An issue that sometimes arises for business owners is whether interest expenses incurred on borrowed funds used in a business remain deductible after the business’s income earning activities have ceased.
As a general rule, in order for interest expenses to be deductible
in the relevant income year, a taxpayer is generally required to
demonstrate that the expense was either incurred in gaining or
producing assessable income, or necessarily incurred in carrying
on a business for the purpose of gaining or producing that
In either case, the taxpayer is required to demonstrate that there
is sufficient connection between the interest expense incurred
and the derivation of assessable income. In past court cases on
this matter, in determining such a connection, consideration was
given to the purpose of the borrowing (commonly referred to as
the “purpose” test) and the use to which the borrowed funds
have been put (the “use” test).
In each judgment, the courts allowed a deduction for interest
expenses incurred on borrowed funds notwithstanding the
disposal of the relevant income producing assets.
Case 1: Partners borrowed to acquire
a delicatessen business.
After a number of years of trading, the business was sold at a
loss. The proceeds of the disposal were paid to the lender but
were insufficient to satisfy the liability fully. The court held that
the interest expense incurred on the outstanding loan balance
Case 2: The taxpayer, with her husband, borrowed money to
fund a trucking and equipment hire business.
After her husband’s death, the wife sold the assets of the
business but the proceeds (plus other amounts on hand)
were insufficient to fully repay the loan. She subsequently
refinanced the loan because she was able to obtain a lower
interest rate through an alternative lender. In
these circumstances, notwithstanding that
the business had ceased, it was held that
the interest costs incurred relating to the
refinanced loan were deductible as the new
loan was considered to have taken on the
same character as the original borrowing.
Establishing a connection
Based on the principles in these cases, the
ATO maintains that a sufficient connection
between the former income earning activities
and the interest expenses incurred following
cessation of those activities must continue to
In practical terms, and to ensure success in
making any such claims, it must be determined
whether a connection between the interest
expense and the former income-earning
activities remains or whether this has been
The ATO has acknowledged that ongoing
interest expenses, in the above circumstances,
may still be deductible irrespective of:
- the loan not being for a fixed term
- the taxpayer having a legal entitlement to repay the principal before maturity, with or without penalty, or
- the original loan being refinanced, whether once or more.
The ATO does state, however, that any connection would be broken if it could be concluded that the taxpayer:
- had kept the loan on foot for reasons unassociated with the former business activity, or
- had made a conscious decision to extend the loan to obtain a commercial advantage that is unrelated to the previous attempts to earn assessable income.
Tax Store Accountants Norfolk Island.