Be careful with tax issues and business “loans”

Many, if not virtually all, SMEs regularly borrow funds in the course of running their businesses. In simple terms, interest on funds borrowed and used for the production of assessable income is tax deductible. However, that’s where the simplicity ends!

It is the nature of the loan, and whether it is a genuine “loan” in the first place, that is critical for tax purposes. A recent case before the Administrative Appeals Tribunal (AAT) highlights the problems that can arise.

In this case, the married taxpayers, Mr and Mrs Jones, were also partners in a business (the husband was an engineer). In February 1994, Mrs Jones advanced $40,000 to the partnership from her own account. The taxpayers claimed the advance was a loan and they each claimed tax deductions in respect of interest and other loan servicing costs in the 1996, 1997 and 1998 years of income. The Commissioner said the couple was not entitled to the deductions and that the advance should not be characterised as a “loan”. In addition, he claimed that, even if the tribunal was satisfied the advance was a loan, there was no evidence that interest was payable.

Mr and Mrs Jones had been engaged in a long-running dispute with the Tax Commissioner and the latest 2009 proceedings arose out of the machinations that followed a 2004 hearing of the Tribunal where it held that Mr and Mrs Jones were carrying on a business in common with a view to a profit. In other words, their relationship was properly described as a partnership within the meaning of the relevant law.

The taxpayers’ language when they described the advance was important in this case. At the hearing, Mr and Mrs Jones both referred to a “loan”, but Mr Jones also said his wife “decided to invest in the business”. Mrs Jones also spoke of an investment. Mr Jones spoke of the intention to achieve “an appropriate rate of return” for his wife. He said the advance provided “funds to kick off and start and run a business”. He said he recalled describing the advance as a loan in discussions with the taxpayers’ accountant, although the Tribunal noted that the accountant appeared to have treated the advance as being of a capital nature in the partnership accounts. Also, the accountant did not record the advance as a loan in the books.

The Tribunal’s view was that the advance was clearly intended to be working capital that would ultimately yield returns for both partners in the form of drawings. The AAT said there was no agreement as to the rate of return, or the term of the advance, and the advance was described as a capital contribution in the accounts. The Tribunal said that, while it acknowledged that the taxpayers used the word “loan”, it considered that word was not decisive given they also described the advance as an investment.

The AAT said it accepted that Mr and Mrs Jones were truthful witnesses but that their evidence only took the Tribunal so far. The AAT said it had to examine that evidence and determine what legal conclusions it should draw from the facts they had provided. The AAT accepted that the advance was not a gift, nor was it some sort of informal arrangement between husband and wife. It was, the Tribunal said, a business transaction. But, it concluded that the advance was properly characterised as a contribution to the capital of the partnership.

The AAT therefore held that the purported loan to a partnership was in fact an investment of capital in the partnership and, therefore, deductions claimed for interest and loan service costs were not allowable. It said the taxpayers had failed the burden of proving otherwise. According to the Tribunal, it was not a loan and was invested in the partnership with a view to earning a profit.

The taxpayers in this case may have genuinely considered that the advance was a loan, but the tax law places the onus on them to prove their claims and they could not do so to the satisfaction of the Tribunal. In the Tribunal’s words, “the bulk of the language used to describe the arrangement, and the details of the arrangement itself, are redolent of a capital contribution rather than a loan”.

From a tax point of view, care is clearly needed when advancing funds in this and similar situations. The advance should be clearly documented and properly described, and features such as interest rates payable, etc should be stated. If an advance is genuinely a loan, the expenses related to that are generally tax deductible, but establishing that it is a loan to the satisfaction of the Tax Office is important.

Terry Hayes is the senior tax writer at Thomson Reuters, a leading Australian provider of tax, accounting and legal information solutions.

For more Terry Hayes features, click here .