expenditure is not incurred in the actual performance of your work. Therefore, the associated expenses are not an allowable deduction under section 8-1 of the ITAA 1997.

Assessable income

Subsection 6-5(2) of the ITAA 1997 states that the assessable income of an Australian resident includes ordinary income derived directly or indirectly from all sources whether in or out of Australia, during the income year.

Salary and wages and other income from personal services is regarded as ordinary income and is assessable under subsection 6-5(2) of the ITAA 1997.

For an amount to be income according to ordinary concepts it must be income derived by the taxpayer. The proposition that a taxpayer will not derive ordinary income unless they are beneficially entitled to the amount has longstanding judicial support. (Taxation Determination TD 2008/9).

In your case, under the terms of your contract you were to pay a specified portion of the amounts received to entity A. As you were not beneficially entitled to such amounts, these amounts do not form part of your assessable income. That is the relevant amounts should have been passed on to entity A and not included in your assessable income.

You have since been requested to repay the relevant amounts to entity A.

The repaid amount is not assessable income and therefore should not be included in your assessable income.

The repayment was made in the 201X-1X financial year. Therefore the relevant amounts should be removed from your assessable income.

Interest expenses 

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, it is necessary to examine 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.

TR 95/25 lists the following general principles to determine whether interest is deductible under section 8-1 ITAA 1997: 

● the interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature

● the character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower 

● a tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity

● interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets, and

● interest on borrowings will not continue to be deductible if the borrowed funds cease to be employed in the borrower's business or income producing activity.

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.

Accordingly, it follows that if a loan is used for the purpose of producing assessable income, the interest incurred on the loan will be deductible. Similarly, if an amount is borrowed to pay for a deductible expense, then the associated interest expenses are generally allowable.

However, in your case, you have incurred interest expenses relating to the payment of an amount to entity A. The amount repaid is to be removed from your assessable income as outlined above. It follows that the borrowed funds do not relate to your assessable income or to your income earning activities. Furthermore, the amount is not an allowable deduction. As the amount is not incurred for an income producing purpose, no deduction is allowed under section 8-1 of the ITAA 1997. Therefore no deduction is allowed in the 201X-1X or future years in relation to the interest expenses incurred.