Edited version of your written advice

Authorisation Number: 1051184343350

Date of advice: 21 February 2017

Ruling

Subject: Interest deductibility of privately borrowed funds on lent to trust

Question

After your family trust ceased carrying on its business, can you claim a personal deduction for interest expenses incurred in relation to borrowings you on-lent to your family trust for its business?

Answer:

No.

This ruling applies for the following periods

Income year ended 30 June 2015

Income year ended 30 June 2016.

The scheme commenced on

1 July 2014.

Relevant facts

You and your spouse were the directors and primary beneficiaries of a discretionary family trust which operated a retail business.

You borrowed money in your own names and on-lent the monies to the trust at the same rate at which you personally borrowed from the bank. The loan was secured against the family home.

You are not in the business of lending money.

The trust used the monies to acquire the franchise and business equipment for the retail business.

The on-lending agreement was not documented.

Your expectation was that the profits generated from the business would pay the loan interest, and eventually pay down the loan principal.

The business began to run at a loss and failed to keep up with the rental payments.

The rental agreement was terminated and the business was evicted from the premises.

It proved untenable to recommence operations at another location, and a voluntary administration was entered into.

The personal loan between yourselves and the bank still exists, and you have been making repayments toward the interest charges.

Relevant legislative provisions

Section 8-1 of the Income Tax Assessment Act 1997

Reasons for decision

Personal deductions for trust loan

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.

Intrinsic in the operation of section 8-1 of the ITAA 1997 is the general rule that a loss or outgoing is not deductible under the section unless it is incurred in gaining or producing the assessable income of the person who incurs it. 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 interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income. 

Taxation Ruling TR 95/33 also considers factors relevant in determining the deductibility of losses and outgoings. TR 95/33 states that if an outgoing produces an amount of assessable income greater than the amount of the outgoing, there would normally be no need to examine the taxpayer's motives and intentions when determining the deductibility of the expenditure.  However, in other cases, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is deductible. If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective (for example, to derive exempt income or derive income for another entity or the obtaining of a tax deduction), then the outgoing must be apportioned between the pursuit of assessable income and the other objective: see Fletcher and Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613.

In Case 26/94 94 ATC 258, a director, who borrowed money to on-lend to his family company that had no capacity to borrow in its own name, was denied a deduction for interest as the purpose of the loan was to assist the company in avoiding liquidation. The connection between the lending and the derivation of future income by the director was too remote.

Although this case is different to your circumstances, the principles are relevant.

Income Tax Ruling IT 2385 discusses the deductibility of expenses incurred by beneficiaries of discretionary trusts. As highlighted in IT 2385, a beneficiary of a discretionary trust is not entitled to a deduction against their trust distribution income as the expenditure is not incurred in gaining or producing their assessable income. There is not a sufficient nexus between the expenditure incurred and the receipt of income.

A beneficiary has a mere expectancy of receiving income from the trust. You, as a beneficiary were not presently entitled to income of the trust when the expenditure was incurred.

We acknowledge that a loss or outgoing may be deductible even if it is incurred after the cessation of income earning activities, but in order to be deductible the occasion of the outgoing must be found in those income earning activities.

Your situation:

You borrowed money from the bank and on-lent it to the family trust and you are not in the business of lending money. You on-lent at the same interest rate you were required to pay.

No amounts or payments were charged by you to the trust for the loans.

The trust used the money to invest in the franchise and equipment for the business.

It was intended that the trust pay interest payments on the loan to you. There was no expectation of a profit being made by you by way of a higher interest rate charged on the loan to the trust than applied to the borrowed funds.

There is no connection with your income earning activities and your loan to the trust. The essential character of your loan to the trust did not include income producing activities for you. It has the nature of a private or domestic loan to a family trust.

The purpose of you incurring the interest expense cannot be seen as characterising the expenditure as incurred in gaining or producing assessable income.

Where a person lends money to a related entity, a deduction for any interest expense incurred will only be allowed where the money is lent on a commercial basis. That is, there must be a reasonable expectation that the person will receive a return. The test that should be considered is whether a reasonable person with no relationship to either party would enter into this arrangement using exactly the same terms and conditions. If the answer is yes, then it would generally be a commercial arrangement.

It is questionable in your case whether you would enter such an arrangement with an unrelated party. Generally for a commercial loan, the amount being charged for on lent funds is at a rate higher than that being incurred. That is, a profit is planned.

It is considered that you did not lend the funds to the trust on a commercial basis. This is because

● the repayments made by the trust were at the same rate of the interest expenses incurred by you for the borrowed funds,

● there is no evidence that a profit would be made, and

● you have treated the payments to you as reimbursements of your interest expenses.

● The on-lending agreement was not documented.

It is considered that you entered into the loan arrangement for some other purpose other than to produce assessable income for yourself. The arrangement is regarded as being private in nature. There is insufficient nexus between your interest outgoing and the derivation of your assessable income. As such, no deduction for the associated expenses incurred for monies on-lent to the trust is allowed under Section 8-1 of the ITAA 1997.

You refer to Taxation Ruling TR 2004/4, paragraphs 10 and 43-45:

You as individuals have borrowed the money, and the deductibility of interest depends on the expectation of you as individuals to gain income from the on lending of the funds to the trust, not the trust making a profit.

Because you as individuals had no expectation of producing assessable income from the lending of the funds, you are not entitled to a deduction for the interest expense that you as individuals incurred.

In your case, the loan arrangement with the trust is not regarded as an income producing activity or a commercial arrangement. You were not carrying on a business as was found in Federal Commissioner of Taxation v. Brown 99 ATC 4600; (1999) 43 ATR 1 and Federal Commissioner of Taxation v. Jones 2002 ATC 4135; (2002) 49 ATR 188. Furthermore the arrangement is not regarded as a passive income earning investment. Therefore, the principals in the above cases and Taxation Ruling TR 2004/4 will not apply in your situation.