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Edited version of your written advice
Authorisation Number: 1051220726511
Date of advice: 11 May 2017
Ruling
Subject: Deductibility of loan interest
Question and answer
Are the interest expenses incurred on a loan used to pay out your former spouse who owned a part shareholding in the Company allowable as a tax deduction?
No.
This ruling applies for the following periods:
Year ended 30 June 20XX
Year ended 30 June 20XX
Year ending 30 June 20XX
The scheme commences on:
1 July 20XX
Relevant facts and circumstances
You are a director and shareholder of a company (the Company).
You receive directors fees/wages and dividends from the Company.
You and your spouse separated and entered into an agreement under the Family Law Act 1975 (the Agreement) which would apply in 'full and final settlement of each party's claim for settlement of property and spousal maintenance'.
Under the Agreement, your former spouse agreed to assign to you all their right, title, share and interest in various items of property including their shareholding in the Company, a dwelling and motor vehicles.
Under the Agreement, you agreed to:
● pay your former spouse a lump sum amount in addition to a lump sum you had paid prior to the agreement being entered into;
● refinance the mortgage over the dwelling signed over to you by your former spouse; and
● assign to your former spouse all your right, title, share and interest in various items of property including another dwelling owned by your former spouse, a motor vehicle, investments held in joint names and superannuation entitlements.
In order to payout your former spouse, you borrowed the funds from the Company by way of a loan agreement which complies with the requirements of section 109N of the Income Tax Assessment Act 1936.
Interest payable by you on the loan has been included in the assessable income of the Company.
Relevant legislative provisions
Income Tax Assessment Act 1936 section 109N
Income Tax Assessment Act 1997 section 8-1
Reasons for decision
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.
The general principles relevant to the deductibility of interest expense are set out in Taxation Ruling TR 95/25. The test is one of characterization and the essential character of an expense is a question of fact to be determined by reference to all the circumstances.
Where a loan is taken out, the use test is applied to determine the deductibility of the interest. This is the basic test of deductibility of interest and looks to the application of the borrowed funds as the main criteria. This 'use' test was established in the case of FC of T v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 (Munro's Case).
Essentially, it is the use to which the borrowed funds are put that will determine the deductibility of the interest. If the borrowed funds are used to produce assessable income, then the interest will be deductible. If the funds are used for non-income producing purposes, then the interest will not be deductible.
In your case, you borrowed funds to pay a court ordered divorce settlement. The Agreement did not specify that the funds were paid to your former spouse for relinquishing their shareholding in the Company. Instead, the Agreement specified that you and your former spouse would divide various items of property between you in exchange for you paying a monetary amount. From the information provided, the quantum of the settlement merely took the value of the shareholding of your former spouse into account in arriving at the final amount payable. Consequently, it is considered that the settlement amount was ultimately made in respect of your marriage breakdown.
The payment of a divorce settlement is considered to be private in nature. Therefore, no part of the loan interest is incurred in gaining or producing your assessable income and is not allowable as a deduction.