Edited version of private advice

Authorisation Number: 1052224945140

Date of advice: 22 March 2024

Ruling

Subject: Deduction for interest incurred on company loan

Question

As a company director, are you entitled to claim a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the interest expense incurred on the company's loan account?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 20YY

Year ended 30 June 20YY

The scheme commenced on:

DD MM YYYY

Relevant facts and circumstances

You were the director and sole shareholder of two companies. During COVID-19 both businesses closed down, and your companies went into liquidation.

There was a company loan that was used to set up the business and purchase stock. You were guarantor for the company loan so you paid it, both the principal and interest, out of your own funds.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

Summary

You are not entitled to a deduction for the interest incurred on the company loan. There is insufficient nexus between the interest expense and your assessable income. The arrangement of using your own funds to pay off the company loan including interest expense was largely private in nature and no deduction is allowable.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing your assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

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.

At paragraphs 21 and 22 of TR 95/25 it gives a number of significant court decisions that have determined that, for an expense to satisfy section 8-1 of the ITAA 1997:

• 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).

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

As outlined in paragraph 3(a) of TR 95/25, there must be a sufficient connection between the interest expense and the activities which produced the assessable income. Paragraphs 3(b), 26 and 27 of TR 95/25 specify 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.

Paragraph 29 of TR 95/25 discusses the 'use' test, established in the High Court case Federal Commissioner of Taxation v Munro (1926) 38 CLR 153, (1926) 32 ALR 339 (Munro's case). It is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. The interest incurred will generally be deductible to the extent that the borrowed funds are used to produce the taxpayer's own assessable income. That is, it is generally accepted that interest incurred on funds borrowed to acquire an income producing asset is an allowable deduction.

Debts are normally incurred by a business in relation to their operations and the earning of the business' assessable income. As highlighted in Munro's case, a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of an entity other than the one who incurs it. For example, where expenses are incurred by a company and paid for by a director or someone else, a deduction is not allowable to the director or that other person.

Taxation Ruling TR 96/23 Income tax: capital gains: implications of a guarantee to pay a debt, discusses the deductibility of payments made under a contract of guarantee. Paragraph 137 of TR 96/23 states that liabilities arising under contracts of guarantee will not be deductible if the provision of guarantees is not a regular and normal incident of your income earning activities. The ruling further states that if the provision of guarantees is not a regular and normal incident of the taxpayer's income earning activities, any payments made under those guarantees will be capital in nature.

Further, the Commissioner's view on whether interest deductions are allowable after the cessation of the relevant income producing activity is outlined in Taxation Ruling TR 2004/4. The implications of the decisions in Brown's case and Jones' case were considered. A deduction for interest is only available after the business has ceased where the entity that used the borrowed funds for an income producing purpose is the one now claiming the deduction for the interest. Paragraph 10 of TR 2004/4 provides that:

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.

In your case you have used your own funds to repay the company's loan, both the principal and interest. Where expenses are incurred by you in relation to another entity's assessable income, a deduction is not allowable. Such expenses do not sufficiently relate to earning your assessable income. They more directly relate to the company's assessable income, that is the expenses belong to the company and you are paying the interest on their behalf. Having regard to all of your circumstances, it is considered that your purpose for the payment of the loan, including the interest, is private in nature. You are not entitled to claim a deduction for the interest under section 8-1 of the ITAA 1997.