Individual Beneficiary Denied Interest Deductions

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In a recent case (Chadbourne and FCT [2020] AATA 2441), the Tribunal held that an individual beneficiary was not entitled to claim interest deductions on the bank loan that was on-lent interest-free to a related discretionary trust. The trust used the fund to purchase an investment property. The beneficiary did not receive any trust income distribution in the relevant years as the trust did not have net income to distribute during the years. In short, it was held that there was no nexus between the expenditure and the derivation of assessable income by the taxpayer. The decision is consistent with the ATO’s long standing view in the former IT 2385 and its subsequent replacement in the Taxation Determination TD 2018/9.

The common way to get around this issue is to ensure that there is a loan agreement between the beneficiary and the discretionary trust to charge interest on an arm’s length basis. For example, the interest charged is set at the same rate as the bank charges. It is important that the loan agreement is properly documented.

Interestingly, the Tribunal stated that, if the taxpayer could establish a present entitlement, the authorities had found that there was a sufficient nexus between the interest expenses incurred on borrowed funds and the assessable income of the borrower derived from a trust, citing Forrest v FCT [2008] AATA 325 (the Forrest case). Moreover, the Tribunal also stated that any assessable income of the taxpayer derived from the Trust need not be derived in the same year as the interest expenses were incurred.

 

It should be noted that the Forrest case was an AAT case and it involved a hybrid trust where the bank loan was used to subscribe for income units in the hybrid trust. The subsequent appeal to the Full Federal Court did not consider the alternative submission relating to the interest expenses where there was a discretionary trust (as opposed to a fixed trust). Therefore, the Tribunal’s comment should not be taken as an authoritative view in this area.

If you have any queries on this, please contact Peter Hong.

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