Employee share scheme: deductibility of interest and borrowing expenses incurred by a non-resident taxpayer on a loan used to exercise share options

Is a non-resident taxpayer entitled to deductions under sections 8-1 and 25-25 of the Income Tax Assessment Act 1997 (ITAA 1997) for interest and borrowing expenses incurred on a loan used to exercise options acquired under an employee share scheme (ESS) where the taxpayer has included an amount of discount given in relation to the rights as assessable income?

No. The non-resident taxpayer is not entitled to the deductions under sections 8-1 and 25-25 of the ITAA 1997 as there is an insufficient connections between the interest and borrowing expenses incurred and the assessable income in the form of the discount given in relation to the rights.

The taxpayer was formerly an Australian resident taxpayer employed by an Australian company.

In 1997, the taxpayer acquired options at a discount to market price under an ESS, which satisfied the conditions for deferred taxation. The taxpayer did not pay any consideration for acquiring the options nor was the discount included in their assessable income under the ESS provisions in the year the options were acquired.

Later, the taxpayer ceased to be a resident for Australian taxation purposes when they transferred overseas.

While a non-resident, the taxpayer took out a loan and used the funds to exercise the options. The taxpayer included the discount given in relation to the rights as assessable income under the ESS provisions in the year in which the options were exercised.

The shares acquired when the options were exercised were not disposed of within 30 days of acquisition.

Any dividends received by the taxpayer from these shares will be excluded from their assessable income: pursuant to section 128D of the Income Tax Assessment Act 1936 (ITAA 1936).

Section 8-1 of the ITAA 1997 allows a deduction for any outgoing to the extent that it is incurred in gaining or producing assessable income, except where the outgoing: • is of a capital nature (paragraph 8-1(2)(a) of the ITAA 1997), • is of a private or domestic nature (paragraph 8-1(2)(b) of the ITAA 1997), or • relates to the earning of exempt or non-assessable non-exempt income (paragraph 8-1(2)(c) of the ITAA 1997).

Subsection 25-25(1) of the ITAA 1997 allows a deduction for expenditure incurred in borrowing money to the extent that the money is used for the purpose of producing assessable income. In most cases the deduction is spread over the period of the loan.

Taxation Ruling TR 95/25 Income tax: deductions for interest under subsection 51(1) of the Income Tax Assessment Act 1936 following FC of T v. Roberts; FC of T v. Smith outlines the general principles as to when interest expenses are deductible. Subparagraph 3(a) of TR 95/25 states that an interest expense is incurred in gaining or producing assessable income if the interest expense has a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and is not of a capital, private or domestic nature. The test is one of characterisation and the essential character of an expense is a question of fact to be determined by reference to all the circumstances.

Taxation Ruling IT 2606 Income tax: deduction for interest on borrowings to fund share acquisitions further explains when interest incurred on funds borrowed for the purpose of share acquisition is considered to be deductible. Generally, as highlighted by paragraph 9 of IT 2606, interest on money borrowed to acquire shares will be incurred in gaining or producing assessable income where it is expected that dividends or other assessable income will be derived from the investments.

Relevantly here, any dividends received by the taxpayer will be non-assessable non-exempt income: pursuant to section 128D of the ITAA 1936. As a result of the operation of paragraph 8-1(2)(c) of the ITAA 1997, the taxpayer is not entitled to a deduction for expenses incurred in gaining or producing those dividends.

Therefore, it must be considered whether the taxpayer is entitled to a deduction for expenses incurred in gaining or producing the discount given in relation to the rights.

The discount given in relation to the rights is included as assessable income in the year in which the options were exercised. The discount is the market value of the shares at the time the shares were acquired less any consideration paid by the taxpayer for the shares in exercising the option.

For the interest and borrowing expenses to be deductible against the discount given in relation to the rights, it must be shown that there is a sufficient connection between these expenses and the discount included in assessable income.

It is considered that the taxpayer's purpose in taking out the loan was to acquire the shares. The discount included in the taxpayer's assessable income in the year the options were exercised was merely incidental to the acquisition of the shares. The interest and borrowing expenses were not incurred for the purpose of gaining or producing the discount.

Therefore, the non-resident taxpayer is not entitled to a deduction under either sections 8-1 and 25-25 of the ITAA 1997 for the interest and borrowing expenses incurred.

Note: reference to the ESS provisions is to both the now repealed Division 13A of Part III of the ITAA 1936 and to Division 83A of Part 2-40 of the ITAA 1997.

Date of Amendment Part Comment 6 April 2018 Issue, Decision and Facts Reworded for internal consistency and clarity. Reasons for Decision Reworded for internal consistency and clarity. Updated with full citations for ATO view documents. 31 October 2014 Decision Update to highlight that the discount on the rights is assessable income. Facts Updated to take into account the repeal of Division 13A of the ITAA 1936 and its replacement with Division 83A of the ITAA 1997. Reason for Decision Updated to take into account the repeal of Division 13A of the ITAA 1936 and include reference to its replacement; Division 83A of the ITAA 1997. Legislative reference Include reference to Division 13A of the ITAA 1936 and Division 83A of the ITAA 1997.

Date of Amendment | Part | Comment

6 April 2018 | Issue, Decision and Facts | Reworded for internal consistency and clarity.

Reasons for Decision | Reworded for internal consistency and clarity. Updated with full citations for ATO view documents.

31 October 2014 | Decision | Update to highlight that the discount on the rights is assessable income.

Facts | Updated to take into account the repeal of Division 13A of the ITAA 1936 and its replacement with Division 83A of the ITAA 1997.

Reason for Decision | Updated to take into account the repeal of Division 13A of the ITAA 1936 and include reference to its replacement; Division 83A of the ITAA 1997.

Legislative reference | Include reference to Division 13A of the ITAA 1936 and Division 83A of the ITAA 1997.