Journal entries are not Loan Agreements: ATO

Commonly Dad borrows money cheaper than his trust. In this recent case, Dad borrows money from the CBA and gives it to his trust. Everything goes wrong.

In Chadbourne v FCT [2020] AATA 2441:

  1. the taxpayer, Mr Chadbourne, borrows money from CBA
  2. he on-lends the money to his family trust
    • his lawyer and accountant fail to recommend a Loan Agreement
    • he has no Loan Agreement
  3. his family trust buys investments
  4. he attempts to claim a deduction for the interest
  5. the ATO denies the deduction
  6. the ATO claims:
    • you cannot infer a loan relationship
    • a written Loan Agreement is required
    • you cannot claim deductions in deriving income from a family trust distribution

Mr Chadbourne borrows money from the Commonwealth Bank. This is to finance the purchase of income-producing investment properties. But, Mr Chadbourne purchases the properties in the name of his discretionary trust.

Later Mr Chadbourne borrows more money. This is to finance the purchase of shares. Once again, the shares are purchased by the trust, not the taxpayer.

There was no loan agreement, and therefore no nexus

Without a Loan Agreement, the ATO contents that there is no nexus between Mr Chadbourne’s interest expense and the assessable income from the trust’s investments. We agree with the ATO.

When you borrow money don’t just do a journal entry:

  1. that the motive for purchasing the investment properties and shares is to generate income and profits
  2. sure the interest was paid by him and the profits were in another entity being a family trust
  3. but the interest deductions should still be allowed as it is associated with the income-producing assets of the trust

Mr Chadbourne’s mistake – loan agreements on the back on an envelope do not work

Without a Loan Agreement between Mr Chadbourne and his family trust, he becomes desperate. Clutching at straws, Mr Chadbourne claims a deduction for the interest expense against the income derived by the trust. However, in truth, the interest expense is claimed against the distribution of income he received from the trust. This is NOT income derived by Mr Chadbourne.

Mr Chadbourne does not derive the assessable income for the purposes of the Income Tax Assessment Act. Without the protection of the Loan Agreement, he merely receives a trust distribution of income.

This makes all the difference. Without a Loan Agreement, there is no nexus between income and the expense. It denies him a tax deduction for the interest. If Mr Chadbourne had merely built a Loan Agreement lending the money to his trust then the interest is claimable. 

One wonders, whether Mr Chadbourne, has a claim against the Commonwealth Bank. 

This is a step by step guide on how Mr Chadbourne should have structured the borrowings.