All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless specified otherwise.
A taxpayer will be entitled to a deduction for interest incurred on a borrowing where it satisfies the requirements of s 8-1.
In order for the interest expense to be deductible, the taxpayer must establish that the essential character of the interest incurred was to gain or produce assessable income (s 8-1). In determining the essential character of an interest outgoing, regard must be had to its connection with the income-producing activities of the taxpayer (FCT v Smith 81 ATC 4114 at p 4117).
The primary test of deductibility of interest is determined by examining the purpose of the loan and the use to which the loan is put (Federal Commissioner of Taxation v Munro (1926) 38 CLR 153).
As a general rule, interest on moneys borrowed to acquire shares will be deductible where it is reasonably expected that taxable distributions will be derived from the investment (s 8-1). Interest will not be deductible where the shares are acquired solely for the purpose of making a capital profit on their resale and the proceeds on sale are not assessable as ordinary income (Taxation Ruling IT 2606), but may be included in the cost base of the asset for CGT purposes.It is assumed that the interest on the original loan to acquire the shares was deductible.
Sale of shares
While the interest on the loan for the income-producing asset would be deductible, it needs to be determined whether the sale of the shares would change this position. The Commissioner has considered how the cessation of an income-earning activity, such as the sale of an income-producing asset for which the money was originally borrowed, affects the deductibility of the interest incurred on the loan.
Where borrowed money has been used to purchase an income-producing asset and that asset is subsequently sold or lost, the original use of that money will not necessarily determine the character of the interest expense accruing on those borrowed funds.
In such a case, the question of the deductibility of interest “… must be resolved by determining whether the essential character of the interest outgoings after the sale… was such that it can be said that those outgoings were incurred by the respondent in the course of the gaining or production of assessable income or, having regard to the business then carried on by it, they were necessarily incurred by the respondent in carrying on that business.” (FCT v Riverside Road Pty Ltd (in liq) 90 ATC 4567 at 4576).
In Taxation Ruling TR 2004/4 the Commissioner accepts that interest incurred after the sale or loss of the income-producing asset may be deductible. Where interest has been incurred after the asset representing the borrowings has been sold or lost, the outgoing will still have been incurred in gaining or producing assessable income if the outgoing was productive of assessable income of an earlier period.
This is a question of the nexus between the outgoing and the income-earning activities. The Commissioner says that interest will not fail to be deductible merely because:
- the loan is not for a fixed term
- the taxpayer has a legal entitlement to repay before maturity the principal with or without penalty, or
- the original loan is refinanced, whether once or more than once.
The nexus will be broken if the taxpayer:
- keeps the loan on foot for reasons unassociated with the former income-earning activities, or
- makes a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred (TR 2004/4).
The Commissioner considers a legal or economic inability to repay suggests that the loan was not kept on foot for purposes other than the former income-earning activities.
In particular, where interest has been incurred after the relevant borrowings (or assets representing those borrowings) have been lost and relevant income-earning activities have ceased, the outgoing will still have been incurred in gaining or producing assessable income if the outgoing was productive of assessable income of an earlier period (TR 2004/4). Therefore, provided the shares were productive of assessable income of an earlier period, the debt remains payable due to inability to repay, and the loan has not been kept on foot for other reasons, the interest on the shortfall under the original loan should remain deductible.
Where interest has been incurred after the relevant borrowings (or assets representing those borrowings) have been lost and relevant income-earning activities have ceased, the outgoing will still have been incurred in gaining or producing assessable income if the outgoing was productive of assessable income of an earlier period. [22-05-2012]
