ATO Interpretative Decision

ATO ID 2005/42

Income Tax

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Issue

Is a non-resident taxpayer entitled to deductions under section 8-1 and section 25-25 of the of the Income Tax Assessment Act 1997 (ITAA 1997) for interest and borrowing expenses on a loan used to exercise options acquired under an employee share scheme where the taxpayer has included an amount of discount given in relation to the rights as assessable income?

Decision

No. The non-resident taxpayer is not entitled to the deductions under section 8-1 and section 25-25 of the ITAA 1997 as there is insufficient nexus between the interest and borrowing expenses and the discount given in relation to the rights.

Facts

The taxpayer was formerly a resident taxpayer employed by an Australian company. In 1997 the taxpayer acquired options, which satisfied the conditions to be qualifying rights, under an employee share scheme. The taxpayer did not pay any consideration for acquiring the options nor did the taxpayer make an election under section 139E of the Income Tax Assessment Act 1936 (ITAA 1936) in the year the options were acquired.

The taxpayer was later transferred overseas and ceased to be a resident for Australian tax purposes.

While a non resident the taxpayer took out a loan and used the funds to exercise the options. The taxpayer included the discount given in relation to the rights as assessable income under subsection 139B(3) of the ITAA 1936 in the year in which the options were exercised.

The shares acquired when the options were exercised were not disposed of within 30 days of acquisition.

Any dividends received by the taxpayer from these shares will be excluded from their assessable income pursuant to section 128D of the ITAA 1936.

Reasons for Decision

Section 8-1 of the ITAA 1997 allows a deduction for any outgoing to the extent that it is incurred in gaining or producing assessable income, except where the outgoing is of a capital, private or domestic nature, or relates to the earning of exempt income.

Section 25-25 of the ITAA 1997 allows a deduction for expenditure incurred in borrowing money to the extent that the money is used for the purpose of producing assessable income. In most cases the deduction is spread over the period of the loan.

The general principles relevant to the deductibility of interest expense are set out in Taxation Ruling TR 95/25. At subparagraph 3(a), TR 95/25 states that the interest expense is incurred in gaining or producing assessable income if the interest expense has a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and is not of a capital, private or domestic nature. The test is one of characterisation and the essential character of an expense is a question of fact to be determined by reference to all the circumstances.

The issue of the deductibility of interest incurred on funds borrowed for the purpose of share acquisitions has been considered in Taxation Ruling IT 2606. Paragraph 9 of IT 2606 provides that as a general rule, interest on money borrowed to acquire shares will be incurred in gaining or producing assessable income, and will therefore be deductible, where it is expected that dividends or other assessable income will be derived from the investments.

In the circumstances here any dividends received by the taxpayer will be non assessable non exempt income pursuant to section 128D of the ITAA 1936. Therefore no deduction is allowable in relation to costs incurred in gaining or producing those dividends (paragraph 8-1(2)(c) of the ITAA 1997).

The question then becomes whether the interest and borrowing expenses are deductible as having been incurred in gaining or producing the discount.

The discount given in relation to the rights is included as assessable income under subsection 139B(3) of the ITAA 1936 in the year in which the options were exercised. The discount is the market value of the shares at the time the shares were acquired less any consideration paid by the taxpayer for the shares in exercising the option.

For the interest and borrowing expenses to be deductible against the discount given in relation to the rights, it must be shown that there is a sufficient nexus between these expenses and the discount included in assessable income.

It is considered that the taxpayer's purpose in taking out the loan was to acquire the shares. The discount included in the taxpayer's assessable income in the year the options were exercised was merely incidental to the acquisition of the shares. The interest and borrowing expenses were not incurred for the purpose of gaining or producing the discount.

Therefore the non-resident taxpayer is not entitled to a deduction under either section 8-1 or section 25-25 of the ITAA 1997 for the interest and borrowing expenses incurred.

Year of income:  Year ended 30 June 2004

Legislative References:
Income Tax Assessment Act 1997
   section 8-1
   paragraph 8-1(2)(c)
   section 25-25

Related Public Rulings (including Determinations)
Taxation Ruling TR 95/25
Taxation Ruling IT 2606

Keywords
Employee share schemes & options
Share discount on employee share scheme
Interest expenses
Borrowing expenses
Statutory income

Siebel/TDMS Reference Number:  4154650

Business Line:  Private Groups and High Wealth Individuals

Date of publication:  11 February 2005

ISSN: 1445-2782