Issue
The issue is whether a deduction for interest expenses incurred in respect of funds borrowed for use in a business or investment activity remain deductible even though those incoming-earning activities may have ceased.
Taxation Ruling
TR 2004/4 refers to the Full Federal Court decisions in the cases of Brown and Jones. The ruling refers to investments in businesses, rental properties and shares.
Brown’s Case
The taxpayer partners borrowed to acquire a Delicatessen business. After a number of years, the business was sold at a loss. The proceeds on the sale were insufficient to cover the loan. The court held that the interest expense incurred on the outstanding loan balance remained deductible.
Jones’s Case
The taxpayer and her husband borrowed money to fund a trucking and equipment hire business. After the husband’s death, the taxpayer sold the assets of the business but the proceeds were insufficient to repay the loan. Subsequently, the taxpayer refinanced the loan because she was able to obtain a lower interest rate through an alternative lender. It was held that the interest costs incurred were deductible as the new loan was considered to have taken on the same character as the original borrowing.
Establishing a nexus
The commissioner states that a sufficient nexus between the former income earning activities and the interest expenses incurred following cessation of those activities, must continue to be maintained.
In particular, the commissioner notes that the interest is still considered to be incurred in gaining or producing ‘assessable income’ if the ‘occasion’ of the outgoing is to be found in whatever was productive of that income in an earlier period.
Interest expenses may still be deductible irrespective of:
- The loan not being for a fixed term
- The taxpayer having legal entitlement to repay the principal before maturity, with or without penalty, or
- The original loan being refinanced.
Breaking the nexus
The commissioner does state that the nexus would be broken if it could be concluded that the taxpayer:
- Has kept the loan on foot for reasons unassociated with the former business activity, or
- Has made a conscious decision to extend the loan to obtain a commercial advantage which is unrelated to the previous attempts to earn assessable income.
Factors to determine whether the nexus is broken include:
- Is the taxpayer entitled to fully repay the loan or is there a fixed term in which interest is required to be paid?
- What is the financial capacity of the taxpayer following the cessation of income earning activity?
- Does the taxpayer hold liquid assets? If so, are these asset holdings substantial?
- Have assets held by the taxpayer been realised/disposed? If so, have the proceeds from the realisation of those assets been used to repay the loan principal?
- Has a significant amount of time elapsed since the cessation of the income earning activites?
- Has the taxpayer refinanced the loan following the cessation of income producing activities?