Private ruling: Deductibility of interest expense
Published: November 2011
Ruling period: Year ended 30 June 2012 | Year ended 30 June 2013 | Year ended 30 June 2014 | Year ended 30 June 2015
Date scheme commenced: 1 July 2011

Ruling: Q1: Is the interest expense incurred by the trustee on the borrowed funds deductible (during the period of the loan or earlier if the loan is repaid in full) pursuant to section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) on the basis that the borrowed funds are being used to repay a beneficiary an amount previously used by the trustee to fund loan repayments on borrowings which the trustee used to acquire an income producing asset? | A1: Yes

Relevant facts and circumstances: The Trust is a discretionary trust. The trustee of the trust is Company A. Person A is named as a beneficiary of the Trust. Other beneficiaries include Person A's spouse, Person A and/or their spouse's siblings, Person A and/or their spouse's children, remoter family, eligible corporations and eligible trusts. The Trust built a warehouse. The property was purchased and the warehouse constructed for a total of $XXX. The Trust financed the property purchase and warehouse construction by way of loan finance from Company B, a related party. The loan finance was $XXX and is interest bearing. The loan finance was a complying Division 7A unsecured loan. The sole shareholder of Company B is Person A. Since building the warehouse the Trust has leased the warehouse to Company B on an arm's length basis. The Trust has made annual loan repayments to Company B (comprising both principal and interest). In most years, the annual loan repayments have been partially funded by the Trust borrowing funds from Person A. The Trust proposes to repay the amount currently owing to Person A. To repay the loan currently owing to Person A, the Trust proposes to borrow from Company B in order to then repay the amount owing. The loan to be borrowed by the Trust from Company B will be documented in a section 109N complying written secured loan agreement. The term of the loan will be XX years. The term of the loan has been determined by reducing the maximum term of the loan (ie 25 years) by the number of years which have passes since the Trust first borrowed the funds from Company B in relation to the construction of the property. The loan will also be interest bearing (ie with interest being charged at the benchmark interest rate set by the Australian Taxation Office for Division 7A purposes). In addition, the loan will be secured over the property, and the unencumbered property valued will exceed 110% of the value of the loan. The Trust will repay the loan owing to Company B in accordance with the Division 7A provisions of the ITAA 1936 by making yearly minimum loan repayments comprising both principal and interest. There is no intention by the Trust to sell the property in the short term.

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 all losses or outgoings to the extent that they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed to the extent that the losses or outgoings are of a capital, private or domestic nature or are necessarily incurred in gaining or producing exempt income. In order for the interest expense to be deductible under section 8-1 of the ITAA 1997 the taxpayer must establish the essential character of the interest incurred was to gain or produce assessable income. In determining the essential character of an interest outgoing, regard must be had to its connection with the income producing activities of the taxpayer ( Federal Commissioner of Taxation v. Smith (1981) 147 CLR 578 at 586; 81 ATC 4114 at 4117; (1981) 11 ATR 538 at 542). Taxation Ruling 95/25 deals with the general principles governing deductibility of interest following the decision of the Full Federal Court in FC of T v. Roberts; FC of T v. Smith 92 ATC 4390. Paragraph 3 of this Ruling outlines various general principles relevant to the question of whether interest is deductible under ITAA 1997. Similarly, Taxation Ruling TR 2005/12 deals with what circumstances a trustee is able to claim a deduction for interest on a loan in relation to payments made to beneficiaries. Interest on a new loan will be deductible if the loan is used to repay an existing loan which, at the time of the second borrowing, was used in an assessable income producing activity or used in a business activity which is directed to the production of assessable income (Roberts and Smith ATC at 4388; ATR at 504). In this situation, Person A loaned various amounts to the trust in order to allow the trust to meet interest commitments in relation to a loan taken out for the acquisition of an income producing asset. Therefore the purpose of the loans from Person A to the trust had the essential character of being for an income producing activity. As the initial loan was for income producing purposes, the subsequent loan that is taken out to repay the initial loan also has the essential character of being for income producing purposes. Therefore, the interest incurred on the loan acquired to repay Person A will be deductible under section 8-1 of the ITAA 1997.

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