Private ruling: Funds on lent by a shareholder
Published: January 2012
Ruling period: Year ended 30 June 2008 | Year ended 30 June 2009 | Year ended 30 June 2010 | Year ended 30 June 2011
Date scheme commenced: I July 2007

Ruling: Q1: Are you entitled to a deduction for the interest on funds borrowed and on-lent to a company in which you were a shareholder? | A1: No. | Q2: Where the company is placed into liquidation and the funds are not repaid, does this give rise to a capital loss? | A2: Yes.


Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Section 104-25 | Income Tax Assessment Act 1997 Section 108-5

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act 1997 (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, or relate to the earning of exempt income. Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income and regard must be given to all the circumstances including the purpose of the borrowing and the use to which the borrowed funds are put. We acknowledge that a loss or outgoing can be deductible even if it is incurred after the cessation of income earning activities, but in order to be deductible the occasion of the outgoing must be found in those income earning activities (Taxation Ruling 2004/4). 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 ) 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 assessable income. The issue of failing to derive interest income was considered in Munro's case . The principles established were that neither the lending to the company in which Mr Munro was a shareholder, nor the financing of an acquisition of shares by his sons were regarded as sufficient to characterise the incurring of the interest as being directed to the gaining of the taxpayer's income. Since Munro's case there have been a significant number of cases in which directors and shareholders of companies have provided benefits at their own expense to the companies with which they were associated which have not satisfied the characterisation test. This includes Case 26/94 94 ATC 258, in which it was held that a director, who borrowed money to on-lend to his family company that had no capacity to borrow in its own name, was denied a deduction for interest as the purpose of the loan was to assist the company in avoiding liquidation. The connection between the lending and the derivation of future income by the director was too remote. Further, a recent decision in Knox v. FC of T 2011 ATC 10-225; AAT Case [2011] AATA 905 held that interest incurred on funds borrowed and on-lent to a company by a joint shareholder and director was not deductible as there was no connection between the interest and the gaining or deriving of assessable interest or dividends by the taxpayer. An exception is the decision of the Full Federal Court in FC of T v. Total Holdings (Australia) Pty Ltd 79 ATC 4279; (1979) 9 ATR 885 ( Total Holdings ). This case recognised the earning of dividends as a sufficient purpose to characterise interest on money borrowed to on-lend to another entity for the purpose of its business as falling within being a deductible expense. Subsequent to this decision, the Commissioner published Taxation Ruling IT 2606 to provide guidance as to how the principles concerning interest deductibility that were established in the Total Holdings decision should be applied. IT 2606 clarified that in circumstances where no income is derived directly by the taxpayer from the transaction to which the interest expense relates, and there is no obvious connection with the carrying on of a business or other income earning activity of the taxpayer, then the taxpayer's purpose may be relevant to the characterisation of the expenditure. Where a person lends money to a related entity, a deduction for any interest or associated expense incurred will only be allowed where the money is lent on a commercial basis. That is, there must be a reasonable expectation that the person will receive a return. In your case there was no expectation of a profit being made by you by way of a higher interest rate charged on the loan to the company than applied to the borrowed funds. That is, you were not to receive any additional income or profit from the loans. It is considered that you did not lend the funds to the company on a commercial basis. Your purpose in lending the money cannot be seen as characterising the expenditure as incurred in gaining or producing assessable income. Rather it was incurred to help the business and its financial position and the interest repayments expected were more a reimbursement of expenses incurred rather than assessable income. There is insufficient nexus between your interest outgoing and the derivation of your assessable income. As one of a number of shareholders, you lent the money to the company for the purpose of providing working capital. Your purpose had to be to benefit all of the shareholders and that duality of purpose means it cannot be taken to have been incurred in gaining or producing your assessable income. Your position is not that of Total Holdings, which wholly owned the company to which it on-lent money. Your position can be likened to that of Munro in Munro's case , in which the High Court viewed the interest as having been borrowed for the purpose of the company producing income for the benefit of all the shareholders. Your case can be distinguished from the Administrative Appeals Tribunal case of Economedes v. Federal Commissioner of Taxation 2004 ATC 2353; 2004 58 ATR 1046; [2004] AATA 1249 ( Economedes case) . That case involved the deductibility of interest expenses incurred by shareholders on borrowings on-lent to associated family companies for the purpose of gaining or producing their assessable income, where they were the sole shareholders who had an expectation, when on-lending the borrowings to the company, that the borrowing would result in interest and dividend income being received from the company at least equal to the interest expense incurred in repaying the loan. In your case, the loan was not made on a commercial basis and would benefit all shareholders. It is considered that the arrangement was to provide loan capital to an associated entity and there is no clear nexus between the interest expense and the earning of your assessable income. The general impression gained is that your loan arrangement has the character of loan capital, rather than being of a revenue nature. Therefore, you are not entitled to a deduction for the interest expenses you incur in relation to the loan, under section 8-1 of the ITAA 1997. | Detailed Reasoning - Capital Loss: You may declare a capital loss under section 104-25 of the ITAA 1997 because section 108-5 of the ITAA 1997 deems a debt owed to you to be a capital gains tax (CGT) asset. As the company was recently liquidated, this is when you incurred the capital loss. Up until this point, there was an expectation that the company may pay the loan back to you when it became profitable. Once the company was placed in liquidation and the business ceased, the funds owed by the company to you were irrecoverable. It was at that time that the loss by you was crystallised since before that time there was an expectation that the company may pay you back when it became profitable. Your capital loss may be offset against current and future capital gains but cannot be offset against your ordinary income.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Relevant facts: You and your spouse owned an interest in a business which operated through a private company. | You were both shareholders in the company, however only your spouse was a director. | There were other parties involved in the company. | You borrowed significant funds using credit cards and personal loans to on-lend to the private company with the intention that the funds, together with the interest, were to be repaid by the company. | The company used these funds to finance its general working capital requirements. | There was no formal written agreement to document this arrangement, however you state that it was understood by all parties concerned, including the directors. | The company has been placed in liquidation after a period of administration. You advise that there is no possibility for repayment of the debt, or the accumulated interest, which is now ongoing.