Issue
Is the taxpayer, a shareholder, entitled to a deduction, under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), for interest expenses incurred on borrowed funds used to purchase shares for the purpose of deriving dividends, where no assessable income was actually derived during the period that the taxpayer held the shares and the company has since been liquidated?
Decision
Yes. The taxpayer is entitled to a deduction, under section 8-1 of the ITAA 1997, for interest expenses incurred on borrowed funds used to purchase shares for the purpose of deriving dividends, where no assessable income was actually derived during the period that the taxpayer held the shares and the company has since been liquidated.
Facts
The taxpayer entered into an agreement to purchase a number of shares in a private company which operated a business. There were no special conditions attached to the shares.
The taxpayer's decision to enter into this agreement was made as a result of attending various meetings with the promoters of the business where it was promised that profits would be made by the business and dividends would be paid to investors. The only documentation provided by the promoters was a contract of sale of the shares.
The taxpayer borrowed money from a bank to purchase the shares and also left their employment to work in one part of the business. The loan was taken out in the taxpayer's and their spouse's name and was secured by a mortgage over the taxpayer's family home. For the first 12 months, the loan was on an 'interest only' basis and the loan agreement is reviewed annually.
The company was placed in liquidation in six months after the taxpayer purchased the shares. The taxpayer did not receive any wages or dividends from the company up to this date. The following reasons have been cited as reasons for the failure of the company: cash flow problems; attendances by police at premises; and high mobility of a young customer base. The taxpayer does not have any relationship with the company other than that of an employee and a shareholder.
At the time the company was liquidated, the taxpayer was not in a financial position to pay out the loan. The taxpayer continues to meet the interest payments on the loan.
Reasons for Decision
Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent which they are incurred in gaining or producing assessable income, except where the loss or outgoing relates to the earning of exempt income, or is of a capital, private or domestic nature.
The reference to 'assessable income' in section 8-1 of the ITAA 1997 has been construed as referring not only to 'assessable income derived in any particular year' but also to 'assessable income that the relevant outgoing would be expected to produced' ( Fletcher v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613 ( Fletcher's Case ); Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; 8 ATD 431). Therefore, the fact that the taxpayer did not derive any assessable income as a result of incurring the interest expenses to purchase the shares does not prevent them from being entitled to a deduction as long as the incurring of the interest expenses is expected to produce assessable income.
Income Tax Ruling IT 2606 applies this principle. Paragraph 9 of IT 2606 provides that as a general rule, interests on money borrowed to acquire shares will be incurred in gaining or producing assessable income (deductible) where it is expected that dividends or other assessable income will be derived from the investment. Such an expectation will usually exist as shares, by their very nature, are inherently capable of generating dividends, whether in the short or long term. However, such an expectation must be reasonable and not a mere theoretical possibility; there must be a prospect of dividends or some other assessable income being received.
The issue of whether the receipt of dividends is a reasonable expectation, and not a mere theoretical possibility, was considered by the Federal Court in Spassked Pty Ltd and Ors v. FC of T 2003 ATC 4184; (2003) 52 ATR 337 ( Spassked's Case ). In considering whether the taxpayer was entitled to deduct the interests on borrowed funds that was used to subscribe to the taxpayer's subsidiary, Lindgren J stated that where the objective circumstances of the relationship between the taxpayer and its subsidiary, the common memberships of their board of directors, the amounts borrowed, the amounts of interest incurred and the amounts of dividends received, standing alone did not determine that the interest expenses were incurred by the taxpayer gaining or producing the assessable income, the taxpayer's motivation or subjective purpose became relevant.
Lindgren J applied Fletcher's case which noted that where no relevant assessable income can be identified, the end which the taxpayer subjectively had in view may constitute an element, and possibly the decisive element, in the characterisation of the outgoing. The High Court in Fletcher's case suggested a 'commonsense' or 'practical' weighing of all the factors. If that consideration reveals that the incurrence of the outgoing is essentially to be explained by reference to the 'independent pursuit of some other objective', then the outgoing will not be deductible.
In Spassked's Case , Lindgren J found that there was no motivation, subjective purpose or subjective expectation that the subsidiary would ever pay dividends to the taxpayer as it was the group's objective that the taxpayer remained a dedicated dividend trap and the loss centre of the company group. Accordingly, Lindgren J held that the interest expense was not a loss or outgoing incurred in gaining or producing assessable income.
In this case, the objective circumstances are: [1] the taxpayer borrowed money from a bank on an interest only basis to purchase shares in the company [2] the company operates a business [3] the taxpayer left their employment to work in part of the business [4] The amount of money borrowed was secured by a mortgage over the taxpayer's family home [5] the company went into liquidation six months after the taxpayer purchased the shares [6] the taxpayer did not receive any wages or dividends from the company, and [7] the taxpayer does not have any relationship with the company other than that of an employee and a shareholder.
It is considered that these objective circumstances are not sufficient to establish that the interest expenses incurred on amounts borrowed to purchase the shares were incurred in gaining or producing assessable income. Accordingly, it is necessary to also look to the taxpayer's subjective intention in borrowing the money to purchase the shares.
Taxation Ruling IT 2606 provides that where purpose (or subjective intention) is relevant to the characterisation of the interest expense, matters such as the dividend policy of the company, the reasons for the borrowing, the use to which the borrowed moneys were to be put and the connection between that use and the income producing activities of the taxpayer may be considered.
The taxpayer's decision to purchase shares in the company was made as a result of attending various meetings with the promoters of the business where it was promised that profits would be made by the business and dividends would be paid to investors. There were no special conditions that attached to the shares. Therefore, it is reasonable to accept that it is the company's policy to pay dividends when it makes a profit. As a shareholder in the company, the taxpayer has an expectation to receive dividends from the company when it makes such profit. The only reason that prevented the taxpayer from deriving dividends from the shares is the company's failure which was caused by a number of factors including: cash flow problems; attendances by police at the premises; and high mobility of a young customer base.
The taxpayer borrowed the funds and used them to acquire the shares for the purpose of gaining assessable income. The taxpayer's expectations to derive assessable income from acquiring the shares were such that they also left their job to work in the part of the business in order to increase their investment and mortgaged their family home as security for the amount borrowed to acquire the shares.
It is considered that, unlike Spassked's Case , there is no independent pursuit of some other objective to borrow the money to acquire the shares other than to derive assessable income. Therefore, it is considered that the expectation to gain or produce assessable income is a reasonable expectation and is more than a mere theoretical possibility. The interest expenses are incurred in gaining or producing assessable income up to when the company is liquidated.
However, the taxpayer also continued to incur interest expenses, in respect of the funds borrowed to purchase the shares, after the company was liquidated. Therefore, it is necessary to consider whether the interest expenses are still incurred in gaining or producing assessable income after the company has been liquidated.
In Federal Commissioner of Taxation v. Brown (1999) 43 ATR 1; 99 ATC 4600 ( Brown's Case ), the Full Federal Court held that a taxpayer may still be entitled to a deduction for recurrent interest expenses incurred after an income producing activity has ceased provided the occasion of the interest expense arose out of the taxpayer's previous income earning activities. Although Brown's Case relates to the second limb of section 8-1 of the ITAA 1997, it is considered that the principles in that case have equal relevance to the first limb of section 8-1 of the ITAA 1997. In Brown's Case , the Full Federal Court stated that the occasion for the recurring payments of interest was found to be in the original loan agreement (carrying with it the obligation to pay interest over the term of the loan) entered into by the taxpayer. The Full Federal Court found that the ceasing of the income producing activity did not operate to break this nexus.
However, the Full Federal Court in Brown's Case also noted two important points: [1] There may come a period of time between the cessation of the income producing activity and the payment of interest which could mean, in all the circumstances of the case, that the payment is no longer sufficiently proximate to the income producing activity to be deductible under section 8-1 of the ITAA 1997; and [2] Had the loan agreement been a 'roll-over' business loan facility which entitled the taxpayer, on the date of each monthly payment, to elect to repay the principal or to 'roll over' the loan, there would be considerable force in the contention that the occasion of the liability was the election to 'roll over' the loan on each monthly payment date, rather than any liability arising under the terms of the original loan agreement.
In relation to point [1], the Full Federal Court in Brown's Case found that such a point had not been reached four years after the cessation of the income producing activity. Accordingly, the Court did not provide further guidance on this point, other than to say that the answers to such questions depend upon a 'commonsense' or 'practical' weighing up of all factors. It is considered that in this case, the payment of the interests incurred will continue to be sufficiently approximate to the taxpayer's income producing activity up until the loan is fully repaid at the end of its term.
In relation to point [2], the Full Federal Court in Federal Commissioner of Taxation v. Jones (2002) 117 FCR 95; 2002 ATC 4135; (2002) 49 ATR 188 interpreted the situation as dealing with a true election. Therefore, where a taxpayer has the resources to repay the loan but decides not to repay it and instead rolls the loan over, the occasion of the liability will be the election to roll over. It is considered that the taxpayer does not have a true election to either repay or roll over the loan because, although his loan agreement is subject to a yearly review, he does not have any resources to repay the loan. Therefore, it is considered that the occasion for the incurring of the interest payments arise under the terms of the original loan agreement.
The interest expenses are incurred in gaining or producing assessable income until the loan is fully repaid. The payment of the interest expenses will be deductible under section 8-1 of the ITAA 1997 provided that the interest expenses are not of a capital, domestic or private nature and do not relate to the earning of exempt income.
The interest expenses incurred do not relate to the earning of exempt income. The interest expenses are not of a capital nature despite the fact that the borrowed funds were used to purchase shares in the company (see Steele v. Deputy Commissioner of Taxation (1999) 197 CLR 459; (1999) 41 ATR 139; 99 ATC 4242). Further, in accordance with Tax Determination TD 93/13, the fact that the borrowed funds were secured by way of mortgage over the taxpayer's family home does not cause the interest expenses to be of a private or domestic nature.
Therefore, as all the requirements in section 8-1 of the ITAA 1997 are satisfied, the taxpayer is entitled to a deduction, under section 8-1 of the ITAA 1997, for interest expenses incurred on borrowed funds used to purchase shares for the purpose of deriving dividends, where no assessable income was actually derived during the period that the taxpayer held the shares and the company has since been liquidated.