Private ruling: Deductibility of interest in relation to money on-lent to a trust, commercial debt forgiveness and capital losses
Date of advice: 29 July 2016
Published: September 2016
Ruling period: Year ended 30 June 2015 | Year ended 30 June 2016 | Year ending 30 June 2017 | Year ending 30 June 2018
Date scheme commenced: 1 July 2008

Ruling: Q1: Are you entitled to a tax deduction of interest on the Line of credit facility in the 2014/15 income year and future years until the loan is repaid? | A1: No | Q2: Can you claim a capital loss for the amount of debt forgiven to the trust in relation to the loan? | A2: Yes, provided the forgiveness is contained in a deed or contract which is binding in law.

Relevant facts and circumstances: The family trust acquired a business. You have provided a copy of the Trust Deed and Explanatory Memorandum for the Hybrid Family Unit Trust. The Family Trust, a hybrid family unit trust has XX ordinary units owned equally by you and your spouse. You borrowed funds from a bank for the purchase of the franchise and this was shown in the financials of the Family Trust as a loan from you. There are no written loan agreements, between you and the Family Trust. You continued to contribute additional funds for working capital increasing the loan. You have verified that the loan amount has been used solely for business purposes by the Family Trust. The Family Trust met all the loan repayment responsibilities of this loan until the business ceased operation. You were unable to fund the capital required to continue the business. No payments were received for the business at time of cessation. The interest on the bank loan was paid and included in the expenses of the Family Trust. In some years the Family Trust paid you the interest on the same terms as the bank loan. You have continued to make repayments on the outstanding loan which has not been refinanced or used for any other purpose since the business closed.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Section 102-20 | Income Tax Assessment Act 1997 Section 104-25 | Income Tax Assessment Act 1997 Subsection 104-25(3) | Income Tax Assessment Act 1997 Section 108-5 Anti-avoidance rules | No

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, or relate to the earning of exempt income. 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 ( Ronpibon's case) , 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 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 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. However, 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. Income Tax Ruling IT 2385 discusses the deductibility of expenses incurred by beneficiaries of discretionary trusts. As highlighted in IT 2385, a beneficiary of a discretionary trust is not entitled to a deduction against their trust distribution income as the expenditure is not incurred in gaining or producing their assessable income. There is not a sufficient nexus between the expenditure incurred and the receipt of income. A beneficiary has a mere expectancy of receiving income from the trust. You have borrowed money from the bank and on-lent this money to the Hybrid Family Unit Trust to acquire the franchise and provide working capital for the conducting of the business. The Family Trust has previously paid you interest in relation to the loan or paid the interest directly to the bank. Where you have received the payments, you have declared this interest income in your tax return and claimed a deduction for the equivalent amount of interest you paid to the bank, because the interest expense was incurred in deriving that assessable income. The deduction was allowable under section 8-1 of the ITAA 1997. You were not in the business of lending money. You had not gone guarantor for the Family Trust on this loan from the bank. The Family Trust has stopped carrying on the franchise business and conducts no other business activity. You intend to forgive the debt owed to you by the Family Trust, therefore will not receive any more interest payments in relation to the money that was on lent to the Family Trust. The business was conducted by the Family Trust which was a Hybrid Family Unit Trust (HYFU Trust). The Family Trust could claim a deduction for the interest paid to you or the bank because it was an expense incurred in carrying on its franchise business and was therefore deductible under section 8-1 of the ITAA 1997. The nature of a HYFU Trust is that it is a flexible trust that combines the advantages of the Unit Trust and the Discretionary Trust. The HYFU Trust provides for the allotment of two types of units, Ordinary Units - similar to those units offered under a standard unit trust; and Special Units. It also provides for the appointment of Discretionary Beneficiaries in the same manner as a Discretionary Trust. The Discretionary Beneficiaries do not have to hold Units to receive a distribution of income or capital from the Trust. Schedule 1 of the Trust Deed shows that there are two initial unit holders being yourself and your spouse. There are no special unit holders. The discretionary beneficiaries are listed at Item 8 in Schedule 1. There are a number of categories of discretionary beneficiaries, including the child of a unit holder. Under Clause 6.2 of the Trust Deed The Trustee has the discretion to pay, apply or set aside for any of the Discretionary Beneficiaries, all or any parts of the income of any year with the authority of a unanimous resolution of all Ordinary Unit Holders. You, as a beneficiary (Ordinary Unitholder) were not presently entitled to income of the trust when the expenditure was incurred. The money you have borrowed from the bank was on-lent to the Family Trust to acquire the franchise and provide capital for it to conduct the business. The borrowed money was not used to purchase the units in the trust. It has not been used to purchase a capital investment to get a return on the investment. The interest you incurred was not deductible on the basis that you had made a passive investment and therefore it cannot be argued that the interest is still deductible after the investment has failed. It cannot be argued that the money was on-lent to the Family Trust on the basis that you would get a return from distributions from the trust. There is no certainty that you would get a distribution from the trust, as you are not the only unit holder in the trust and also there is the discretion for the trustee to distribute income to discretionary beneficiaries. The Family Trust could claim a deduction for the interest it paid to you, as the expense was incurred in carrying on its business and possibly in relation to the purchase of the initial franchise. When the trust ceases business, it would be possible for it to continue to claim a deduction for ongoing interest as the expense arose out of the conducting of the business and would be in-line with those situations in TR 2004/4, interest following the cessation of, relevant income earning activities. The interest deduction that you were claiming did not arise from you conducting a business, therefore your situation can be distinguished from TR 2004/4. There has not been a cessation of the business activity that you were involved in. If you and your partner had borrowed money and bought the units in a standard unit trust and were the only beneficiaries entitled to income from the trust you may have been able to continue to claim your share of the interest expense on the loan after the business ceased, as the interest would have been in relation to the investment asset you had acquired. If you forgive the debt owed to you by the Family Trust you are forgoing your right to derive any future income or return of capital from the loan arrangement. It is considered that in these circumstances you would not be able to continue to claim a deduction for the interest incurred after forgiving the debt. Your case can be distinguished from those in TR 2004/4. The fact that you cannot earn interest income anymore, is not in relation to the cessation of a business, it is because you have forgiven the debt. | Detailed Reasoning - Capital loss: A capital loss may arise under subsection 104-25(3) of the ITAA 1997 (CGT event C2). Under section 108-5 of the ITAA 1997 an asset for CGT purposes is any form of property or a legal or equitable right that is not property. An example of a CGT asset is a debt owed to you. Under section 102-20 of the ITAA 1997 you make a capital gain or capital loss as a result of a CGT event. Section 104-25 of the ITAA 1997 provides that CGT event C2 happens if the ownership of an intangible CGT asset ends by the asset: (a) being redeemed or cancelled (b) being released, discharged or satisfied (c) expiring; or (d) being abandoned, surrendered or forfeited The time of the event is when you enter into the contract that results in the asset ending or if there is no contract, when the asset ends. The mere writing off of a debt (by a taxpayer) is insufficient to constitute a cancellation, release, discharge, satisfaction, surrender, forfeiture, expiry or abandonment at law or in equity. A debt ceases to exist only when some act or thing occurs which binds at law the creditor from recovering the debt. The writing off of a bad debt or even a promise not to enforce the debt is not enough to extinguish it. Rather the act of forgiveness must be contained in a deed or in a contract. Accordingly, CGT event C2 does not happen to a debt and a capital loss cannot be claimed until the rights under the agreement are legally and irrevocably surrendered, released or abandoned and, as a result, all provable debts are released. | Detailed Reasoning - Additional information: If you do forgive the debt, this does impact on the Family Trust, in that the Commercial Debt forgiveness rules will apply and it will lose the carry forward capital and business losses.