Private ruling: Deductible Interest Expenses
Published: August 2013
Ruling period: Income year ending 30 June 2014 to Income year ending 30 June 2024
Date scheme commenced: Income year ending 30 June 2014

Ruling: Q1: Is the taxpayer entitled to a deduction for interest expenses incurred on funds borrowed where the principal loan amount is on-lent to a trust under section 8-1 of the Income Tax Assessment Act (ITAA 1997)? | A1: Yes.

Relevant facts and circumstances: The taxpayer is proposing to: · establish a trust (the trust); · borrow funds from an external lender (external loan), at arm's length; and · advance the full amount of the external loan to the trustee of the trust as a loan under the arrangement described in the loan Agreement and the trust deed. The loan to the trustee will be interest free. The trustee will use the funds advanced to acquire an investment. The investment will be a long term investment. The trust deed defines the taxpayer as a primary beneficiary. The secondary beneficiary is related to the taxpayer. The loan agreement between the primary beneficiary and the borrower referred to in the trust deed states that the beneficiary has agreed to lend the borrower an amount equal to the trust loan and has borrowed an amount from the external lender to enable it to make the trust loan In consideration for making the loan to the trust, the primary beneficiary will become absolutely entitled to the lesser of: · The distribution amount; or · The total of the net Income for that year. The distribution amount is defined as the distribution amount in each financial year being the amount equal to the interest payable on the external loan in that financial year plus the margin (if any) provided that, if the priority distribution for a financial year is less than the distribution amount for that financial year, the shortfall will be added to and form part of the distribution amount for the following financial year. The priority distribution is defined as the amount the primary beneficiary must receive pursuant to the trust deed. Net Income is defined in the trust deed and means the amount determined in accordance with section 95 of the Income Tax Assessment Act 1936 excluding any notional amounts. The secondary beneficiaries are absolutely entitled to the balance of the net Income for each year as tenants in common in equal shares. Any beneficiary who is absolutely entitled to a portion of the net income has an indefeasible vested interest in that amount of the net Income and will be presently entitled to it as at 30 June in the relevant year. Pursuant to the trust deed the trustee may at any time up to and including the perpetuity date distribute the whole or any part of the fund to the secondary beneficiaries. However, this is subject to other parts of the trust deed. Pursuant to the trust deed the trustee may not make a distribution while any loan or distribution amount remains unpaid. Pursuant to the trust deed if the trustee enters into a loan agreement with the primary beneficiary the trustee cannot enter into (or attempt to enter into) another loan unless the first loan (and all distribution amounts in respect of that loan) have been repaid in full. Under the trust deed the trustee must not exercise their power with respect to the amendment or variation of any of the provisions of the trust deed in a way that affects the entitlement of the beneficiaries including the clauses of the trust deed dealing with the determination and distribution of income if there is a loan owing or any unpaid distribution amount.

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

Reasons for decision: Summary: Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing to the extent that it is incurred in gaining or producing assessable income or it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Section 8-1 of the ITAA 1997 states: (1) You can deduct from your assessable income any loss or outgoing to the extent that: · it is incurred in gaining or producing your assessable income; or · it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. (2) However, you cannot deduct a loss or outgoing under this section to the extent that: (a) it is a loss or outgoing of capital, or of a capital nature; or (b) it is a loss or outgoing of a private or domestic nature;… Interest is deductible if it satisfies the requirements in section 8-1 of the ITAA 1997. Whether interest has been incurred in gaining or producing assessable income depends on how the loan on which the interest is paid has been used. If borrowed money is laid out for the purpose of gaining assessable income then the interest on the borrowed money will be incidental and relevant to the gaining of that income (FC of T v Munro (1926) 38 CLR 153 at 170). The laying out of the borrowed money for the purpose of gaining assessable income furnishes the required connection between the interest payment upon it by the taxpayer and the income derived by them for its use. In FC of T v Smith 81 ATC 4114 Gibbs C.J. Stephen, Mason and Wilson JJ , in referring to the requirement that the expenditure be incidental and relevant to the operations or activities regularly carried on for the production of income said, at p4117 that: What is incidental and relevant in the sense mentioned falls to be determined not by reference to the certainty or likelihood of the outgoing resulting in the generation of income but to its nature and character, and generally to its connection with the operations which more directly gain or produce the assessable income. The taxpayer proposes to borrow money from an external lender which the taxpayer will on-lend interest free to the trustee of a trust. The taxpayer will expect to receive income from the trust by way of a distribution amount equal to the interest payable by the taxpayer on the external loan plus a margin. Therefore, the interest payable on the external loan is incidental and relevant to the gaining of assessable income from the trust. The interest outgoing has a connection with the gaining or production of assessable income. The fundamental test on the deductibility of an outgoing under section 51 of the Income Tax Assessment Act 1936 (ITAA 1936) (now section 8-1 of the ITAA 1997) and which was applied by the High Court in Ronpibon Tin NL & Tongkah Compound NL v FC of T (1949) 78 CLR 47 was expressed (at pp 56-57) as follows: For expenditure to form an allowable deduction as an outgoing incurred in gaining or producing assessable income it must be incidental and relevant to that end. The words 'incurred in gaining or producing the assessable income 'mean in the course of gaining or producing such income. Their operation has been explained in cases decided under the previous enactments: see particularly Amalgamated Zinc (de Bavay's) Ltd v Federal Commissioner of Taxation (1936) 54 C.L.R. 295, 303-304, 307, 309-310; 3 A.T.D. 288, and W. Neville & Co. Ltd. v Federal Commissioner of Taxation (1937 ) 56 C.L.R. 290, 300-301, 305-306, 308; A.T.D. 187. Notwithstanding the differences in other respects in the present provision, the expression 'incurred in gaining or producing the assessable income' has been left unchanged and bears the same meaning. In brief substance, to come within the initial part of the subsection it is both sufficient and necessary that the occasion of the loss or outgoing should be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income. In these circumstances, the taxpayer expects to receive assessable income from the trust but it is not certain whether any assessable income will, in fact, be derived from the trust or that any distribution can be made when the interest outgoing is incurred. However, the purpose of the investment is to derive assessable income and it is the taxpayer's intention and expectation that the taxpayer will receive assessable income and the investment has been structured so as to allow any income to be distributed to the taxpayer if it comes in. Provided there is a nexus between the expenditure or outgoing and the production of assessable income or activities productive of assessable income a taxpayer will not be precluded from being entitled to a deduction for the expenditure or outgoing even if no assessable income is derived. The decision of the High Court in Steele v DCT (1999) 41 ATR 139 affirms the principle that interest incurred before any assessable income is derived is deductible, provided there is sufficient nexus between the payment of interest and the earning of any potential future income. Further, in FC of T v Total Holdings (Aust) Pty Ltd 79 ATC 4279 Lockhart J said at p 4283: The circumstance that each item of expenditure cannot be traced to a particular item of income does not prevent the deduction of the expenditure. The decision of the Full Federal Court in Crawford v FC of T 93 ATC 5234 (Crawford) supports the deductibility of interest in similar circumstances to your arrangement. His Honour Hill J said at 5241: Where moneys are borrowed and on lent at a rate of interest no less than that incurred on the borrowing, it will ordinarily be the case that this objective circumstance without more will serve to characterise the outgoing as incurred in gaining or producing assessable income, even where no assessable income is in fact derived in the year of income. This process of characterisation would necessarily assume that the agreement to pay interest on the funds on lent was a real and not a sham agreement. His Honour Hill J said (at p5242): Absent any suggestion that the loan transaction between Dr Crawford and Kymmead was a sham, the very existence of the loan agreement between them, with its attendant interest obligation, provided material from which purpose could be inferred. There was, however, in the present case more evidence than this. The decision suggests that in the absence of any argument as to sham, where moneys are on-lent under an arrangement where the return to the lender will not be less than the interest incurred, the interest outgoing should be deductible and even though no assessable income may be derived in the particular year in which the deduction is claimed, or the relevant income may be less than the amount of the deduction. In the taxpayer's situation, the taxpayer will on-lend the borrowed money to the trustee of a trust interest free. But the terms of the loan agreement require the trustee to distribute an amount equal to the interest the taxpayer incurs on the external loan plus a margin. Therefore, the taxpayer expects to receive an amount in excess of the interest the taxpayer will pay on the external loan. The fact that the taxpayer on-lends money at a lower rate of interest does not necessarily mean that the liability to pay interest is not incurred wholly in earning assessable income. Their Honours Deane and Sheppard JJ in FC of T v Ure 81 ATC 4100 at 4108 recognised that the taxpayer may expect or hope that the re-lending will lead to assessable income in another form being derived or preserved, for example, as dividends on shares held in the company to which the money is lent at a favourable rate. In the taxpayer's circumstances, even though the trustee or borrower will not incur any interest on the loan the taxpayer expects to receive an amount in excess of the interest incurred on the external loan. The interest incurred on the external loan is therefore characterised as an outgoing incurred in gaining or producing assessable income. His Honour Hill J in referring to the purpose for the expenditure or outgoing referred to the decision of the Full High Court in Fletcher v FC of T 91 ATC 4950 (Fletcher) and said at pp 5240 and 5241): As that and other cases make clear, the question of whether an outgoing is deductible requires there to be identified the essential character of that outgoing. In the process of characterisation, the end which a taxpayer subjectively has in view in incurring an outgoing may, as the High Court points out, constitute an element and possibly the decisive element in the process of characterisation. However, as the Court in that decision also pointed out, the process of characterisation will commonly proceed without reference to the subjective thought processes of the taxpayer. In the normal case the objective relationship between an outgoing and assessable income earned will, without more, suffice to characterise the outgoing as one incurred in gaining or producing assessable income. In the present case, had interest in fact been derived in the years of income in question, there is no doubt that that interest would have been assessable income and the relationship between outgoings incurred in that year and the assessable income derived, would have been self-evident. Even where no income at all is derived the objective circumstances may serve to characterise an outgoing for interest as having been incurred in gaining or producing assessable income. However, as the High Court pointed out in Fletcher, cases where no assessable income is derived, or assessable income less than an outgoing is derived, may require a closer examination of all the relevant circumstances in determining the question of characterisation. The High Court in Fletcher said (at 4958): It is a "commonsense" or "practical" weighing of all the factors which must provide the ultimate answer. If, upon consideration of all those factors, it appears that, notwithstanding the disproportion between outgoing and income, the whole outgoing is properly to be characterised as genuinely and not colourably incurred in gaining or producing assessable income, the entire outgoing will fall within the first limb of s.51(1) unless it is either somehow excluded by the exception of "outgoings of capital or of a capital private or domestic nature" or incurred in relation to the gaining or production of exempt income". His Honour Hill J in Crawford said (at 5241 and 5242): One explanation for the need to look no further in the ordinary case will be that even if subjective purpose were relevant it could be inferred from the objective circumstance that the loan made with the borrowed funds was at a rate of interest at least equal to the interest incurred that the taxpayer's subjective purpose was to gain assessable income. | Detailed Reasoning - The relevant clauses of the Trust Deed and the Loan Agreement: The taxpayer's purpose of making the loan is to on-lend it to the trust and to receive assessable income from the trust. The loan agreement and the trust deed provide the circumstances from which the taxpayer's subjective purpose can be inferred, as per His Honour Justice Hill's comment in Crawford (supra). Consequently, the interest outgoing is relevant and incidental to gaining or producing assessable income from the trust and is wholly deductible under section 8-1 of the ITAA 1997, notwithstanding that the assessable income cannot be determined before it comes in.