Private ruling: Interest expenses after cessation of business
Date of advice: 22 November 2018
Published: April 2019
Ruling period: Year ended 30 June 2018.
Date scheme commenced: 1 July 2017.

Ruling: Q1: Can you claim a deduction for interest expenses associated with a working capital payment made by you against your other income following the liquidation of your franchise? | A1: No | Q2: Can you claim a deduction for interest expenses against your other income where you borrowed funds to fulfil the exit agreement requirements following the liquidation of your franchise? | A2: No. | Q3: Is there a maximum timeframe on the deductibility of the interest against your other income? | A3: No

Relevant facts and circumstances: You signed a Shareholders Agreement as trustee for your trust where you were made a director and a shareholder of your franchise. You also became the guarantor of the franchise’s loans. The Shareholders Agreement stipulated that the trust needed to supply working capital of $XX,XXX. You borrowed additional funds as required against your home to provide the franchise with working capital. This total amount of $XX,XXX is shown on the Financial Report as Partner Loan Accounts – You. As part of the Shareholders Agreement the trust will purchase ‘A’ Class shares in the franchise. Approximately five years after signing the Shareholders Agreement you as trustee for the trust entered into an Exit Agreement with the franchise and its head office for the following terms: ● The trust will sell the ‘A’ Class shares back to head office; ● The trust has agreed to pay 50% of the franchises bank debt to release your guarantees over the debt; ● You have agreed to pay 50% of the Service and Related Fee Debt of the franchise to head office; and ● You have agreed to resign as director and employee of the franchise. For the trust to adhere to the terms of the Exit Agreement you were required to borrow another $XXX,XXX against your home to finalise the debt and the Service and Related Fee Debt. Section 2.4 of the Exit Agreement states that: Upon the service and related debt being discharged by you, head office agrees to immediately release and indemnifies you from any claims relating to the service and related debt. The franchise did not pay any dividends to you or the trust at any time. The franchise did not make any payment to you or the trust to reduce the working capital loan provided. You were a guarantor of the franchises loans. You are not currently in a financial position to pay off the loan in a lump-sum. You are not in the business of providing guarantees.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1

Reasons for decision: Detailed Reasoning - Interest expenses: 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. 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 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 'use' test, established in the High Court case Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, (1926) 32 ALR 339 ( Munro’s case ) is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. The interest incurred will generally be deductible to the extent that the borrowed funds are used to produce assessable income. | Summary: You are not entitled to a deduction for the interest incurred on the funds borrowed and used to pay a working capital payment to the franchise. There is insufficient nexus between the interest expense and your income earning activities. | Detailed Reasoning - In your case:: You borrowed funds to pay the franchise a working capital payment as stipulated in the shareholders agreement – the initial contribution was for $XX,XXX but increased to a total of $XX,XXX. This money was borrowed against your home and is shown on the Financial Report of the franchise as Partner Loan Accounts – You. There was no formal agreement between you and the franchise which stipulated that you should receive a payment of income in the form of – dividends, interest payment or any other payment. Given you received no income from the capital payments made the interest expense associated with the borrowing of the funds in not deductible against your other income. | Summary: You are not entitled to a deduction for the interest incurred on the funds borrowed and used to pay out the franchise’s debt. There is insufficient nexus between the interest expense and your income earning activities. | Detailed Reasoning - In your case:: You borrowed funds to pay out the franchise loan. As a general rule, 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 ( Munro’s case ). For taxation purposes, the franchise is a separate entity. Interest on a new loan used to repay an existing income producing loan will generally be deductible as the character of the new loan is derived from the original borrowing. However, where separate entities are involved and the purpose of the loan changes, this principle does not apply. Although the borrowed funds of the franchise were used to produce assessable income for the business, your subsequent loan cannot be said to be used for the same purpose. The funds you borrowed have not been used to produce assessable income. Taxation Ruling TR 96/23 discusses the deductibility of payments made under guarantee. The ruling states that liabilities arising under contracts of guarantee will not be deductible under section 8-1 of the ITAA 1997 if the provision of guarantees and the losses or outgoings under the guarantees are not regular and normal incidents of the taxpayer’s income earning activities. You were guarantor for the franchises loans. You were not in the business of providing guarantees. The purpose of your loan was not to produce any assessable income for yourself but to pay out the franchise’s debt and indirectly or directly fulfil your commitment as guarantor. Your loan only came about after the franchise went into liquidation. The associated expenses therefore arose when there was no possibility of the franchise any deriving assessable income. The fact that you were guarantor for the franchise’s loan does not have a connection with your income producing activities. As the interest takes on the same character as the use of the borrowed funds, it too would be regarded as having a non-income producing character. You are therefore not entitled to a deduction under section 8-1 of the ITAA 1997 for the expenses incurred on your loan used to pay out the comp franchise any’s debt. Interest incurred following the cessation of the business You refer to Federal Commissioner of Taxation v. Brown (1999) 99 ATC 4600 ( Browns case ) and Commissioner of Taxation v. Jones (2002) 2002 ATC 4135 ( Jones case ). TR 2004/4 considers the implications of the Full Federal Court decisions in the Browns case and Jones case and whether interest deductions are allowable after the cessation of the relevant income producing activity. The Brown and Jones decisions concern the deductibility of certain interest incurred after the cessation of business. In these cases the relevant debt was incurred as part of the actual business activities of the individuals providing a relevant connection between income that was derived and the cost of servicing the debt after the business ceased. This is not the situation in your case. You were not carrying on the business, rather it was the franchise. Your interest expenses arose after the franchise went into liquidation and you borrowed money to pay out the franchise’s loan. It is therefore considered that your loan is not sufficiently connected to any prior income earning activity of yours. That is, the connection between the incurring of the interest expense and the earning of assessable income by the franchise is too remote. As your borrowed funds were not used to produce any assessable income, the principles of TR 2004/4 have no application in your case. Although the franchise previously earned assessable income and you were the director and shareholder in the franchise, however this connection is not sufficient to allow a deduction. | Detailed Reasoning - Question 3: Interest expenses incurred as a direct result of carrying on a business that has ceased has sufficient connection between that interest expense and the income earning activities of the business. Provided the borrower did not have the ability to repay the loan in a lump sum and it was not a conscious decision to extend the loan, the borrower is entitled to a deduction for the interest they incurred, that was imposed after the cessation of the franchise, in the year it is incurred. Additional information It should be noted that if you do at any stage have the capacity to repay the loan and choose not to, the Commissioner would generally consider that the nexus between the interest and the gaining of assessable income would be broken and further interest deductions would not be allowable.