Interest expense: loan to company by company director

Is the taxpayer, a private company director, entitled to an interest deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for monies on-lent to the private company?

No. The taxpayer, a private company director, is not entitled to an interest deduction under section 8-1 of the ITAA 1997 for monies on-lent to the private company.

A taxpayer and spouse obtained a business loan which was on-lent to their private company.

The company used the funds to acquire a business.

No loan agreement existed between the taxpayer, their spouse and their private company.

The only income derived by the taxpayer from the company was salary.

No loan repayments were made as the anticipated profits of the company did not eventuate.

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent that they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed to the extent that the losses or outgoings are of a capital, private or domestic nature or are necessarily incurred in gaining or producing exempt income.

In order for the interest expense to be deductible under section 8-1 of the ITAA 1997 the taxpayer must establish the essential character of the interest incurred was to gain or produce assessable income. In determining the essential character of an interest outgoing, regard must be had to its connection with the income producing activities of the taxpayer ( Federal Commissioner of Taxation v. Smith (1981) 147 CLR 578 at 586; 81 ATC 4114 at 4117; (1981) 11 ATR 538 at 542).

The issue of failing to derive any interest income was first considered in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153 (Munro's Case). 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.

Since Munro's Case there have been a significant number of cases in which directors and shareholders of companies have provided benefits at their own expense to the companies with which they were associated which have not satisfied the characterisation test.

The exception is the decision of the Full Federal Court in FC of T v. Total Holdings (Australia) Pty Ltd 79 ATC 4279; (1979) 9 ATR 885 ( Total Holdings ). This case recognised the earning of dividends as a sufficient purpose to characterise interest on money borrowed to on-lend to another entity for the purpose of its business as falling within subsection 51(1) of the Income Tax Assessment Act 1936 .

Subsequent to this decision, the Commissioner published Taxation Ruling IT 2606 to provide guidance as to how the principles concerning interest deductibility that were established in the Total Holdings decision should be applied.

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.

In the present case, it was intended that the company pay the loan repayments, both principal and interest, on behalf of the taxpayer. There was no expectation of a profit being made by the taxpayer by way of a higher interest rate charged on the loan to the company than applied to the borrowed funds. The only income derived by the taxpayer was salary, however Case 51/97 97 ATC 543; AAT Case 12,438 (1997) 38 ATR 1019 confirms there is no connection between a taxpayer's salary and borrowings that are subsequently on-lent to the company.

The loan made to the company is unrelated to the taxpayer's income producing activities as an employee.

The company has not distributed income to the taxpayer in their capacity as a director and the taxpayer has offered no foreseeable prospect that the company will produce income from the on-lending.

The taxpayer's purpose in incurring the interest expense cannot be seen as characterising the expenditure as incurred in gaining or producing assessable income.

Therefore, the taxpayer is not entitled to a deduction under section 8-1 of the ITAA 1997 for the interest expense incurred for monies on-lent to the private company.