Borrowed money to pay your business tax debt? The interest could be deductible

The obscure deductibility gem alluded to in this article’s headline is in fact true. It was about 1990 when the ATO was asked about the tax deductibility of interest on a loan a business may have taken out to repay a tax debt. Borrowed money to pay your business tax debt?

It was the third time, according to its records, that the matter was raised (of the two previous requests for clarification, one was made as far back as 1951 and the other even older, in 1921).

The 1990 query resulted in the ATO issuing a taxation ruling (IT 2582) to put the matter to bed, which has stood ever since — and thankfully dusted off by Tax & Super Australia’s tax technical specialists.

In its ruling, the ATO admits that there were, and are, a number of “practical difficulties” associated with denying such a specific deduction for taxpayers carrying on a business. The difficulty goes right to the heart of the Income Tax Assessment Act 1936 (ITAA36), which is the basis for much of the existing Australian taxation rules and regulations.

Before July 1, 1997, the main provision that applied to determine the deductibility of interest was the general deductions provision contained in s 51(1) of ITAA36. As part of the redrafting of the Australian legislation into a simplified form this provision has been re-enacted as s 8-1 of the Income Tax Assessment Act 1997 (ITAA97) with effect from July 1, 1997.

The terminology and style of this provision differs only slightly from the original and, in any event, the effect of the new act (as expressed in s 1-3) is not to change the law but to restate it in a clearer or simpler style. Thus the law is not intended to be changed by this re-enactment and the old case law and administrative pronouncements are to apply with equal force to the new s 8-1.

Specifically, under s 51(1), the legislation says: “All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to the gaining or production of exempt income.”

The “difficulties” the ATO refers to comes about due to the fact that paying a tax debt is neither of a capital nature nor done to gain “exempt” income. Consequently, the 1990 ruling goes on to say, it was decided that “where a taxpayer carries on a business producing assessable income and pays interest on an overdraft, no action is to be taken to disallow the interest attributable to a part of the bank overdraft equal in amount to the income tax paid out of the bank account which is in debit”. The ATO says the interpretation can be found in paragraph six, Canberra Income Tax Circular Memorandum No. 616 (although we couldn’t locate a copy) — and it is a practice that has endured to the present day.

The relevant section of the 1990 ruling states: “Where a taxpayer carries on a business for the purpose of gaining or producing assessable income and, in connection with the carrying on of that business, borrows money to pay income tax (whether to preserve the assets of the business, maximise the return on them, retain sufficient money to fund the business or otherwise) then it is considered that the interest incurred on those borrowings is a normal incident of conducting that business. That is, such an expense is an expense incurred in carrying on that business and hence qualifies for deduction under the second limb of subsection 51(1) of the act.”

Our internal technical specialists who construct Tax & Super Australia’s annual tome the Tax Summary, which has preserved the above ruling for grateful tax paying businesses, also point out however that the ruling does not apply to interest on borrowings that are not connected with the carrying on of a business for the purpose of producing assessable income. So while having the tax-geek smarts to uncover such deduction gems, Tax & Super Australia’s technical writers also have the level headedness to understand the practical limitations of Australia’s sometimes obtuse tax law.

 

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