Deductions: interest expense on a loan to acquire options

Is interest incurred by a taxpayer on a loan used to purchase options to acquire shares, deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. Interest incurred on a loan used to purchase options is not deductible under section 8-1 of the ITAA 1997.

The taxpayer enters into a loan arrangement to purchase options to acquire shares in their employer.

The options acquired under the arrangement are acquired at market value (as calculated under Subdivision F of Division 13A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936)).

The taxpayer is not carrying on an enterprise of share trading and holds the options on capital account.

The taxpayer has no entitlement to actual dividends or a dividend equivalent, arising from holding the options.

Interest is deductible under section 8-1 of the ITAA 1997 to the extent that it is incurred in gaining or producing assessable income or in carrying on a business for that purpose, except to the extent that the expense is of a capital, private or domestic nature, or incurred in gaining or producing exempt income or non-assessable non-exempt income.

Whether an interest expense has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. The 'use' test, established in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.

In that regard, Taxation Ruling IT 2606 in paragraph 9, states that: ...interest on money borrowed to acquire shares will be deductible under the first limb of subsection 51(1) where it is expected that dividends or other assessable income will be derived from the investment.

Unlike shares, the options acquired by the taxpayer have no entitlement to dividends and whilst the taxpayer may in the future, exercise the options and acquire shares from which they may expect to receive dividends, the taxpayer will not otherwise derive assessable income from holding the options.

In relation to the disposal of options by the taxpayer, assessable income may also include a net capital gain under section 102-5 of the ITAA 1997. Where interest is incurred on a loan to acquire such options, section 51AAA of the ITAA 1936 ensures that the interest is not deductible under section 8-1 of the ITAA 1997 (formerly subsection 51(1) of the ITAA 1936) by reason of the inclusion in assessable income of the capital gain on disposal of the options.

The Commissioner does not consider that the principles established in the decisions in FC of T v. Total Holdings (Australia) Pty. Limited 79 ATC 4279; (1979) 9 ATR 885; and Steele v. Federal Commissioner of Taxation (1999) 197 CLR 459; 99 ATC 4242; (1999) 41 ATR 139 apply to these circumstances because the interest expenditure is considered to be both preliminary to and remote from any possible derivation of assessable income once an option has been converted to a share. The interest expense also lacks the necessary connection to an income producing purpose.

Therefore, as the requirements of section 8-1 of the ITAA 1997 are not satisfied, the taxpayer is not entitled to a deduction for an interest expense incurred in relation to a loan to acquire options to acquire shares.