Private ruling: Income Tax - Interest Deductions
Date of advice: 24 November 2016
Published: April 2017
Ruling period: Year ending 30 June 2017
Date scheme commenced: 1 July 2016

Ruling: Q1: Will the proposed loan to provide funds to repay the majority of the Unpaid Present Entitlement balances be sufficiently connected with the gaining or producing of assessable income? | A1: Yes. | Q2: Will the proposed repayment of the Unpaid present Entitlement balances due to the beneficiaries constitute the payment of a “Returnable Amount” as referred to in TR 2005/12? | A2: Yes. | Q3: Will the ongoing loan interest to be incurred on the proposed loan to repay the majority of the Unpaid Present Entitlement balances due to the beneficiaries of the trust be a taxable deductible expense to the trust? | A3: Yes.

Relevant facts and circumstances: The Trust is a discretionary trust. The Trust acquired a commercial building and land. The initial land and building purchase cost was funded by way of a mortgage loan with a bank and the remainder of the finance was provided by beneficiary loans. In addition, the beneficiaries had also provided funds to the trust, to facilitate the later capital improvements to the building. The renovated commercial building was let to a commercial tenant on a long term lease and has generated rental income. In some financial years, a net profit has been derived by The Trust and distributed to the beneficiaries respectively, with cash distributions being made in reduction of their entitlements. The initial funds advanced by the beneficiaries were first provided to allow for an investment account to be held by the trust, subsequently deriving interest income, and to allow for the payment of the balance of the funds initially required to facilitate the purchase of the commercial land and building. The balances of the Unpaid Present Entitlement of the beneficiaries has increased over a number of financial years, with these additional funds being used as working capital of the trust to pay necessary operating costs and to facilitate repairs when needed on the property. You are considering seeking a new mortgage loan to facilitate the payment of the current Unpaid Present Entitlement balances, as owed by the trustee to the respective beneficiaries. The amount of the payment will depend on the amount provided by the bank.

Relevant legislative provisions: Income Tax Assessment Act 1936 Section 95 | Income Tax Assessment Act 1997 Section 8-1

Reasons for decision: Summary: Subsection 8-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides: You can deduct from your assessable income any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. Section 95 of the Income Tax Assessment Act 1936 (ITAA 1936) defines the net income of a trust estate to mean the total assessable income of the trust estate calculated under the ITAA 1936 as if the trustee were a taxpayer in respect of the income and were a resident, less all allowable deductions (subject to certain exceptions). The interest expense incurred by a trustee of a trust estate in respect of borrowed funds must be sufficiently connected with the assessable income earning activity, or business, carried on by the trustee as trustee of the trust estate, to result in the interest expense being deductible. The interest expenses will be sufficiently connected if the purpose of the trustee in borrowing funds, when viewed objectively, is to refinance a 'returnable amount'. The term 'returnable amount' is defined in paragraph 5 of Taxation Ruling TR 2005/12 Income tax: deductibility of interest expenses incurred by trustees on funds borrowed in connection with the payment of distributions to beneficiaries (TR 2005/12). It is used to refer to money or property forming part of the trust estate that: (a) is employed by the trustee in gaining or producing the assessable income of the trust estate, or in carrying on business for that purpose; and that (b) a beneficiary of the trust estate is entitled to require to be returned to that beneficiary; and that (c) is or represents money or property that was previously transferred by the beneficiary (or another person on the beneficiary's behalf) to the trustee of the trust estate, including money or property previously retained by the trustee out of funds to which the beneficiary was presently entitled. Paragraph 9 of TR 2005/12 provides some factual situations that illustrate circumstances in which money or property is a returnable amount in the sense that that expression is used in the Ruling: • a beneficiary has an unpaid present entitlement to some or all of the capital of a trust estate, or some or all of the net income of the trust estate, and the amount to which the beneficiary is entitled has been retained by the trustee and used in the gaining or producing of assessable income of the trust; and • a beneficiary lends an amount to the trustee who uses the money for income producing purposes (for example, by depositing it at interest in a bank). Paragraph 20 of TR 2005/12 provides that: 20. The primary rule is that the deductibility of interest on borrowed moneys follows the purpose and use of the money (for example, the discharging of an obligation to pay a distribution). By way of exception, when the objective purpose of the trustee in borrowing funds is to refinance money previously invested in the production of income, whether or not the interest expense is deductible is determined by the use to which the amount being refinanced was previously put. In considering the term 'returnable amount' it is clear that the trust meets the requirements of both paragraphs 5(a) and (c) of TR 2005/12. The trustee raised the trust capital from the beneficiaries of The Trust to partially fund the purchase of an investment property. The balance of the property was funded by borrowings from a bank. Whilst there is a 'returnable amount' the trust still needs to be able to show that the objective purpose of the proposed borrowings is to refinance capital previously contributed by the beneficiaries and not merely to discharge an obligation to make a distribution. In your case the money provided by the beneficiaries to The Trust was used facilitate the purchase of a property which is used in gaining or producing its assessable income. Amounts that were not distributed in financial years and retained by the trustee were also used in the gaining or producing of assessable income of the trust therefore the repayment of the current unpaid present entitlement will constitute a 'returnable amount' and any interest incurred on a loan to repay these entitlement will be deductible under section 8-1 of the ITAA 1997 as the loan will be sufficiently connected with the gaining or producing assessable income of The Trust.