Private ruling: Investment expenses
Published: May 2015
Ruling period: Year Ended 30 June 2012 | Year Ended 30 June 2013 | Year Ended 30 June 2014 | Year Ended 30 June 2015 | Year Ended 30 June 2016
Date scheme commenced: 1 July 20XX

Ruling: Q1: Are the amounts of income returned from your investment with X correctly assessable to you in the relevant years? | A1: Yes | Q2: Can you claim deductions for interest expenses continuing to be incurred after the cessation of your investment with X? | A2: Yes

Relevant facts and circumstances: You entered into an agreement with X during the financial year ended 30 June 20XX in relation to investing in shares on foreign markets. You transferred AUDXXX,XXX into the trading account for X which was located in with the G Bank in a foreign country. You obtained these funds from a loan through a bank in Australia. You received monthly updates on how your funds were being traded on international stock markets. The monthly reports were showing the monthly movements on your accounts along with the fees/commissions being charged on the trading transactions. In 20XX you began transferring funds from the G Bank to your Australian bank account. These amounts were representing profits. You continued with your investment up until the end of the 20XX financial year. Amounts received as "profits" as per the monthly statements were recorded as income on your tax returns for both the 20XX and 20XX financial years. You also claimed tax deductions against these amounts. Overall, a net income was included on which you paid income tax. During the year ended 30 June 20XX, you received legal documentation that X had become deregistered and no contact could be made either by yourselves or local law enforcement agencies. X failed to send through any more monthly reports after this time and your G Bank accounts were frozen. You have been informed by legal representatives that no trading business was ever conducted by X. All monthly reports that you received were fraudulent and that the persons controlling X had retained all remaining capital invested by clients. Overall, you deposited AUDXXX,XXX into the G Bank account and withdrew income of AUDXXX,XXX before the accounts were frozen. You have advised that you did not have any say on which shares were bought and sold. These decisions were made by X; you simply received a monthly statement indicating how your investment was performing. The lending you obtained from the Australian bank was in the form of two line of credit facilities, one for $XXX,XXX and the other $XXX,XXX. You are currently making interest only repayments on your line of credit facility. Your current outstanding balance on your line of credit facility is $XXX,XXX, of which $XX,XXX relates to your investment in X. You also use your line of credit facility to fund purchases of shares via E*TRADE and to deposit the proceeds from these share trades. You seek clarification whether the amounts already declared as income should be assessable and also whether your ongoing interest deductions are allowable as deductions.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 section 8-1

Reasons for decision: Summary: You have correctly declared income from your investment with X in your assessments for the relevant years. You are entitled to a deduction for the interest incurred on a line of credit after the cessation of your investment with X. | Detailed Reasoning - Question 1: Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a taxpayer includes income according to ordinary concepts, which is called ordinary income. Ordinary income has generally been held to include income from rendering personal services, income from property or investment returns and income from carrying on a business. Interest income is considered ordinary income for the purposes of section 6-5 of the ITAA 1997. Interest is taken to have been received as soon as it is applied or dealt with in any way on behalf of a person or as the person directs. Income that is reinvested, accumulated, capitalised or otherwise dealt with on behalf of the person is received as soon as it is reinvested as the taxpayer has directed. The monthly returns that you received were as a result of a scheme similar to a Ponzi scheme. A Ponzi scheme is a type of investment fraud that promises investors higher returns. As more investors participate, the money contributed by later investors is paid to the initial investors, purportedly as the promised returns on their investment, giving the appearance of a valid investment scheme. The character of the receipt in the hands of the investor, rather than the character of the fund of money out of which it is paid, will determine whether or not it is income. Therefore, the fact that capital funds of new investors were used to pay existing investors their entitlements will not determine the character of the payment in the hands of the receiving investor. The Administrative Appeals Tribunal (AAT) has made decisions on cases where the taxpayer has been defrauded of the capital invested while being assessed on the interest income derived. In AAT case [2001] AATA 19, Maber and Deputy Commissioner of Taxation 46 ATR 1096 ( Maber ) and AAT case [2003] AATA 449, Re Horn and Federal Commissioner of Taxation 52 ATR 1139, 2003 ATC 2111 ( Horn ) it was held that periodical payments, in respect of failed mortgage schemes, were paid to the relevant taxpayers as interest on the money lent, even though they were likely to lose some or all of the principal. In Maber the Commissioner considered that the payments received by the taxpayer were income and the taxpayer applied for a review of the decision. The question for the tribunal was whether the periodic payments received by the taxpayer should be considered a return of capital or in the nature of income, being interest payments pursuant to the mortgage agreement. The taxpayer had invested $70,000 with a mortgage broker and received interest payments on the investment. The taxpayer disputed the treatment of interest as income, arguing that because the mortgage was a sham and she had effectively been defrauded, the payments to her should be treated as a return of capital. No development had occurred on the mortgaged property and evidence before the tribunal raised considerable doubt as to the bona fide use of the mortgage money in terms of the mortgage deed. The evidence indicated that some of the taxpayer's money (and the money of other investors) was used to meet the broker's obligations other than those under the mortgage. Some was paid out in questionable circumstances and some was used to fund interest payments to the taxpayer. The taxpayer claimed that this evidence indicated that the mortgage broker set out from the outset to deceive and defraud the mortgagees and that therefore, the money that she had paid over to the broker had in fact been stolen. Further, since the mortgage had no legal efficacy then any payment purporting to be interest pursuant to the mortgage did not have that character, but should be considered a return of capital. The Commissioner contended that monthly remittances to the taxpayer were income according to ordinary concepts within the meaning of section 6-5 of the ITAA 1997. The Commissioner argued that the mortgagor remained indebted at all times to the mortgagee for full repayment of the investment amount, and the relationship between the parties was dictated by the terms of the mortgage instrument. In dismissing the application the AAT held that: (1) It is not sustained that what was received by the taxpayer was a return of capital as the money received could not be said to comprise any specific or identifiable part advance by any particular lender. The money had become part of the property of the mortgagor, subject to trusts created by contractual obligations under the mortgage deed, (2) Although the mortgagor did not deal with the mortgage moneys properly, the mortgage could not be said to be a sham, as there was a properly stamped mortgage document, payments were made pursuant to mortgage obligations and at all times the agreement was enforceable. The fact that subsequent events prevented a realisation of the mortgage does not necessarily make it a sham. For these reasons, the payments which were received by the taxpayer were income, and (3) Any payments from the pool of funds was to be characterised by their legal purpose and, in this case, the objective legal purpose of the payments to the taxpayer was to meet the mortgagors obligation to pay interest under the mortgage deed. The decision in Maber was affirmed in Horn . In dismissing the application the AAT found that: (1) Despite the fact that there was evidence that mortgagors acted outside the provisions of mortgage deeds, improperly intermingled funds, and mislead the investors, the objective purpose of the receipt in the hands of the taxpayer mortgagee was to satisfy the mortgagors obligations to pay interest on the money lent, and (2) As the money received by the taxpayers was interest it should be treated as income for taxation purposes, and not a return of capital. We consider your case to be similar to the taxpayers in the Maber and Horn cases above, and the payments you received should be included in your assessable income under section 6-5. Amounts purporting to be investment returns were advised to you via monthly statements and were received by you. The fact that X may not have actually engaged in foreign share trading on your behalf, wouldn't alter the outcome. Accordingly, you are not able to remove the previously reported income from your returns. | Detailed Reasoning - 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 the outgoings are of a capital, private or domestic nature. Taxation Ruling TR 2004/4 provides the Commissioner's view on the deductibility of interest where the income-producing asset has been disposed of and the taxpayer is still liable for the balance of the loan. In general, the interest expense will continue to be deductible where: • the taxpayer borrowed money to acquire an income-producing asset • the income-producing asset has been disposed of • the proceeds from the disposal have been applied against the loan and not used for personal or non-income producing purposes • the taxpayer does not have the legal power to repay the loan ( FC of T v. Brown 99 ATC 4600, (1999) 43 ATR 1) or does not have the financial resources to repay the loan fully ( FC of T v. Jones 2002 ATC 4135, (2002) 49 ATR 188), and • is unable to avoid incurring ongoing interest liabilities. In this situation, a nexus will continue to exist between the interest outgoings and the relevant income earning activities at least until the end of the period during which the interest cannot be avoided. However, where it can be inferred that a taxpayer has: • kept the loan on foot for reasons unas FC of T v. Jones 2002 ATC 4135, (2002) 49 ATR 188sociated with the former income earning activities, or • made 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 and relevant income-earning activities will be broken. In this case, your investment with X has ceased as it was discovered that the investment was a fraud. The income you received from X has been applied to your line of credit facility. We accept that a nexus continues to exist between the interest outgoings and the relevant income earning activities. Therefore, you are entitled to a deduction for interest incurred on the line of credit.