Edited version of private advice

Authorisation Number: 1052376909110

Date of advice: 26 March 2025

Ruling

Subject: Deductions

Question 1

Is interest payable under an extended loan agreement deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer 1

Interest expense related to the acquisition of the shares will be deductable under section 8-1 of the ITAA 1997 in the relevant tax periods while the Taxpayer has ownership of the shares.

Upon the Taxpayer's disposal of the shares, the nexus between the interest expense and an income producing purpose will be broken, which will result in the interest expense ceasing to be deductible under section 8-1 of the ITAA 1997.

This ruling applies for the following periods:

Income years ended 30 June 20XX to 30 June 20XZ

The scheme commenced on:

During the income year ended 30 June 20XX

Relevant facts and circumstances

The Taxpayer entered into a loan agreement with joint lenders (company X and individual Z) on commercial terms to acquire shares in the Company a number of years ago.

The Taxpayer refinanced the existing loan agreement with the joint lenders to amend the terms and interest amounts a few years later.

Later, the Taxpayer entered into a new loan agreement so that individual Z became the sole lender.

Recently, the Company entered a Scheme whereby Entity Q would acquire all the shares in the Company.

Under the terms of the Scheme, shareholders in the Company would in turn receive: a cash consideration of $X per share; a special dividend and/or return of capital of up to $X per share; and the right to a potential earn out consideration of up to $X per Share.

The Scheme is currently awaiting approval.

The Taxpayer advised that it is expected that, if the Scheme is approved, its implementation date will be in a future financial year.

Consequently, the Taxpayer and individual Z have agreed to extend the terms of the loan agreement (the extended loan agreement).

The terms of the extended loan agreement provide that the Taxpayer, upon the disposal of the shares:

•          does have the legal power to repay that loan early; and

•          will not be subject to any break fee or early repayment costs upon the early repayment of that loan.

The Taxpayer advised that upon disposal of the shares in Company (under the terms of the Scheme), the Taxpayer will either repay the loan or acquire a different income producing asset with the borrowed funds.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for decision

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 the outgoings are of a capital, private or domestic nature.

Taxation Ruling TR 2004/4 Income tax: deductions for interest incurred prior to commencement of, or following the cessation of, relevant income earning activities further focuses on tracing the application of the borrowed monies, i.e., "the use to which the borrowed funds were put".

Paragraph 6 states: the deductibility of interest is typically determined through the examination of the purpose of the borrowing and the use to which the borrowed funds are put (Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613, FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52, and Steele v. FC of T 99 ATC 4242; (1999) 41 ATR 139 (Steele)).

Paragraph 7 states that: Ordinarily '...the purpose of the borrowing will be ascertained from the use to which the borrowed funds were put...' (Hill J in Kidston Goldmines Limited v. FC of T 91 ATC 4538 at 4545; (1991) 22 ATR 168 at 176). However, as his Honour later observed in FC of T v. JD Roberts; FC of T v. Smith 92 ATC 4380 at 4388; (1992) 23 ATR 494 at 504, '...a rigid tracing of funds will not always be necessary or appropriate...'.

Paragraphs 10 to 14 of TR 2004/4 also provide that:

Interest incurred after assessable income

10. 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, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, 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.

11. 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 income earning activities.

12. An outgoing of interest in such circumstances will not fail to be deductible merely because:

•          the loan is not for a fixed term;

•          the taxpayer has a legal entitlement to repay the principal before maturity, with or without penalty; or

•          the original loan is refinanced, whether once or more than once.

13. However, if the taxpayer:

•          keeps the loan on foot for reasons unassociated 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,

the nexus between the outgoings of interest and the relevant income earning activities will be broken.

14. A legal (FC of T v. Brown 99 ATC 4600; (1999) 43 ATR 1 ) or economic (FC of T v. Jones 2002 ATC 4135; (2002) 49 ATR 188) inability to repay is suggestive of the loan not having been kept on foot for purposes other than the former income earning activities.

In this case:

•          The Taxpayer has secured shares with borrowed funds, which have been subsequently refinanced. Therefore, interest expense related to the acquisition of the shares will be deductable under section 8-1 of the ITAA 1997 while the Taxpayer has ownership of the shares.

•          Under the terms of the extended loan agreement, the Taxpayer, upon the disposal of the shares:

-       have the legal power to repay that loan early; and

-       not be subject to any break fee or early repayment costs upon the early repayment of that loan.

•          Upon the disposal of the shares under the Scheme:

-       axpayer will receive:

§   cash consideration of $X per share;

§   the cash amount of a special dividend and/or return of capital of up to $X per share; and

§   the right to a potential earn out scheme consideration of up to $X per Share.

-       ncome producing assets (the shares) will be disposed of, such that the nexus between the interest expense and an income producing purpose will be broken, which will result in the interest expense ceasing to be deductible under section 8-1 of the ITAA 1997 (this conclusion is unaffected by the contingency of any potential earn out consideration that may be received by the Taxpayer at a future time).

•          The Taxpayer has advised that upon disposal of the shares, the Taxpayer will either repay the loan or acquire a different income producing asset with the borrowed funds:

-       e event of the Taxpayer repaying the loan, there will no longer be an expense of interest and, therefore, deductibility of the interest expense will cease.

-        As the acquisition, by the Taxpayer, of a different income producing asset, with the borrowed funds, is contingent upon future events the Commissioner is unable to consider this as a fact that is a part of the scheme that is being ruled upon.