Edited version of private advice

Authorisation Number: 1051611445707

Date of advice: 27 November 2019

Ruling

Subject: Income tax - interest deduction

Question

Are you entitled to a deduction for a portion of the interest incurred on a loan where the borrowing was used partly to pay off debts owed by the business, which has now ceased its operations?

Answer

Yes

This ruling applies for the following period:

Financial year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

From XX/XX/XXXX to XX/XX/XXX, you were the proprietor of a business.

On XX/XX/XXXX you personally borrowed an amount, of which XX.XX% was used to pay off debts incurred by the business and the balance being used for private purposes.

The business was sold on XX/XX/XXXX. Funds received on sale were not sufficient to satisfy the borrowing liability and were instead used to pay various business creditors.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

You are entitled to claim a deduction for a portion of the interest expenses incurred on the borrowing where it was used to pay off debts related to the business. The proportion of interest deductible will be equal to the proportion of capital used to derive the business income. The connection between the outgoings of interest and the income earning activities has not been broken following cessation of the business.

Detailed reasoning

Deductions for interest

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that you can deduct from your assessable income any loss or outgoing to the extent that it is incurred in gaining or producing assessable income, or is necessarily incurred in carrying on a business for that purpose. However, you cannot deduct a loss or outgoing under this section that is of a capital, private or domestic nature.

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 contains the Tax Office view on when interest is deductible and specifies there must be a sufficient connection (nexus) between the interest expense and the activities which produce assessable income for a deduction to be allowed.

Typically, the deductibility of interest will be determined through an examination of the purpose of the borrowing and the use to which the borrowed funds are put (Fletcher & Ors v. Federal Commissioner of Taxation 91 ATC 4950; (1991) 22 ATR 613, Federal Commissioner of Taxation v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52, Steele v. Federal Commissioner of Taxation Steele 99 ATC 4242; (1999) 41 ATR 139).

The 'use' test (established in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153) is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

Generally, to be deductible under the first limb of section 8-1 of the ITAA 1997, the occasion of the loss or outgoing should be found in whatever is productive of assessable income (Ronpibon Tin v. Federal Commissioner of Taxation (1949) 78 CLR 47 at 57(Ronpibon)).

Taxation ruling TR 2004/4 (TR 2004/4) - deductions for interest following the cessation of relevant income earning activities

The Tax Office view on whether or not a deduction for interest under section 8-1 of the ITAA 1997 may be allowed after the cessation of relevant income earning activities is contained in 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 specifies in paragraph 10 that:

Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and relevant income earning activities (whether business or non-business) have ceased, ... the outgoing will still have been incurred in gaining or producing 'the assessable income' if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgment about the nexus between the outgoing and the (previously related) income earning activities (TR 2004/4, paragraph 11). If the nexus remains unbroken, a deduction will generally be available.

Paragraph 13 of TR 2004/4 specifies that the nexus between the outgoings of interest and the relevant income earning activities will be broken if the taxpayer:

keeps the loan on foot for reasons not associated with the former income earning activities, or

makes a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred.

Situations where the continuing liability to interest is seen to be a burdensome legacy of the past are suggestive of a continuing nexus with prior assessable income. In contrast, cases in which that liability is seen to be associated with present or future advantages are more suggestive of a broken nexus.

The issue of the deductibility of interest after the cessation of relevant income earning activities has been considered by the Courts, specifically 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.

In both cases, the Court held that the interest continued to be deductible despite the cessation of the relevant income earning activities.

In deciding in any particular case whether an inference can be drawn that a taxpayer has kept a loan on foot for reasons unassociated with the former income earning activities, or for an ongoing commercial advantage which is unrelated to the former income producing activities, paragraph 49 of TR 2004/4 notes that it is necessary to undertake a commonsense or practical weighing of all the factors of the case.

Paragraph 50 of TR 2004/4 states that, in weighing the factors of a case, the following should be observed:

·        The less the financial resources of the taxpayer, the more likely it is that an inference could be drawn that the existence of a continuing obligation to pay interest is a burdensome legacy of the past rather than a result of the taxpayer choosing to keep the loan on foot for reasons unassociated with the former income activities.

·        The more liquid the resources of the taxpayer, the more likely the inference could be drawn that the loan is being kept on foot for reasons unassociated with the former income earning activities. The inference is unlikely to be drawn if it would be unreasonable in the circumstances to expect the taxpayer to apply their liquid resources against the loan;

·        The realisation or exchange or assets without a diversion of these resources in repayment of the principal will tend to indicate a breaking of any nexus that might previously have been maintained even after the cessation of the income earning activities.

·        The greater the time since the cessation of the income earning activities, the more likely it is that an inference could be drawn that the continuing obligation to pay interest is a result of the taxpayer choosing to keep the loan on foot for reasons unassociated with the former income earning activities; and

·        Refinancing of a loan does not of itself break the nexus between the outgoings of interest under the loan and the prior income earning activities. However, the decision to refinance may, in all the circumstances, lead to the inference being drawn that the taxpayer has made a conscious decision to extend the loan, and has done this in order to derive an ongoing commercial advantage.

Application to your circumstances

In your case, it is accepted that a portion of the borrowing was incurred in gaining the assessable income of the business. A deduction is allowed following the cessation of the business because the nexus between the outgoings of interest and the relevant income earning activities is not broken. The continuing liability to interest is a burdensome legacy of the past. The sale of business did not produce capital proceeds sufficient to discharge the borrowing liability and was instead used to pay off business creditors.

As the interest expenses have been incurred on a borrowing that has partly been used for income producing purposes and partly for private purposes, there is no connection between the portion of the loan used for private purposes and the production of assessable income. The interest will only be deductible according to the portion of the loan used to derive assessable income.

Where it is necessary to apportion a loss or outgoing, the appropriate method of apportionment will depend on the facts of each case. However, the method adopted in any particular case must be both 'fair and reasonable' in all the circumstances (Ronpibon at 437). Generally the proportion of interest deductible will be equal to the proportion of capital used to derive assessable income.