Income tax - look-through companies: interest deductibility where funds are borrowed to make a payment to shareholders to reflect an asset revaluation

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 in the following circumstances:
   • the LTC purchases an asset from which it derives income;
   • the asset is subsequently re-valued above its purchase price; and
   • the LTC uses the borrowed money to make payments to its shareholders reflecting the increase in the asset's value.

Answer

2. The principle from FC of T v Roberts; FC of T v Smith 92 ATC 4380 will not justify a deduction for interest payments.  The borrowed money is making a payment out of an unrealised asset revaluation and, therefore, is not replacing and repaying amounts tangibly invested in the LTC by the shareholders.
3. A deduction may be available under general interest deductibility principles where the relevant nexus is met (for example if the funds were advanced to shareholders at a market rate of interest).

Explanation

4. The Commissioner has received inquiries from taxpayers asking whether interest will be deductible where an LTC borrows to make payments to shareholders that reflect the increase in value in an asset owned by the LTC.

Discussion

Interest deductibility

5. Usually a company would be entitled to an automatic interest deduction under s DB 7. However, LTCs do not qualify for the deduction under s DB 7.
6. 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.
7. 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.
8. 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 the partnership 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.
9. 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.
10. Applying the principles in Roberts and Smith to the scenario outlined in the question, the borrowed money has been used to make payments out of an unrealised asset revaluation.  As the revaluation has not been realised by sale, the increased value is only an account entry. Consequently, the borrowed funds have not been used to replace and repay amounts tangibly invested in the LTC by the shareholders. Therefore, in accordance with Roberts and Smith, no interest deductions would be allowed.
11. A deduction may be available under general interest deductibility principles where the relevant nexus is met. An example of this is where the funds borrowed were advanced to shareholders at a market rate of interest. In these circumstances deductibility does not rely on an application of the replace and repay principle from Roberts and Smith.

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, and HB 1