Private ruling: Interest deduction - Shareholder loans and third party loans
Date of advice: 27 April 2016
Published: June 2016
Ruling period: Year ending 30 June 2015 | Year ending 30 June 2016 | Year ending 30 June 2017 | Year ending 30 June 2018 | Year ending 30 June 2019 | Year ending 30 June 2020
Date scheme commenced: 1 July 2014

Ruling: Q1: Is the entity entitled to a deduction for 100% of the interest expenses under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in relation to the interest incurred on third party loans as a result of investment in and funding of the company and for the payment of income tax? | A1: Yes. | Q2: Is the entity entitled to a deduction for 100% of the interest expenses under section 8-1 of the ITAA 1997 in relation to the interest incurred on shareholder loans as a result of investment in and funding of the company? | A2: Yes.

Relevant facts and circumstances: The entity is an Australian Incorporated and resident company. The entity has unrelated shareholders who each hold an equal portion of the equity of the entity. During the 20XX financial year the entity acquired an interest in the company. A total number of shares were acquired in the company through a subscription for new shares at $X per share. The shares acquired represent approximately XX% of the total share capital of the company. Other unrelated parties acquired shares in the company on the same basis at this time. The company was incorporated to take on and lease a precinct, and to establish a business and a number of hospitality businesses and to sub-lease an number of commercial tenancies, all of which are situated in the precinct. The investments in the company were made pursuant to a number of agreements that were entered in to by the shareholders of the company including: 1. Subscription Agreement; 2. Shareholders Agreement (SA); and 3. Shareholder Loan Agreement The business of the company has been carefully considered in its establishment. It is governed by detailed plans and budgets which have been agreed by the shareholders. This is a long term undertaking of the company to establish a substantial hotel, hospitality and ancillary business. Under the SA, it has been agreed by all shareholders that they will fund any working capital requirement of the company, in excess of the initial subscription price, by an interest free loan to the company in proportion to their equity interests. The company shareholders agreed that funds would be lent by shareholders to the company interest free so as to enable an acceleration of profitability of the company. Detailed modelling of the operations determined that the company will be profitable some six years earlier without any interest burden. As a result of accelerated profitability, the company anticipates that it would be able to pay dividends to shareholders earlier than if it had an interest expense burden. As such, in addition to its initial equity subscription, the entity provided an interest free loan to the company (Initial Loan Funding). The total fund provided by the entity, to the company, at this stage, was over $5 million. At the end of 20XX, the company determined that it would require additional working capital and pursuant to the SA made a call on all shareholders to provide additional interest free loan funding in proportion to their equity interests. For the entity this required it to provide additional funds to the company as an interest free loan (Follow on Loan Funding). In order to fund its initial investment in the company, and its subsequent loans to the company, the entity was required to borrow funds. Initially the entity's shareholders provided an interest free advance to the entity. The entity subsequently borrowed from an unrelated third party on normal arms-length terms including the requirement to pay interest on the outstanding balance (3 rd Party Loan) The initial cash flows may be summarised as follows: The 3 rd Party Loan facility specifically deals with the approved uses of the funds borrowed and in the case of the initial advance this could only be used for the entity for: 1. Subscription for shares in the company; and 2. A shareholder loan to the company The 3 rd Party Loan Facility contemplates regular repayments of the monies payable to the lender, including the advance, and interest. The 3 rd Party Loan Facility also allows the entity to request further drawdowns of the advance to enable the entity to pay its Income Tax liabilities. In order to provide the Follow On Loan Funding, the entity borrowed $XXX,XXX from its shareholders or their associates on a proportionate basis (the Shareholder Loans). The funds were borrowed on normal commercial terms and the respective loans required payments of interest to the lenders. In accordance with the SA the entity on-lent those funds to the company on an interest free basis. As a consequence of the above, the entity has incurred interest expense in relation to the 3 rd Party Loan facility and Shareholder Loans enable it to: 1. Fund its original investment into the company; 2. To provide interest free loan funding to the company pursuant to its obligations under the SA; and 3. Make Income tax payments In addition to its investment in the company, the entity provides services, which generates assessable income. It is expected that the entity will generate net assessable income and be taxable each year.

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. The entity has borrowed interest bearing funds for three main purposes: 1. To subscribe for shares in the company; and 2. To provide loan funding to company ; 3. To facilitate general working capital and make payments of any tax obligations. The objective of the company in investing in the company is to derive dividends in the future and on an ongoing basis. There is a sufficient nexus between the interest expense incurred in gaining or producing assessable income from the dividends from the company. It is clearly the intent of the entity to receive dividend income as a result of their investment. The objective for entity in providing further interest free funding to the company is to accelerate the generation of profits and therefore accelerate the payment of dividends to the entity. Taxation Ruling IT 2606 clarified that in circumstances where no income is derived directly by the taxpayer from the transaction, to which the interest expense relates, and there is no obvious connection with the carrying on of a business or other income earning activity of the taxpayer, then the taxpayer's purpose may be relevant to the characterisation of the expenditure. The ruling provides guidance as to how the principles concerning interest deductibility are applied as a result of the decision of the Full Federal Court in Federal Commissioner of Taxation v. Total Holdings (Australia) Pty Ltd (1979) 79 ATC 4279; 9 ATR 885 ( Total Holdings) . The Commissioner advises that whether a deduction is allowable for interest relating to interest free on lending and share acquisitions in particular cases will depend on the facts of individual cases. The relevant principles are located in paragraph 20 of the ruling and are summarised below: | Detailed Reasoning - 20: (a) Before there can be a deduction, it must be shown that there is a connection between the incurring of the interest and either - (i) the activities of the company which do, or are expected to, produce assessable income; or (ii) the business of the company, being a business carried on for the purpose of earning assessable income. (b) Where the connection between the interest expense and the production of assessable income is clear by reference to the objective facts, the expense will be deductible without any need to have regard to the company's purpose (Fletcher at ATC 4565). (c) If, however, no income is derived by the company from the transaction to which the interest expense relates, and there is no obvious connection with the carrying on of a business to gain or produce assessable income, then the company's purpose, though not determinative of deductibility, may be relevant to the characterisation of the expenditure i.e. to the determination of whether it has the requisite connection to the company's income-producing or business activities (John's case; Fletcher's case). (d) In the process of characterisation all the relevant circumstances must be weighed, and where purpose becomes relevant this will encompass the direct and indirect objects and advantages which the company sought in making the outgoing. (e) Factors to be considered in determining the essential character of the interest expense include the actual use to which the borrowed moneys were put and the connection between that use and the activities by which the company usually produces assessable income. In this case, the third party loans were obtained for the purposes of making an investment in the company. The company is an undertaking for the development of a retail and accommodation precinct. The development is expected to generate a significant income over time and expects to pay dividends as soon as possible. The provision of loans to the company on an interest free basis is expected to expedite the payment of dividends to the entity. The provision of follow on loan funding is a requirement for shareholders under the Shareholders Agreement. The funds will contribute to the working capital of the company to enable it to meet its development objectives. The shareholder loans were obtained for the purpose of enabling the entity to provide the follow on loan funding to the company. Based on this, the purpose in you lending the money to the entity can be seen as expenditure incurred in gaining or producing your assessable income. There is a sufficient nexus between your interest outgoing and the derivation of your assessable income. As the loan was made on a commercial basis, and there is the expectation of dividends in the future, a deduction is allowed for the interest expense on the loan monies on-lent to the company under section 8-1 of the ITAA 1997. Taxation Ruling IT 2582 states that 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. That is, such an expense is an expense incurred in carrying on that business and hence qualifies for a deduction.