Private ruling: Interest expenses
Date of advice: 7 August 2018
Published: October 2018
Ruling period: Year ending 30 June 2019
Date scheme commenced: I July 2018

Ruling: Q1: Are you entitled to a deduction for all the interest expenses incurred and debited from your principal account? | A1: No. | Q2: Are you entitled to a deduction for the portion of interest expenses incurred and debited from your principal account that relates to your income-earning share investments? | A2: Yes. | Q3: Are you entitled to a deduction for the portion of interest expenses incurred and debited from your principal account that relates to the sub-accounts and share investments of others? | A3: No.


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 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, or relate to the earning of exempt income. A number of significant court decisions have determined that for an expense to be an allowable deduction: ● it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense ( Lunney v. FC of T ; (1958) 100 CLR 478, ● there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income ( Ronpibon Tin NL v. FC of T , (1949) 78 CLR 47 ( Ronpibon’s case) , and ● it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income ( Charles Moore Co (WA) Pty Ltd v. FC of T , (1956) 95 CLR 344; FC of T v. Hatchett , 71 ATC 4184). Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that it is not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances. Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, regard must be given to all the circumstances including the purpose of the borrowing and the use to which the borrowed funds are put. If the money is borrowed for the purpose of, or applied in, producing both assessable and non-assessable income, rather than producing only assessable income, the interest expense may need to be apportioned (see Ronpibon’s case at 59; 8 ATD 431 at 437; Kidston Goldmines Ltd v. FC of T 91 ATC 4538 at 4544-46; (1991) 22 ATR 168 at 175-177). As a general rule, a loss or outgoing will not be deductible unless it is incurred in gaining or producing the assessable income of the taxpayer who incurs it ( Federal Commissioner of Taxation v Munro (1926) 38 CLR 153) (1926) 32 ALR 339 ( Munro's case ). You are a separate entity from your relations and family trust who are taxable in their own right. It is a long standing principle that a taxpayer does not satisfy section 8-1 of the ITAA 1997 merely by demonstrating some casual connection between the expenditure and the derivation of income. What must be shown is a closer and more immediate connection. The expenditure must be incurred in gaining or producing your assessable income ( Lunney’s case ). These principles have been affirmed by the High Court in Commissioner of Taxation v Payne [2001] HCA 3. Since Munro's case there have been a significant number of cases in which taxpayers have provided benefits at their own expense to other entities with which they were associated which have not satisfied the characterisation test. Taxation Ruling TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions sets out the Commissioner's views on the meaning of incurred. Generally, a taxpayer incurs an expense at the time they owe a present money debt that they cannot escape. In your case the interest expenses are being deducted from your principal account and therefore you are incurring the associated expenses. Where expenses are incurred by a taxpayer in relation to other entities assessable income, a deduction is not allowable. Such expenses do not sufficiently relate to the taxpayer’s assessable income. They more directly relate to the other entities assessable income. That is the expenses belong to the other entities and the taxpayer is paying the expenditure on their behalf. In Ure v Federal Commissioner of Taxation 81 ATC 4100 the derivation of assessable income was not the sole purpose of the loan arrangement, and a deduction was only allowed up to the amount of assessable income. In Case 26/94 94 ATC 258, a director, who borrowed money to on-lend to his family company that had no capacity to borrow in its own name, was denied a deduction for interest as the purpose of the loan was to assist the company in avoiding liquidation. The connection between the lending and the derivation of future income by the director was too remote. Although the above circumstances are different to your circumstances, the principles are relevant. Taxation Ruling TR 95/33 Income tax: subsection 51(1) - relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings considers various issues in determining the deductibility of losses and outgoings. TR 95/33 requires an examination of all the circumstances surrounding the expenditure to ensure that the interest expense could be properly characterised as genuinely, and not colourably, incurred in gaining or producing assessable income. 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 (for example, to derive exempt income or derive income for another entity or the obtaining of a tax deduction), then the outgoing must be apportioned between the pursuit of assessable income and the other objective: see Fletcher & Ors v. FC of T 91 ATC 4950; (1991) 22 ATR 613 ( Fletcher ’s c ase ). When it is necessary to apportion a loss or outgoing, the appropriate method of apportionment will depend on the facts of each case. However, the method adopted in any particular case must be both 'fair and reasonable' in all the circumstances ( Ronpibon’s case ). Income Tax Ruling IT 2167 Income Tax: rental properties - non-economic rental, holiday home, share of residence, etc. cases, family trust cases discusses arms-length arrangements with rental properties and relatives. Although your investments do not relate to rental properties, the principles in this ruling are relevant. The essential question in relation to arrangements with family members is whether the arrangements are consistent with normal commercial practices. If the arrangement is commercial, the owner of the property would be treated no differently for income tax purpose from any other owner in a comparable arms-length situation. The test that should be considered to show whether the arrangement is at arm’s length, is whether a reasonable person with no relationship to either party would enter into this arrangement using exactly the same terms and conditions. If the answer is yes, then it would be an arm’s length and commercial arrangement. Where a person lends money to a related entity or takes responsibility for their loan, a deduction for any interest or associated expense incurred will only be allowed where the arrangement is a commercial basis. There must be a reasonable expectation that the person will receive a return. Taxation Ruling TR 2000/2 Income tax: deductibility of interest on moneys drawn down under line of credit facilities and redraw facilities considers the deductibility of interest incurred by borrowers on money drawn down under line of credit facilities and loans offering redraw facilities. The ruling establishes drawing any excess or available funds from the loan is treated as a new loan. As such the purpose or use of the drawing is relevant. That is, the deductible portion of interest when further borrowings are made depends on the use to which the redrawn funds are put. Where a person uses the redrawn funds for different purposes then the loan account becomes a mixed purpose account. In a mixed purpose loan, the interest must be apportioned between the income producing and non-income producing purposes. The part of the accrued interest attributable to the funds used for private purposes is not deductible. You refer to paragraphs 6 and 12 of TR 2000/2. It is acknowledged that a line of credit facility may have a number of sub-accounts held by different borrowers and the associated interest may be deductible. However as further explained in paragraph 13 of TR 2000/2, the deductibility of accrued interest is determined by the application of the borrowed funds. It is acknowledged that the borrowed funds have been used for share investments, however in your circumstances, many of the share investments do not belong to you. Rather they belong to the sub-account holders. As you are incurring interest on behalf of the sub-account holders, the associated interest expenses do not relate to your assessable income and therefore no deduction is allowable for this portion of the interest expenses under section 8-1 of the ITAA 1997. The loan arrangement is not made on a commercial basis and it is considered that the arrangement was made for some other purpose other than to produce assessable income for you. The purpose in the arrangement cannot be seen as characterising the expenditure as incurred solely in gaining or producing your assessable income. Therefore, any deduction for the interest expenses you have incurred will need to be apportioned. You are not deriving any more assessable income from the arrangement, however you are incurring more interest expenses. As highlighted in Munro’s case , a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of an entity other than the one who incurs it. As the loan funds relate to investments belonging to you and other parties, the interest expense deduction needs to be apportioned. That is, the interest expenses for the sub accounts relate to shares that belong to other entities. The associated loan funds in the sub-accounts are not being used for the purpose of producing your assessable income. Rather they relate to income for the other entities. No deduction is allowed for this portion of the interest expenses. You are only entitled to a deduction for the portion of the interest expenses incurred that relate to your income producing share investments.

Relevant facts: You, your relations and a Family Trust all have share investments. | Your relations would like to consolidate their investments in a joint margin loan but are unable to obtain the margin loan. | As you have a higher income, entity A have advised that they can set up a margin loan with a principal account in your name and sub-accounts for your relations and the Family Trust. All funds in the loan facility relate to income producing share transactions. | You, as principal account holder will be responsible for payment of interest and costs of the principal account and sub-accounts. Interest for all margin lending accounts will be deducted from your principal account.