Private ruling: Deduction for interest expense against interest received
Date of advice: 9 April 2019
Published: May 2019
Ruling period: 1 July 20XX to 30 June 20XX | 1 July 20XX to 30 June 20XX | 1 July 20XX to 30 June 20XX
Date scheme commenced: 1 July 20XX

Ruling: Q1: Are you entitled to claim a deduction for the interest expense against interest received? | A1: No | Q2: Are you entitled claim a deduction for interest in excess of the interest received? | A2: No

Relevant facts and circumstances: You borrowed funds from Y during the financial years ended 30 June 20XX and 30 June 20XX. You have a background in investments and stockbroking. The funds were borrowed to utilise your expertise and invest in fixed interest securities and achieve above returns of income and growth. Interest income was earned as per the investment strategy. The income was declared in your 20XX and 20XX tax returns of $X and $X respectively. Y ou reviewed the loan situation and it was agreed that interest should be paid on the loan. Calculations were prepared and were submitted to the ATO as a Voluntary Disclosure. The Commissioner accepted the voluntary disclosure. T he borrowed money was deemed to be a bona fide loan. The individual wishes to claim a tax deduction on the interest paid on the loan in relation to the fixed interest portion of the loan. The loan was repaid and interest paid on X.

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 your assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. Factors in determining the deductibility of a loss or outgoing comprising interest, require being able to show that it is incurred by the taxpayer in gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature; or necessarily incurred by the taxpayer in carrying on a business for the purpose of gaining or producing assessable income of the taxpayer and the loss or outgoing is not capital, or of a capital, private or domestic nature. 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), 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. The interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income. 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 also considers factors relevant in determining the deductibility of losses and outgoings. TR 95/33 states that 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 when determining the deductibility of the expenditure. If the outgoing produces no 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 deductible. 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. 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. The issue of failing to derive interest income was considered in Federal Commissioner of Taxation v Munro (1926) 38 CLR 153, (1926) 32 ALR 339. The principles established here were that neither the lending to the company in which Mr Munro was a shareholder, nor the financing of an acquisition of shares by his sons were regarded as sufficient to characterise the incurring of the interest as being directed to the gaining of the taxpayer's income. Although the above circumstances are different to your circumstances, the principles are relevant. There was not a sufficient connection between the interest paid in X and the interest income derived. The total interest expense that you seek to claim as a deduction is well in excess of the interest income that you wish to relate it to. There has been no reason given that would explain how it was necessary to incur this additional amount of interest expense in deriving any interest income. | Detailed Reasoning - The time when the expense was incurred: 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. The guidelines developed by the courts that help to determine if an expense has been incurred include: ● there must be a presently existing liability to pay a pecuniary sum ● presently existing liability is determined on the circumstances of the case ● an expense is incurred when actually paid if there was no presently existing liability. Taxation Ruling TR 94/26 Income tax: subsection 51(1) - meaning of incurred - implications of the High Court decision in Coles Myer Finance also provides the Tax Offices views on the meaning of incurred and states at paragraph 6 that: Whether there is a presently existing pecuniary liability is a question which must be determined in light of the particular facts of each case, and especially by reference to the terms of the contract or arrangement under which the liability is said to arise. For a loss or outgoing to be deductible under the positive limbs, it must be incurred in the income year and must also be properly referable to the income year in question to be deductible in that year. In some circumstances related to a liability, a taxpayer must be completely subjected or definitively comm itted to an outgoing for this to be deductible, even though it may not be payable until a future income year (Taxation Ruling TR 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities which considers the deductibility of interest expenses incurred prior to the commencement of income earning activities, or after income earning activities have ceased). You have borrowed money from the related entity and invested it to earn interest. You have earned interest income and declared it in your 20XX and 20XX tax returns. You decided that interest should be paid on the loan and you submitted calculations to the ATO as a voluntary disclosure. The interest expense was incurred when there was a liability to pay it or when it was paid. The interest was paid to the entity on X. As the interest expense was not incurred until more than a year after the interest income was received, it was not an outgoing related to deriving that assessable income. There had been no arrangement to pay interest when the money was borrowed. It was paid after advice from an advisor that it should be paid. The deduction is not allowable under section 8-1 of the ITAA 1997.