Deductibility: 'annual financing costs' paid in advance under a fixed interest commercial bill facility - date incurred

Are 'annual financing costs', paid in advance under a Fixed Rate Commercial Bill Facility, incurred on the date that the facility is drawn down and on the subsequent anniversary date of the drawdown, given that the purpose for which the facility is drawn satisfies the conditions for deductibility under the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. The 'annual financing costs', paid in advance under a Fixed Rate Commercial Bill Facility, are incurred on the date that the facility is drawn down and on the subsequent anniversary date of the drawdown.

The taxpayer is an individual who borrows funds to purchase shares which are held as an investment.

The taxpayer funds the share purchase with a fixed rate commercial bill facility (the facility) offered by the Bank. The facility has a limit of $100,000 and a two year term commencing when the facility is drawn.

Under the facility agreement the taxpayer makes three payments only: (i) An 'annual financing cost' of $10,000 on the date that the facility is drawn (ii) A second 'annual financing cost' of $10,000 payable one year later at the commencement of the second year of the two year term; and (iii) $100,000 payable at the end of the second year being the face value of the last bill drawn.

Bills drawn under the facility have a tenor of approximately 90 days.

On or before a drawdown date (including a roll-over date), the Bank uses authorities provided by the taxpayer to draw, sign and present the bills which the taxpayer has requested the Bank to accept and discount on the drawdown date so that each bill: • is dated with the drawdown date • is drawn by the taxpayer or on their behalf with the name of the payee to be completed by the Bank • names the Bank as drawer and acceptor; and • is for a face amount determined by the Bank.

The taxpayer may prevent the roll-over of a fixed rate bill by providing the Bank with written notice that they do not wish to roll the bill. However, should the taxpayer do so, they must compensate the Bank for any losses that it might incur in replacing the bill in the market place at the fixed yield.

The deductibility of the financing costs falls for consideration under several specific sections of the Income Tax Assessment Act 1936 (ITAA 1936).

Division 16E of the ITAA 1936 spreads the return on a 'qualifying security' over the term of the security and includes in assessable income that amount, calculated in accordance with the division that is attributable to each of a number of particular years of income. Section 70B of the ITAA 1936, on the other hand, includes a loss on the disposal or redemption of a 'traditional security' in the assessable income of the taxpayer in the year of income in which the disposal or redemption occurs.

For Division 16E of the ITAA 1936 to apply, the facility must first satisfy the definition of 'security' in subsection 159GP(1) of the ITAA 1936 which specifies a number of criteria. The funds accessed under the facility are obtained from issuing bills of exchange pursuant to the facility, however, the facility agreement is not itself a bill of exchange. In K D Morris & Sons Pty Ltd (in liq) v. Bank of Queensland (1980) 146 CLR 165 the High Court considered the true view of a bill facility was that of a single contract, namely the facility, rather than a complex of as many contracts as there were periodic roll over operations and their accompanying drawing and accepting of bills under the facility.

Nor is the facility a loan. For the facility to be characterised as a loan there must exist the legal relation of lender and borrower ( Inland Revenue Commissioners v. Rowntree and Co. Ltd. [1948] 1 ALL ER 482). The facility does not give rise to a loan of money nor is there a promise to repay. Essentially, the funds raised under the facility are obtained from bank bills and buying bills at a discount is quite distinct from money lending. The absence of a discount does not alter the thrust of the arguments put by the authorities in any significant way.

Nor can the facility agreement be said to be a contract under which a person is 'liable to pay' an amount or amounts. The taxpayer must decide to draw down on the bills for the Bank to become entitled to receive the financing cost. Since the facility gives the taxpayer the right but not the obligation to draw bills it cannot be said that the taxpayer is 'liable to pay' the financing cost under a contract.

Since the facility is not a 'security' as defined in section 159GP(1) of the ITAA 1936, Division 16E of the ITAA 1936 does not apply to the facility. Since section 70B of the ITAA 1936 uses the same definition of 'security' it also has no application.

The deductibility of the financing costs also falls for consideration under Subdivision H of Division 3 of Part III of the ITAA 1936 which contains some specific provisions for certain prepaid amounts. The Subdivision spreads a prepaid amount over the period that things are done in relation to the expenditure.

For an individual taxpayer with expenditure that was not incurred in carrying on a business section 82KZM of the ITAA 1936 is the operative section of this subdivision. One of the conditions to be met before this section can apply is that the 'eligible service period' in relation to an amount of expenditure starts when that which is to be done under the agreement is required to commence and ends when it is required to cease.

Under the facility two annual payments are made. When the taxpayer makes the first of these payments the Bank is required to purchase the taxpayer's bill at its face value. Further, pursuant to the facility, the Bank is required to purchase any subsequent bills that are issued in the first year at their face value. However, the Bank's obligations in relation to this amount of expenditure do not extend beyond the first year. The obligation on the Bank to purchase bills at their face value in the second year only arises upon payment of the second annual financing. Therefore the financing costs can be said to give rise to two separate 'eligible service periods' each of which have duration of less than 12 months. The 'eligible service periods' do not extend beyond the subsequent year of income. Consequently, subsection 82KZM(1) of the ITAA 1936 does not apply to the financing costs paid by the taxpayer.

Given that the cost of the funds is an allowable deduction under section 8-1 of the ITAA 1997 it remains to be determined when the deduction is to be allowed.

If the Bank were to purchase the bills at a discount when they were drawn, the taxpayer's obligation to pay the discount amount clearly arises at the time the relevant bills are drawn and the deduction for the discount is apportioned on a straight line basis between two years of income where relevant ( Coles Myer Finance Limited v. Federal Commissioner of Taxation (1993) 176 CLR 640; 93 ATC 4214; (1993) 25 ATR 95). Although the taxpayer in Coles Myer Finance was a finance company, the Commissioner takes the view that the decision applies to all taxpayers, including individuals, who use commercial bills to raise funds to be used in their income producing business or activity and whose taxable income is calculated on an accruals basis (Taxation Ruling TR 93/2).

However, as the Bank purchases the bills from the taxpayer at their face value rather than at a discount, there is no difference between the amount at which a particular bill is sold and the amount at which that bill is redeemed. Therefore, there is no gain or loss on any of the individual bill transactions to be deductible under section 8-1 of the ITAA 1997.

Rather, the loss or outgoing that falls for consideration for deduction arises from the payment of each financing cost. Provided that the taxpayer pays the Bank the annual financing cost specified in the Bank's Letter of Offer, the Bank will accept the bills drawn by the taxpayer in the ensuing year. Further the Bank covenants to purchase the bills from the taxpayer at their face value. The first financing cost is paid in advance on the draw down date.

Therefore, the taxpayer incurs the financing cost on the date that it is paid. The amount is deductible in full in the year of income in which the payment is made.