In a decision that may send chills down the spine of Australian corporate groups, the Full Federal Court recently denied a tax deduction for interest expenditure to a business taxpayer.
The case in question is Advanced Holdings Pty Ltd v Commissioner of Taxation  FCAFC 135 (Advanced Holdings).
The Advanced Holdings case was about the re-financing of existing loans by a group of companies and trusts in the property development sector. The facts, issues and questions considered by the Full Federal Court in this case were significant. For the sake of brevity, I have summarised the position solely regarding the interest deductibility issue in this article.
In Advanced Holdings, the taxpayer was the trustee of a trust developing a series of properties in inner Sydney. The evidence clearly showed that the taxpayer was part of a larger group associated with a property developer by the name of Charbel Demian (the Demian Group). This latter point is significant regarding the interest deductibility issue.
During the Global Financial Crisis (GFC), the taxpayer refinanced their development of the Sydney properties with a third party financier known as Abacus. Due to the GFC, the taxpayer was close to defaulting on their original loans for the purchase of the Sydney properties with NAB and Capital Finance. The Abacus loan funds were used to pay off the original NAB and Capital Finance loans. In addition, Abacus requested that any proceeds from a future sale of the Sydney properties be first used to pay off other outstanding debts by the Demian Group to Abacus.
Several years after the GFC, the taxpayer sold the Sydney properties for a significant profit. It then sought to claim a tax deduction for interest and borrowing expenses associated with the funds loaned from Abacus. The Commissioner of Taxation denied the interest and borrowing expenses and the taxpayer sought relief in the Federal Court on the deductibility issue (and it must be said a variety of other tax related issues too). The Federal Court trial judge denied the deduction for interest and borrowing expenses to the taxpayer, and the taxpayer appealed to the Full Federal Court.
Full Federal Court Decision
The Full Federal Court also unanimously denied the taxpayer the interest and borrowing deductions claimed.
There were four main grounds for denying a tax deduction for the expenditure claimed. These four grounds should be of interest to all business taxpayers regarding their borrowings and especially for any re-financing within corporate groups.
- The court accepted the principle that interest on borrowings to fund the purchase of trading stock (in this case the taxpayer claimed that, as a property developer, the purchase of the inner Sydney properties was their trading stock), would be tax deductible. However, the court found that the taxpayer had not established that the original NAB / Capital Finance loans were an incident of the commercial operations by which the taxpayer acquired the properties. Further, the court observed that the re-financing of such loans (even if they were originally to purchase trading stock), would not necessarily also be on revenue account and therefore tax deductible.
- The court held that the Abacus loan was not a mere substitution of the loans to purchase the inner Sydney properties, but rather a rescue package to save the entire Demian Group from financial collapse at the height of the GFC. The court therefore held that the real purpose of the re-financing was to save the wider Demian Group – which did not amount to a revenue or income producing purpose.
- The court held that the amounts paid in discharge of the obligations by way of a guarantee of the indebtedness of the other companies and trusts within the Demian Group and the payment of these amounts, was wholly separate from the acquisition of the Sydney properties. This was not considered to be part of the income producing activities of the taxpayer.
- Finally, the court found that the taxpayer’s basis of apportionment of the Abacus loan interest and borrowing expenses (submitted to be on revenue account) did not identify any amount related to the production of the taxpayer’s assessable income or anything else having a revenue purpose.
Implications of Decision
The Advanced Holdings decision reminds us that like other business expenditure, interest and borrowing expenses must also meet the statutory test to be tax deductible. Where such expenditure has a clear ‘capital purpose’, the deductibility of the expenditure will be denied.
In the present case, it was clear that the primary purpose of the GFC-inspired Abacus re-financing facility was to prevent the Demian Group from collapse during the GFC. The Full Federal Court held that such a purpose was on capital account.
The Full Federal Court endorsed the principle that for trading entities, interest expenses associated with the acquisition of trading stock is tax deductible expenditure. However, business taxpayers may feel somewhat uncomfortable regarding the Court’s observation that a re-financing of borrowed funds used to purchase trading stock, would not necessarily also be on revenue account. It will be interesting to see whether the Commissioner of Taxation will issue a Decision Impact Statement after this case to possibly consider a re-focus on the purpose of business borrowings.
In summary, Advanced Holdings requires business taxpayers to carefully consider the tax deductibility of interest expenses on existing borrowings. In addition, business taxpayers should carefully consider the position where external debt is cross collateralised across numerous group entities, as it was in the Advanced Holdings case. Such cross collateralisation may possibly impact the deductibility of the interest expenditure.
If you have any questions about this article, please get in touch with an author or any member of our Tax team(s).
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