Private ruling: Deductibility of accrued notional interest expenses
Date of advice: 3 August 2023
Published: 18 September 2023
Ruling period: Income Year ended 30 June 20XX
Date scheme commenced: 1 MM 20XX

Ruling: Q1: Will an interest deduction on the loan from a shareholder be available to Company A for past and present notional expenses once they become a presently existing obligation of Company A under section 8-1 of the Income Tax Assessment Act 1997? | A1: Yes.

Relevant facts and circumstances: Company A is a head entity of a tax consolidated group. Trust X is a 50% shareholder of Company A and has lent money to Company A to assist in conducting Company A's business over a number of years. The director of Trust X's corporate trustee is also a director of Company A. While Trust X and Company A are related parties, you have advised that all dealings are at arm's length. The other director of Company A, who is also the other 50% shareholder of Company A through a trust, is unrelated to the director of Trust X's corporate trustee. That is, they are business partners, but not associates as defined under Income Tax Assessment Act 1936 . The directors and shareholders of Company A agreed that all monies lent into the business by shareholders would incur notional interest that is compounded monthly. This agreement is recorded in multiple documents such as Company A's Shareholder Agreement and other agreements executed by the shareholders of Company A. No formal loan agreement exists outside of the abovementioned documents. Clauses within the Shareholder Agreement of Company A sets out the agreed terms between shareholders for funds advanced for working capital purposes. Other agreements were executed to vary the agreed terms stated within the Shareholder Agreement for the purposes of varying the interest rates and adding more security over the loan. As at DD MM 20XX, the loan amount outstanding from Company A to Trust X for the loans made since MM 20XX was $XXX comprising of capital of $XXX and interest of $XXX. A Letter of Demand for interest on loans was issued by Trust X to Company A on DD MM 20XX for the outstanding loan amount of $XXX, accrued since MM 20XX. In relation to the outstanding loan amount no deduction for interest has been claimed by Company A on the basis that the interest was not a present obligation of Company A. That is, the interest was notionally accruing in the background, but had never been demanded by Trust X. Interest had not been charged previously by Trust X due to concerns about Company A's financial circumstances. It was understood between the shareholders and directors of Company A that interest notionally accruing on shareholder loans would be deferred until Company A had sufficient profits from its business and the company's cashflow permitted payment. Trust X's concerns were that they are vulnerable being an unsecured creditor of Company A at a time when the industry that Company A is conducting business in is under enormous pressure. Having supported Company A since its inception and continuing to lend in funds, Trust X has made a decision that its time that Trust X debts were reflected in Company A's financial statement, so it captures the accumulated interest and Trust X has a right to claim. In doing so, the interest will go from notional amount to a presently existing liability and will elevate the rights of Trust X as a creditor if conditions do not improve for relevant industry.

Relevant legislative provisions: Section 8-1 of the Income Tax Assessment Act 1997

Reasons for decision: Summary: Under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), an interest deduction on the loans from Trust X is available to Company A for past and present notional interest expenses as those accrued interest expenses became a presently existing obligation of Company A upon the issue of letter of demand by Trust X. | Detailed Reasoning - Detailed reasoning: Section 8-1 of the ITAA 1997 allows a deduction for 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 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) provides the Commissioner's view on the deductibility of interest expenses following the Full Federal Court decision in FC of T v. Roberts; FC of T v. Smith 92 ATC 4380; (1992) 23 ATR 494 . 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. It includes: 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. It includes: "... 3. To qualify for deduction under section 8-1 a loss or outgoing must have been incurred. | Detailed Reasoning - Incurred: 4. There is no statutory definition of the term 'incurred'. 5. As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape. But this broad guide must be read subject to the propositions developed by the courts, which are set out immediately below. 6. The courts have been reluctant to attempt an exhaustive definition of a term such as 'incurred'. The following propositions do not purport to do this, they help to outline the scope of the definition. The following general rules, settled by case law, assist in most cases in defining whether and when a loss or outgoing has been incurred: (a) a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitely committed in the year of income. Accordingly, a loss or outgoing may be incurred within section 8-1 even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing, That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum; ... 15. It is often the case that an outgoing will be both incurred and paid in the same year of income, and no issue of timing arises. However, the point in time when an outgoing may be taken to be deductible becomes an issue of practical concern to taxpayers who have unpaid liabilities at year end or outgoings which relate to two or more income years. | Detailed Reasoning - Presently existing liability: 16. A loss or outgoing may be incurred for the purposes of section 8-1 even though no money has actually been paid out. In W Nevill & Company Ltd v. FC of T (1937) 56 CLR 290 at 302 it was said: 'the word used is 'incurred' and not 'made' or 'paid'. The language lends colour to the suggestion that, if a liability to pay money as an outgoing comes into existence, [the section is satisfied] even though the liability has not been actually discharged at the relevant time... it is only the incurring of the outgoing that must be actual; the section does not say in terms that there must be an actual outgoing - a payment out.' ... 17. The proposition was recently confirmed by the High Court in FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52 (Energy Resources ) when, quoting from James Flood , it said (ATC at 4539; ATR at 56): 'Section 51(1) "has been interpreted to cover outgoings to which the taxpayer is definitively committed in the year of income although there has been no actual disbursement".' 18. The liability must be 'more than impending, threatened or expected' - refer New Zealand Flax (CLR at 207). '[W]hat is clearly necessary is that there should be a presently existing liability' - Nilsen Development Laboratories (CLR at 624). It is not a existing liability if it is contingent - refer James Flood (CLR at 506); Nilsen Development Laboratories (CLR at 207); Marbren Pty Ltd v. FC of T 84 ATC 4783 at 4788-4789; (1984) 15 ATR 1145 at 1152. | Detailed Reasoning - Defeasible: 19. A taxpayer can be completely subjected to a liability even though it is defeasible by others - refer Commonwealth Aluminium Corporation Ltd (77 ATC 4151 at 4161; (1977) 7 ATR 376 at 386). 20. But, it is to be emphasised that the taxpayer must be definitively committed to the outgoing, even though it may be defeasible. A taxpayer who takes goods on approval for example could not be said to be definitively committed to their purchase. ... | Detailed Reasoning - Accounting practice: 22. The determination that an outgoing has been incurred depends on a jurisprudential analysis of whether there is a presently existing pecuniary liability, having regard to the terms of the contract and other arrangements giving rise to that liability, rather than a commercial view of the arrangements... ..." In Marbren Pty Ltd v. FC of T 84 ATC 4783 ( Marbren ), in determining the deductibility of a contingent liability arrangement, consideration is made that where a liability to pay interest is contingent on a demand by the lender, the interest is not incurred unless and until the demand is made. | Detailed Reasoning - Application to your circumstances: As specified in TR 95/25, for interest expenses to be deductible, there must be a sufficient connection between the interest expense and the activities which produce assessable income. Further TR 95/25 specifies that to determine whether the associated interest expenses are deductible, regard must be given to all circumstances including the objective purpose of the borrowing and the use to which the borrowed funds are put. TR 95/25 also addresses the 'use test', which is the basic test for the deductibility of interest which ascertains the character of interest on money borrowed by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower. Company A borrowed funds from its shareholder, Trust X, to fund for its business activities. Interest expenses of Company A have accrued on its borrowed funds from Trust X, which has been used in carrying on a business for the purpose of gaining assessable income. It will therefore be deemed to be an allowable deduction under section 8-1 of the ITAA 1997. TR 97/7 explains that to qualify for deduction under section 8-1 of the ITAA 1997, a loss or outgoing must have been incurred. It specifies that you incur an outgoing at the time you owe a present money debt that it cannot escape. It is not needed that you actually have paid any money to have incurred an outgoing provided that you are definitely committed in the year of income. That is, it is not sufficient if the liability is merely contingent or not more than pending, threatened or expected, no matter how certain it is in the yar of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability. Further in Marbren , it is established that where a liability to pay interest is contingent on a demand by the lender, the interest is not incurred unless and until the demand is made. A letter of demand was issued by Trust X to Company A on DD MM 20XX for the outstanding loan amount of $XXX, accrued since MM 20XX. Upon the issue of the demand, the notional interest amount is no longer contingent and became a presently existing liability of Company A. As indicated in TR 97/7, even though Company A has not actually paid any money to Trust X, it has incurred an outgoing following the letter of demand, converting the notional interest amount to a presently existing, non-contingent obligation to pay a pecuniary sum of money. Therefore, as the letter of demand was issued on DD MM 20XX, Company A has incurred the interest expensed within the income year ended 30 June 20XX. | Detailed Reasoning - Conclusion: Company A has borrowed funds from Trust X for the purpose of carrying on its business in gaining assessable income. Interest expenses have accrued notionally for Company A since MM 20XX in relation to the funds borrowed from Trust X. A Letter of demand was issued by Trust X to Company A on DD MM 20XX for the accrued expenses amount of $XXX. As per Marbren , this amount became a presently existing liability of Company A upon the demand on DD MM 20XX. The accrued interest amount is incurred by Company A on DD MM 20XX as Company A has incurred an outgoing at the time the liability arises. The amount of the presently existing liability will be an allowable deduction for Company A in the income year ended 30 June 20XX under section 8-1 of the ITAA 1997.

There must be a sufficient connection between the interest expense and the activities which produce assessable income. The test is one of characterisation, and the essential character of the expenses is a question of fact to be determined by reference to all the circumstances; | 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 (the use test); and | Regard must also be had to all the circumstances, including 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.