Private ruling: Deduction of loan interest - loan by the beneficiaries to the trust
Date of advice: 31 May 2019
Published: August 2019
Ruling period: Year ending 30 June 2019 | Year ending 30 June 2020 | Year ending 30 June 2021 | Year ending 30 June 2022 | Year ending 30 June 2023 | Year ending 30 June 2024
Date scheme commenced: 1 July 2018

Ruling: Q1: Will the interest expenses incurred by the Trust on the loans from the Taxpayers be fully deductible to the Trust? | A1: Yes. | Q2: Will only the loan interest physically paid by the Trust to the Taxpayers be deductible to the Trust and returned as assessable income by the Taxpayers? | A2: Yes. | Q3: Will a deduction for interest expenses incurred by the Taxpayers on the loans from the external financier be limited to the amount of assessable interest income derived by the Taxpayers from the Trust in an income year? | A3: Yes. | Q4: Will the interest expenses incurred by the Taxpayers on the loans from the external financier be deductible to the Taxpayers if no loan interest is paid to the taxpayers by the Trust in an income year? | A4: No.

Relevant facts and circumstances: The Taxpayers are beneficiaries of the Trust. The Trust borrowed funds from a bank to fund a property purchase with additional borrowed funds being contributed by each of the Taxpayers. The property was purchased for the purpose of carrying on a business. After some preliminary preparation work, the business commenced to operate from the property in early 20XX. The business is still in its early stages and is currently incurring operating losses; however, it is anticipated that it will eventually produce a profit. In order to remove the encumbrance on the property and provide greater flexibility for the operation of the business by the Trust, the Taxpayers are looking to refinance the bank loan such that all funding relating to the property will be sourced from each of the Taxpayers. The Taxpayers intend to borrow funds in equal proportions from an external financier which will be on-lent to the Trust so it can repay the bank loan. The loans to the Taxpayers from the external financier will have a finite loan term, interest charged at commercial rates and interest payments will be due for payment likely on a monthly basis. The Trust and the Taxpayers will enter into a loan agreement which will have a term in excess of five years with interest being charged at commercial rates; however, the amount of interest payable by the Trust to the Taxpayers will be limited to what the Trust can actually afford to pay. That is, the payment of loan interest will be dependent on the net profit of the Trust and will be capped at a rate equivalent to prevailing commercial rates. This means that in an income year in which the Trust suffers a tax loss, the interest payable will be nil. In an income year in which the Trust derives positive net income that is less than interest calculated at commercial rates, the interest payment will equal the amount of Trust net income. In an income year in which the net income of the Trust exceeds the amount of loan interest calculated at commercial rates, the interest payable will be based on the prevailing commercial rate.

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

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows you a deduction for any loss or outgoing that is incurred in gaining or producing your assessable income, to the extent that it is not of a private, capital or domestic nature. Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. There must be a sufficient connection between the interest expense and the activities which produce assessable income to claim a deduction. To determine whether the associated interest expenses are deductible, it is necessary to examine the purpose of the borrowing and the use to which the borrowed funds are put. The 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. Accordingly, it follows that if a loan is used for business or investment purposes from which income is to be derived, the interest expense incurred on the loan will be deductible. Further, interest on a new loan, borrowed by the same entity, used to repay an existing business or investment loan will generally also be deductible as the character of the new loan is derived from the original borrowing. That is, when a loan is refinanced, the new loan takes on the same character as the previous loan. Refinancing a loan does not in itself break the nexus between the outgoings of interest under a loan and the income earning activities. | Detailed Reasoning - Interest incurred prior to the derivation of assessable income: It is not necessary that interest expense incurred should produce assessable income in the same year in which the interest expense is incurred. Taxation Ruling TR 2004/4, in considering the decision of the High Court in Steele v. Deputy Commissioner of Taxation (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139, concludes that interest incurred in a period prior to the derivation of relevant assessable income will be incurred in gaining or producing the assessable income where: · the interest is not incurred 'too soon', is not preliminary to the income earning activities and is not a prelude to those activities; · the interest is not private or domestic; · the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost; · the interest is incurred with one end in view, the gaining or producing of assessable income; and · continuing efforts are undertaken in pursuit of that end. | Detailed Reasoning - Apportionment: Where expenditure has both an income-producing purpose and a non-income-producing purpose, the expense must be apportioned on a fair and reasonable basis ( Ronpibon Tin NL & Tongkah Compound NL v. FCT (1949) 78 CLR 47). Taxation Ruling TR 95/33 discusses the relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings. Apportionment of an expense may be required in situations where there is a disproportion between the expenditure and the assessable income and the disproportion is explained by a motive other than the gaining or producing of assessable income. If an outgoing produces an amount of assessable income greater than the amount of the outgoing, there would normally be no need to examine the taxpayer's motives and intentions in characterising the outgoing as being deductible. However, if the outgoing does not produce any assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is wholly deductible. This may, depending on the circumstances of the particular case, include an examination of the taxpayer's subjective purpose, motive or intention in making the outgoing. If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective, then the outgoing must be apportioned between the pursuit of assessable income and the other objective. Other objectives may include the manufacturing of a tax deduction or where the expenditure is of a private or domestic nature ( Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 ( Fletcher ); Ure v. FCT (1981) 11 ATR 484; 81 ATC 4100 ( Ure )). In the Fletcher and Ure cases, the interest deductions allowed were limited to the amount of assessable income derived by the taxpayers in the particular income year. Related to the above, Taxation Determination TD 2018/9 explains that a beneficiary of a discretionary trust who borrows money, and on-lends all or part of that money to the trustee of the discretionary trust interest-free, is usually not entitled to a deduction for any interest expenditure incurred by the beneficiary in relation to the borrowed money on-lent to the trustee. It is only where: a) the beneficiary is presently entitled to income of the trust estate at the time the expense is incurred, and b) the expense has a nexus with the income to which the beneficiary is presently entitled that some part of the interest expense might be deductible. Even then, the interest expense is likely to have been incurred in the pursuit of one or more objectives other than the derivation of assessable income by the beneficiary and will not be deductible to the extent of any non-income producing objective. | Detailed Reasoning - Deductibility of interest expenses incurred by the Trust on the refinanced loan: In the current case, the Trust borrowed funds from a financier to assist in establishing a business and the Taxpayers now intend to refinance this loan themselves so the Trust can repay the loan from the financier. Consequently, it is considered that the refinancing of the loan to the Trust by the Taxpayers will not break the nexus between the outgoings of interest under the loan and the income earning activities. Therefore, the interest expenses incurred by the Trust on the loans from the Taxpayers will be deductible when the interest is physically paid. | Detailed Reasoning - Deductibility of interest expenses incurred by the Taxpayers on the new loans: In the current case, the Taxpayers will refinance the bank loan to the Trust by borrowing funds from an external financier which will be on-lent to the Trust so it can repay the bank loan. The Taxpayers will be incurring regular interest expenses on their respective loans; however, the Trust will only be making loan interest payments to the Taxpayers when it can afford to do so. Consequently, as the amount of interest income derived by the Taxpayers from the Trust may be less than the interest expenses they incur on their borrowings, the motives of the Taxpayers in refinancing the loan must be considered. In this case, the reason given for the proposed refinancing of the bank loan to the Trust is to remove the encumbrance to the bank on the property and provide greater flexibility for the operation of the business by the Trust. Although this reason may assist the Trust in operating its business, it is not related to the earning of interest income by the Taxpayers as under the proposed loan agreement they will be agreeing to forego interest income if the Trust is unable to make the payments. An arrangement such as this can be distinguished from a commercial loan arrangement between arm's length parties. Consequently, it is considered that one of the objectives of the loan refinancing relates to a private arrangement between the Trust and the beneficiaries of the Trust Therefore, the Taxpayers will only be able to deduct so much of the loan interest expenses they incur that is no more than the amount of the interest income received from the Trust in any given year of income.