Private ruling: Income Tax - Deductions - interest expense
Published: February 2014
Ruling period: Year ending 30 June 2014 | Year ending 30 June 2015
Date scheme commenced: 1 January 2014

Ruling: Q1: Is the interest incurred on funds borrowed by the trust to fund a capital distribution to its unit holders deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes

Relevant facts and circumstances: The trust is a unit trust. The trust has issued fully paid units to unit holders to raise trust capital. The trust also borrowed from a commercial bank. The trust used the trust capital and the bank finance to acquire the property. The loan has subsequently increased at 30 June 2013 to fund further capital expenditure to the property owned by the trust. The property is an office building. The trust rents the building to various tenants and the net income is distributed to the unit holders quarterly. The trustee is proposing to make a capital distribution to unit holders. The trustee proposes to return some of the original trust capital invested by the unit holders by declaring a capital distribution under the Deed. The capital distribution will be made pro-rata to unit holders according to the number of units held at the distribution date. Upon the proposed return of capital there will be no change to the number of units as there will be no redemption or cancellation of units. The return of capital will reduce the value of the units held by each unit holder. In order to fund the payment of the unit holders' capital distribution entitlement the trust will borrow a similar amount from the bank and pay the cash to the unit holders in full satisfaction of their capital distribution entitlement. The proposed capital return will be made solely in relation to the initial trust capital contributed by the unit holders. This will be evidenced by the fact that the proposed return of capital is less than the initial trust capital contributed and it will be accounted for in the financial statements of the trust by being debited solely to the unit holders' funds account. To the extent that the property has increased in value any such unrealised revaluation gain is accounted for separately to the unit holders' capital funds in an account described in the financial statements as the "Accumulated profits attributable to unit holders". As mentioned above, no amount will be debited to this account as part of this return of capital.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1936 section 95

Reasons for decision: Summary: The interest incurred on funds borrowed by the trust to fund a capital distribution to its unit holders will be deductible under section 8-1 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Subsection 8-1(1) of the ITAA 1997 provides: 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. Section 95 of the Income Tax Assessment Act 1936 (ITAA 1936) defines the net income of a trust estate to mean the total assessable income of the trust estate calculated under the ITAA 1936 as if the trustee were a taxpayer in respect of the income and were a resident, less all allowable deductions (subject to certain exceptions). The interest expense incurred by a trustee of a trust estate in respect of borrowed funds must be sufficiently connected with the assessable income earning activity, or business, carried on by the trustee as trustee of the trust estate, to result in the interest expense being deductible. The interest expenses will be sufficiently connected if the purpose of the trustee in borrowing funds, when viewed objectively, is to refinance a 'returnable amount'. The term 'returnable amount' is defined in paragraph 5 of Taxation Ruling TR 2005/12 Income tax: deductibility of interest expenses incurred by trustees on funds borrowed in connection with the payment of distributions to beneficiaries (TR 2005/12). It is used to refer to money or property forming part of the trust estate that: (a) is employed by the trustee in gaining or producing the assessable income of the trust estate, or in carrying on business for that purpose; and that (b) a beneficiary of the trust estate is entitled to require to be returned to that beneficiary; and that (c) is or represents money or property that was previously transferred by the beneficiary (or another person on the beneficiary's behalf) to the trustee of the trust estate, including money or property previously retained by the trustee out of funds to which the beneficiary was presently entitled. Paragraph 9 of TR 2005/12 provides some factual situations that illustrate circumstances in which money or property is a returnable amount in the sense that that expression is used in the Ruling: · an individual has subscribed money for units in a unit trust and has a right of redemption in relation to the units, and the money is used by the trustee to purchase income producing assets; · a beneficiary has an unpaid present entitlement to some or all of the capital of a trust estate, or some or all of the net income of the trust estate, and the amount to which the beneficiary is entitled has been retained by the trustee and used in the gaining or producing of assessable income of the trust; and · a beneficiary lends an amount to the trustee who uses the money for income producing purposes (for example, by depositing it at interest in a bank). Paragraph 20 of TR 2005/12 provides that: 20. The primary rule is that the deductibility of interest on borrowed moneys follows the purpose and use of the money (for example, the discharging of an obligation to pay a distribution). By way of exception, when the objective purpose of the trustee in borrowing funds is to refinance money previously invested in the production of income, whether or not the interest expense is deductible is determined by the use to which the amount being refinanced was previously put. The trustee proposes to make a distribution of capital to the unit holders under the terms of the Deed. The Deed allows the trustee to make this distribution. The proposed distribution would be funded by borrowing from a bank. The amount would be debited against the "Unit holders' funds" account. The distribution would result in the value of each unit being reduced. In considering the term 'returnable amount' it is clear that the trust meets the requirements of both paragraphs 5(a) and (c) of TR 2005/12. The trustee raised the trust capital from the issue of units in the trust to partially fund the purchase of an investment property. The balance of the property was funded by borrowings from a bank. The property is used by the trust in gaining or producing its assessable income, or in carrying on business for that purpose. It is the requirement of paragraph 5(b) that needs further consideration. Does the unit holder have an amount they are entitled to require to be returned? The trustee has the discretion to distribute any amount of capital to the unit holders under the terms of the Deed. However, it is not until this discretion is exercised that the unit holders then become entitled to the distribution. It is at this point that a returnable amount comes into existence and the condition in paragraph 5(b) is satisfied. Whilst there is a 'returnable amount' the trust still needs to be able to show that the objective purpose of the proposed borrowings is to refinance capital previously contributed by the unit holders and not merely to discharge an obligation to make a distribution. Paragraph 21 of TR 2005/12 provides that: 21. It will not always be a simple matter to determine which of the two possible outcomes (deductible /non-deductible) arises in any particular case. Ultimately this question can only be answered by determining the objective purpose of the trustee in borrowing the funds. To the extent that the objective purpose of the trustee was to replace an amount that had previously been provided to the trustee by, or on behalf of, a beneficiary of the trust estate, and had previously been used in an assessable income earning activity, or business, carried on by the trustee in the relevant capacity, then the principle set out in Roberts & Smith will apply. On the other hand, where the borrowing is simply to discharge an obligation to pay a monetary distribution to a beneficiary, then it is likely that interest incurred on the borrowing will not be deductible. Hayden's case is illustrative of this proposition. In this particular case the trustee proposes to use the borrowed funds to return capital to the unit holders on a pro rata basis and debit the amount against the "Unit holders' funds" account resulting in a reduction in the value of each unit. The amount proposed to be refinanced was money originally raised by the trust to enable the purchase of the trust property. Therefore, as there is a 'returnable amount' and the sole objective of the trust in borrowing funds is to refinance this amount, the interest expense incurred on the funds borrowed to fund the capital distribution would be deductible.