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Edited version of private advice
Authorisation Number: 1051632748643
Date of advice: 6 February 2020
Ruling
Subject: Income tax - interest deductions
Question
Is the interest on the portion of the borrowings that is used to pay Individual B outstanding UPE and loan to the Trust deductible?
Answer
Yes. In this case the UPE and the loan was used facilitate the purchase of a shares in Entity B which is used in gaining or producing its assessable income. Amounts that were not distributed in financial years and retained by the trustee were also used in the gaining or producing of assessable income of the trust therefore the repayment of the current UPE and outstanding loan to Ms Smith will constitute a 'returnable amount' and any interest incurred on a loan to repay these entitlement will be deductible under section 8-1 of the Income Tax Assessment Act 1997 as the loan will be sufficiently connected with the gaining or producing assessable income of The Trust.
This ruling applies for the following periods:
Year ended 30 June 20XX
Year ended 30 June 20XX
Year ended 30 June 20XX
Year ended 30 June 20XX
Year ended 30 June 20XX
Year ended 30 June 20XX
Year ended 30 June 20XX
Year ended 30 June 20XX
The scheme commences on:
1 October 20XX
Relevant facts and circumstances
The Trust was established.
Individual A and Individual B were married and beneficiaries of the Trust.
The Trust has invested the trust funds in the shares of Entity B and is the sole shareholder of Entity B. Entity B functions as an investment holding company.
The sole investment of Entity B is its shareholding in Entity A. Entity A is an active trading entity and operates as the headquarters and head franchisor of Entity C.
Over the years, the trustee of the Trust has made distributions in favour of Individual A and Individual B. The exercise of the trustee's distribution power has given rise to an obligation to pay distribution amounts to Individual B. Individual B had decided to leave part of her present entitlements in the hands of the trustee. The trustee has used these funds from Individual B's unpaid present entitlement (UPE) to invest in income producing assets (being more shares in Entity A via Entity B).
Individual B also lent funds to the Trust which were used to invest in income producing assets (more shares in Entity A via Entity B).
The accounts of the Trust show that the trust could not have funded its current level of shareholding in Entity A without Individual B's UPE and loan.
Individual A and Individual B divorced.
There is a family court order relating to the divorce settlement. One of the requirements of the court order is that Individual A must Individual B a specified amount which includes her UPE in the Trust and her loan to the Trust.
The financial statements of the Trust and Entity B for the year ended 30 June 20XX have not yet been prepared however the estimated amount of Individual B's UPE at the time of settlement is approximately $XXX. The estimated amount of Individual B's loan to the Trust at the time of settlement is $ XX.
If Individual B does not receive the specified amount from Individual A as per the court order, the Trust is required under the court order to direct Entity B to sell as many Entity A shares as is necessary to raise the required amount of funds to payout Individual B. Entity A is a private company and according to its shareholders' agreement, any shares sold must first be offered to existing Entity A shareholders at a price derived from a formula in the shareholders' agreement based on a multiple of 3 times the average EBIT over the previous two financial years; before being offered to external investors.
The trustee of the Trust is of the opinion that it is not an ideal time to sell down Entity A shares due to the fact that the price that will be derived by the shareholders agreement is below market value, particularly due to the EBIT of the previous two financial years being adversely affected by extraordinary write-downs. Given the pre-emptive rights of the other shareholders, it would therefore be expected that they would exercise the rights to purchase these shares at a price below market. A recent independent valuation of Entity A also supports this view.
The trustee of the Trust has decided that it would be financially better for the Trust to borrow the funds necessary to pay the specified amount to Individual B rather than direct its fully owned subsidiary, Entity B, to sell part of its shareholding in Entity A.
The trustee of the Trust is of the opinion that there has been a temporary decline in the market value of Entity A shares due to business performance and the current economic conditions. However, the trustee of the Trust expects the market value of the Entity A shares to increase in the future when business performance and economic conditions improve.
The Trust of the Trust will obtain a loan to repay the UPE and loan outstanding to Individual B.
Relevant legislative provisions
Income Tax Assessment Act 1997 section 8-1