Income tax - look-through companies: interest deductibility on funds borrowed to repay shareholder current accounts

All legislative references are to the Income Tax Act 2007 unless otherwise stated.

This Question We've Been Asked applies in respect of ss DB 6 and HB 1.

Question

1. We have been asked whether interest is deductible where a look-through company (LTC) borrows money on arm's length terms to repay current account loans from its shareholders.

Answer

2. Interest will be deductible to the extent the borrowing replaces current account loans from shareholders that were used directly in the LTC's assessable or excluded income earning activity or business. This is subject to ss HB 11 and HB 12 and to paragraphs [3] and [4] below.
3. The LTC must be carrying on an income earning activity or business for the purpose of deriving assessable or excluded income both at the time the funds are borrowed and at the time interest on those funds is payable.
4. Interest will not be deductible to the extent the borrowed funds are used to replace current year income.

Explanation

5. The Commissioner has received inquiries from taxpayers asking when interest will be deductible where an LTC borrows to repay current account loans from its shareholders. This issue has arisen because some taxpayers have interpreted "look-through" to mean you simply ignore all transactions between the LTC and the owner of an effective look-through interest in the LTC. This would mean you look through the LTC to the owner's use of the funds. In many cases, this would mean the requirements for interest deductibility would not be satisfied.
6. However, the Commissioner considers the above interpretation is incorrect. The Commissioner's view is that the owner's use of the funds received from the LTC for the repayment of a current account loan is not relevant to the issue of interest deductibility.

Discussion

Interest deductibility

7. Usually a company would be entitled to an automatic interest deduction under s DB 7. However, LTCs are not companies for the purposes of s DB 7.
8. A deduction for interest incurred may be available under s DB 6. Section DB 6 allows a deduction for interest incurred provided the general permission in s DA 1 is satisfied. Section DA 1 allows a deduction for interest incurred by a taxpayer in deriving their assessable income or incurred by them in the course of carrying on a business for the purpose of deriving their assessable income. Section HB 1(4) provides that the LTC's activity is treated as being carried on by persons holding "effective look-through interests" in the LTC. Consequently, persons with effective look-through interests in the LTC will be entitled to any interest deductions that the LTC would have been entitled to (in the absence of s HB 1) in proportion to that person's effective look-through interest.
9. The Commissioner's view is that the interest deductibility test is satisfied where a sufficient connection exists between the interest incurred and the assessable income. A sufficient connection will be established where borrowed funds are used to replace amounts invested in income-earning activities and to repay those amounts to the persons who invested them.
10. This is established by FC of T v Roberts; FC of T v Smith 92 ATC 4380. In this decision, the Full Federal Court of Australia held that a partnership could deduct interest payments to the extent it used the borrowed money to replace and repay amounts actually invested in it by the partners. By contrast, the court held that interest payments could not be deducted to the extent the partnership used the borrowed money to make payments out of unrealised asset revaluations or internally generated goodwill. This was because unrealised asset revaluations and internally generated goodwill were not amounts tangibly invested by the partners into the partnership - they were only account entries.
11. In Public Rulings - BR Pub 10/14 - BR Pub 10/19 "Interest Deductibility ­- Roberts and Smith - Borrowing to replace and repay amounts invested in an income earning activity or business", published in Tax Information Bulletin Vol 22, No 10 (December 2010), the Commissioner took the position that Roberts and Smith is good law in New Zealand. The Commentary to Public Rulings - BR Pub 10/14 - BR Pub 10/19 extensively considers Roberts and Smith. Readers should consult the Commentary to better understand the Commissioner's view of Roberts and Smith. BR Pub 10/18 is the most relevant to the issues considered in this QWBA.
12. Applying the principles in Roberts and Smith to the scenario outlined in the question, the LTC has used the borrowed funds to replace and repay amounts the shareholders have invested in it by way of the current account loans. Therefore, in accordance with Roberts and Smith, an interest deduction would be allowed.
13. For completeness, it is necessary to note the effect of the expense limitation rule s HB 11 (commonly known as the "loss limitation rule"). This provision applies to LTCs. It operates to limit the deductions a person with an effective look-through interest can deduct in an income year. It applies to all deductions, including interest. Section HB 12 applies to allow a person with an effective look-through interest to carry forward any limited deductions into future years, subject to the expense limitation rule in s HB 11. Broadly speaking, the expense limitation rule ensures an owner can offset losses only to the extent these reflect their economic losses.

References

Related rulings/statements
BR Pub 10/14 - BR Pub 10/19 "Interest Deductibility - Roberts and Smith - Borrowing to replace and repay amounts invested in an income earning activity or business" Tax Information Bulletin Vol 22, No 10 (December 2010)

Case references
FC of T v Roberts; FC of T v Smith 92 ATC 4380

Subject references
Interest deductibility
Look-through company

Legislative references
Income Tax Act 2007, ss DA 1, DB 6, DB 7, HB 1, HB 11, and HB 12