Edited version of private advice

Authorisation Number: 1052318527736

Date of advice: 6 November 2024

Ruling

Subject: Interest deductions on limited recourse loan

Question 1

Does Division 247 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to a limited recourse loan used to purchase shares?

Answer

Yes.

Question 2

Subject to Division 247 of the ITAA 1997, are the interest expenses incurred on the limited recourse loan deductible under section 8-1 of the ITAA 1997?

Answer

Yes.

Question 3

Are the interest expenses incurred for the purposes of section 8-1 of the ITAA 1997, only deductible in the income year they are paid?

Answer

No.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commenced on:

April 20XX

Relevant facts and circumstances

You were an employee of company A.

You are the legal and beneficial owner of company A options.

You included the Employee Share Scheme discount associated with the A options in your 20XX tax return.

You exercised the options and purchased A shares in the 20XX income year.

You entered into a limited recourse loan agreement (Loan Agreement) to purchase all the A shares.

You provided a copy of the Loan Agreement which details the obligations of the parties.

Clause 6 of the Loan Agreement covers the 'Repayment of Amount Owing' and clause 6(f) states:

Without limiting clauses 6(g) and 6(h) the Lender and the Borrower acknowledge and agree that the Lender's recourse against the Borrower for the repayment of the Amount Owing or otherwise in connection with any Transaction Document is limited to the amount that is received by the Borrower or the Lender from or otherwise in connection with owning or Disposing of the Secured Property or exercising it rights under the Security, plus and amounts otherwise repaid by the Borrower pursuant to clause 6(a).

The 'Secured Property' is defined to mean 'a first registered specific security deed, granted by the Borrower to and in favour of the Lender, in respect of the Borrower's right, title and interest in the A Shares'.

Clause 7 of the Loan Agreement covers 'Interest on Amount Owing' and states:

(a)    The Borrower must pay to the Lender Interest on the Amount Owing at the Interest Rate.

(b)    Interest accrues on the Amount Owing from day to day, on and from the Effective Date until and including the day all of the Amount Owing is repaid in full.

(c)    Interest payable under this agreement will be capitalised monthly in arrears.

The Interest Rate means X% per annum.

The Amount Owing means:

(a)    Loan Amount and

(b)    any accrued Interest,

payable under the Transaction Documents and still outstanding

Clause 9 of the Loan Agreement covers 'Default interest' and states:

(a)    Subject to clause 6(f) the Borrower must pay to the Lender interest on money payable to the Lender under this agreement but unpaid at the Interest Rate plus X%.

(b)    Interest accrues from day to day, on and from the day that the relevant money becomes payable under this agreement until and including the day of payment.

(c)    Interest payable by the Borrower under this clause 9 will be capitalised monthly in arrears on or before the last day of each calendar month.

During the 20XX income year you received and included in your tax return, franked dividends from holding the A shares.

You left your employment with company A and were required to sell all the A shares.

The borrowed funds and interest owing was withheld from the sale proceeds.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 247

Income Tax Assessment Act 1997 Section 247-10

Income Tax Assessment Act Subsection 247-15(5)

Income Tax Assessment Act 1997 Subsection 247-20(3)

Income Tax Assessment Act 1997 Subsection 247-20(6)

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Question 1

As an investor, you may use a capital protected product, known as capital protected borrowing, to fund the acquisition of investments. Capital protected products include limited recourse loans.

With a limited recourse loan, if, as the borrower, you default on the loan, the lender is limited in the action that it can take to recover the amount loaned. For a capital protected product, the lender's recourse is limited to the underlying shares, units or stapled securities. Because of the capital protection feature in a limited recourse loan, the lender will usually charge you higher rates of interest or additional fees.

Division 247 of the ITAA 1997 applies to capital protected borrowings and separately identifies an appropriate portion of the total consideration paid by a borrower as the premium paid for capital protection.

Section 247-10 of the ITAA 1997 describes when a borrowing under an arrangement satisfies the requirements as a capital protected borrowing. Subsection 247-10(1) states:

An arrangement under which a borrowing is made, or credit is provided, is a capital protected borrowing if the borrower is wholly or partly protected against a fall in the market value of a thing (the protected thing ) to the extent that:

(a) the borrower uses the amount borrowed or credit provided to acquire the protected thing; or

(b) the borrower uses the protected thing as security for the borrowing or provision of credit.

That protection is called capital protection (Subsection 247-10(2) of the ITAA 1997).

Subsection 247-15(5) of the ITAA 1997 applies to capital protected borrowings entered into after 30 June 2007, where the share is listed on an approved stock exchange. It also applies to shares that are not relevantly listed on an approved stock exchange but where the issuing company is widely held.

The object of Division 247 is to ensure that amounts paid for capital protection under capital protected borrowings are treated as a payment for a put option granted by the lender (subsection 247-20(6) of the ITAA 1997) and not deductible under section 8-1 of the ITAA 1997. This premium is treated for capital gains tax (CGT) purposes as the price paid for a put option, whether or not a put option is actually granted to the borrower.

We consider that your Loan Agreement to purchase the A shares is a capital protected borrowing under section 247-10 of the ITAA 1997. The A shares are considered to be shares in a widely held company for the purposes of section 995-1 of the ITAA 1997.

For capital protected products entered into on or after 13 May 2008, the amount that you can reasonably attribute to capital protection is calculated by using the 'Method statement' under subsection 247-20(3) of the ITAA 1997.

The calculation uses the benchmark rate, being the Reserve Banks of Australia's indicator lending rate for standard variable housing loans plus 100 basis points (1%) to the same amount of borrowing. Refer to our web site ato.gov.au and search quick code QC 17547, "How to calculate deductions for a capital protected borrowing".

Question 2

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 assessable income, except where they 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 (TR 95/25). Paragraph 3 of TR 95/25 sets out the general principles relevant to the question of whether interest is deductible under section 8-1 of the ITAA 1997 and includes:

(a)    The interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature. The test is one of characterisation and the essential character of an expense is a question fact to be determined by reference to all the circumstances.

(b)    The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower. However, regard must be had to all the circumstances, including the character of the taxpayer's undertaking or business, the objective purpose of the borrowing, and the nature of the transaction or series of transactions of which the borrowing of funds is an element. In some cases, the taxpayer's subjective purpose, intention or motive may be relevant in deciding the deductibility of interest.

(c)    A tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity. Normally this would be the case for non-business taxpayers...

You borrowed funds to purchase A shares. As an investor of A shares you have derived assessable income by way of franked dividends from this investment. The interest expenses are deducible under section 8-1 of the ITAA 1997 because they have sufficient connection with gaining or producing your assessable income.

However, the interest deductions are only deductible to the extent they are not attributable to the premium you have paid for capital protection under Division 247 of the ITAA 1997 (i.e. to the extent they are not of a capital nature).

Question 3

Taxation Ruling TR 97/7 Income Tax: section 8-1 - meaning of 'incurred' - timing of deductions (TR 97/7), sets out the Commissioner's view on the meaning of incurred in section 8-1 of ITAA 1997.

To qualify for a deduction under section 8-1 a loss or outgoing must have been incurred. TR 97/7 at paragraph 6 provides the general rules settled by case law in defining whether and when a loss or outgoing has been incurred. Furthermore, the outgoing must also be referable to the year of income in which the deduction is sought (Coles Myer Finance Pty Ltd v. FC of T 93 ATC 4214 at 4222).

You have entered into a legal arrangement which makes you liable to pay interest on the loan. Interest under the Loan Agreement accrues daily and whilst the lender did not demand payment and was prepared to wait until you sold the A shares, this does not mean that you are not definitively committed to the payment of interest. You have a presently existing liability to pay the interest expenses and as such you have incurred the interest expenses under section 8-1 of the ITAA 1997.

However, the interest expenses must be 'properly referable' to the particular year in question. To determine the timing of the deductibility of interest in the case of interest on a loan, we consider the period of the loan is the relevant period (Taxation Ruling TR 94/26 Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance).

The liability to pay interest on the limited recourse loan came into existence at the start of the Loan Agreement. The profitable advantage was provided to you to use the funds for income producing purposes and this benefit continued for the period of the loan.

Therefore, the interest is properly referable and deductible during the period of the limited recourse loan. The interest expenses otherwise deductible under section 8-1 of the ITAA 1997 are not deductible in full when they were paid (i.e. 20XX income year); instead they are deductible in the income years interest expenses accrued on the limited recourse loan.

Conclusion

The interest deductions incurred on the limited recourse loan are deductible pursuant to section 8-1 of the ITAA 1997, in the income year that the interest expenses accrued. However, to the extent the interest expenses are reasonably attributable to the cost of capital protection under Division 247, they are not deductible under section 8-1 of the ITAA 1997.