Private ruling: Income tax: Deductions - section 8-1 and section 25-5 of the Income Tax Assessment Act 1997
Date of advice: 22 June 2015
Published: June 2015
Ruling period: Year ended 30 June 2012 | Year ended 30 June 2013 | Year ended 30 June 2014
Date scheme commenced: The scheme has commenced.

Ruling: Q1: Is interest incurred, during the relevant years, on a loan used to pay an income tax debt in dispute deductible, either in whole or in part, under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No. | Q2: Is interest incurred, during the relevant years, on a loan used to pay an income tax debt in dispute deductible, either in whole or in part, under section 25-5(1) of the ITAA 1997? | A2: No.

Relevant facts and circumstances: In 20XX, the Commissioner issued a notice of amended assessment to the taxpayer for the year ended 30 June 200X. Between early 20XX and late 20XX, the Commissioner issued the taxpayer with notices of scheme shortfall penalty (notices of penalty). In August 20XX, the taxpayer submitted an objection to the amended assessment and notices of penalty. On dd/mm/20XX, taxpayer agreed to a 50/50 payment/deferral arrangement in accordance with Practice Statement Law Administration 2011/4. 50% of the disputed tax liability was paid in early 20YY. The amount was obtained by way of a loan. The objection was successful and the taxpayer received a full refund of the additional income tax paid and a full remission of penalties in 20ZZ. The taxpayer incurred interest expenses in relation to the loan in the relevant years. The Commissioner paid interest for overpayment to the taxpayer in 20ZZ. The interest was included as assessable income in the taxpayers' relevant income tax return. The taxpayer does not carry on businesses. It receives distributions from related trusts and incurs administration costs.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 | Subsection 8-1(1) | Paragraph 8-1(1)(a) | Subsection 8-1(2) | Section 25-5 | Subsection 25-5(1) | Subsection 25-5(2) | Paragraph 25-5(2)(c)

Reasons for decision: Summary: Subsection 8-1(1) of the ITAA 1997 provides that: 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. Subsection 8-1(2) of the ITAA 1997 limits the deduction to the extent that the loss or outgoing is of a capital, private or domestic nature. 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 (TR 95/25) outlines the implications flowing from these decisions for individuals, general law partnerships, partnerships for tax purposes only and companies. The following general principles are relevant to the question whether interest is deductible under section 8-1 of the ITAA 1997 (paragraph 3 of TR 95/25): • The interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature. • The character of interest on money borrowed is generally ascertained by reference to the objective circumstances of the use to which the borrowed funds are put by the borrower. • A tracing of the borrowed money which establishes that it has been applied to an income producing use may demonstrate the relevant connection between the interest and the income producing activity. Normally this would be the case for non-business taxpayers. • A rigid tracing of the borrowed money will not always be necessary or appropriate. • Interest on borrowed funds will not be deductible simply because it can be said to preserve assessable income producing assets. • Interest on borrowings will not continue to be deductible if the borrowed funds cease to be employed in the borrower's business or income producing activity. • The interest will not be deductible, to the extent to which it is private or domestic in nature, or is incurred in relation to the gaining or production of exempt income. Paragraph 23 of TR 95/25 provides the following: 23. In determining the deductibility of a loss or outgoing regard should be had to all the objective circumstances surrounding the incurring of the loss or outgoing and in some circumstances the subjective purpose of the taxpayer may also be relevant. Fletcher v. FC of T 91 ATC 4950; (1991) 22 ATR 613. Tests such as the purpose of the borrowing or the use and application of the borrowed funds are tools to assist in what is essentially a question of fact ( Kidston Goldmines Ltd v. FC of T 91 ATC 4538; (1991) 22 ATR 168). The use (or purpose) test is considered at paragraphs 26 and 27 of TR 95/25: 26. As Hill J stated ( Roberts and Smith ATC at 4388; ATR at 504): 'As the cases, including Kidston , all show, the characterisation of interest borrowed will generally be ascertained by reference to the objective circumstances of the use to which the borrowed funds are put. However, a rigid tracing of funds will not always be necessary as appropriate.' 27. Generally, the starting point for determining the essential character of an interest expense is to determine the 'use' to which the borrowed funds have been put, i.e., you trace the borrowed funds ( Roberts and Smith ATC at 4388; ATR at 504; Kidston Goldmines Ltd v. FC of T 91 ATC 4538 at 4546; (1991) 22 ATR 168 at 177, Hayden v. FC of T 96 ATC 4797 at 4801; (1996) 33 ATR 352 at 356). However, such tracing will not necessarily be determinative ( Roberts and Smith ATC at 4388; ATR at 504). This will be particularly so in a multi-faceted and widely owned business. As Hill J warned in Roberts and Smith (ATC at 4388; ATR at 503-504), there is a danger in substituting for the words in subsection 51(1) language which does not appear in it. Taxation Ruling IT 2582 Income Tax: Deductibility of interest incurred on moneys borrowed to pay income tax (IT 2582) considers whether interest incurred on moneys borrowed by companies to pay income tax qualifies for deduction under the general deduction provision of the Income Tax Assessment Act . Paragraph 6 of IT 2582 states in part: 6. Where a taxpayer carries on a business for the purpose of gaining or producing assessable income and, in connection with the carrying on of that business, borrows money to pay income tax (whether to preserve the assets of the business, maximise the return on them, retain sufficient money to fund the business or otherwise) then it is considered that the interest incurred on those borrowings is a normal incident of conducting that business. …. Similarly to IT 2582, ATO Interpretative Decision ATO ID 2006/269 Income Tax Deductions and Expenses: Interest incurred on moneys borrowed by a sole trader to pay income tax (ATO ID 2006/269) also considers the deductibility of interest incurred on monies borrowed to pay income tax. In this decision the individual taxpayer is allowed a deduction under section 8-1 of the ITAA 1997 as they were "carrying on a business as a sole trader". In contrast, in ATO Interpretative Decision ATO ID 2002/607 Income Tax Deductibility of interest on loan taken out to pay a tax debt (ATO ID 2002/607) the taxpayer (an individual with investment income) was denied a deduction under both section 8-1 and section 25-5 of the ITAA 1997. It was decided that the interest expense was not incurred by the taxpayer in earning their assessable income and it was specifically precluded as a deduction for tax-related expenses under paragraph 25-5(2)(c) of the ITAA 1997. The taxpayer derives its assessable income from distributions from related trusts. As the taxpayer is not carrying on a business for the purpose of gaining or producing assessable income only paragraph 8-1(1)(a) of the ITAA 1997 is relevant in respect of the interest expenses incurred on the loan used to pay their tax debt. The taxpayer stated that " In our view, t he interest expense was incurred in preserving the working capital of the taxpayer, and, at the very least, it was incurred in producing assessable interest income which was paid by the Commissioner. That is, if not for the borrowing by the taxpayer and the payment of (part of) the tax and penalties in dispute, it would not have derived interest income. " In FC of T v. Munro (1926) 38 CLR 153 the High Court considered whether interest incurred on a borrowing which was not used to produce assessable income, but was secured by an income producing asset, was deductible. The taxpayer argued that if the interest obligations were not discharged, the income producing asset that secured the borrowing would be in jeopardy. Thus, the discharge of the obligation to pay interest was incurred in producing assessable income. The High Court rejected this proposition. Further, in H ayden v. FC of T 96 ATC 4797; (1996) 33 ATR 352 the Federal Court considered whether interest incurred by an Executor on borrowings that were used to discharge an obligation of the deceased estate was deductible under subsection 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936). The fact that the borrowing of funds permitted income producing assets to remain as part of the estate so that the income stream to the estate was not diminished did not bring the interest of the borrowings within a loss or outgoing under subsection 51(1) of the ITAA 1936. In discussing whether interest expenses were deductible in producing assessable income, it was held in Ure v Federal Commissioner of Taxation 81 ATC 4100 at 4104 ( Ure ) that it: 'must be incidental and relevant to the gaining of that income …. An outgoing of interest may be incidental and relevant to the gaining of assessable income where the borrowed money is laid out for the purpose of gaining that income …. The laying out of the borrowed money for the purpose of gaining assessable income furnishes the required connection between the interest paid upon it by the taxpayer and the income derived by him from its use'. It was also held in Ure that the 'purposes for which [borrowed] money is laid out is an issue of fact, turning upon the objective circumstances which human experience would judge relevant to the issue' ( Ure 81 ATC 4100 at 4104). To determine the taxpayer's purpose: 'It is simply to take some relevant factors into account in determining the purposes for which money is laid out. Those purposes do not depend upon the state of the taxpayer's mind but upon what the taxpayer in the circumstances of the case is ascertained to have done in using and arranging for the use of the borrowed moneys' (81 ATC 4100 at 4104). The taxpayer further stated that " The taxpayer borrowed money for the purpose of paying 50% of the tax in dispute… " Based on this statement it is reasonable to conclude that the purpose of entering into the loan was to satisfy the requirements of the 50/50 arrangement entered into with the Commissioner in 20XX and not for the purpose of gaining or producing assessable income in the form of interest income or distributions from trusts. Further, at the time the loan was obtained it was not known that the objection would be determined in favour of the taxpayer and that they would receive interest for what was considered an overpayment of tax in the relevant year ended. Similar circumstances to your situation can be found in Case V48 88 ATC 380; AAT Case 4178 (1988) 19 ATR 3334. In this case, the taxpayer, a marine surveyor, claimed a deduction in the 1985 year for interest and charges on a loan which he had taken out to pay income tax for the 1982 and 1983 income years. The taxpayer paid these assessments in 1985 but lodged objections to them. As a result of the objections, amended assessments were issued reducing the taxpayer's liability. In May 1986 the Commissioner issued a cheque in favour of the taxpayer for the tax conceded to have been overpaid, together with interest under the Interest on Overpayments Act. The taxpayer claimed that the interest he paid and the loan charges incurred to pay his taxes as assessed should be deductible under section 51(1) and 67(1) of the ITAA 1936. He argued that just as interest on overpayment is brought into account as an addition in assessing taxable income, so too interest and charges paid to meet excessive assessments should be treated as deductible. The claim was disallowed. It was held that the payments were not made in gaining or producing assessable income. The payments were also not necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. Accordingly, the payments were not deductible. Therefore, the interest incurred on the loan in the relevant years is not deductible under section 8-1 of the ITAA 1997 as it has not been incurred in gaining or producing the assessable income of the taxpayer. Subsection 25-5(1) of the ITAA 1997 allows a deduction for tax-related expenses, including managing your tax affairs or complying with an obligation imposed on you by a Commonwealth law, insofar as that obligation relates to the tax affairs of an entity. However, paragraph 25-5(2)(c) of the ITAA 1997 specifically excludes from deductibility under subsection 25-5(1) of the ITAA 1997 any expenditure associated with borrowing money (including payments of interest) to pay a tax liability. Whilst the facts are not identical to yours, ATO ID 2002/607 does provide an ATO view on the deductibility of interest on a loan taken out to pay a tax debt under both section 8-1 of the ITAA 1997 and more relevantly section 25-5 of the ITAA 1997. It concluded that a deduction was not allowable under either section of the ITAA 1997. Therefore, the interest incurred on the loan in the relevant years not deductible under subsection 25-5(1) of the ITAA 1997.