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Can a taxpayer who short sells shares, deduct from assessable income under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), an amount equivalent to the market value as at 30 June, of shares it is required to acquire to close out its short position?

No. A taxpayer who short sells shares cannot deduct from assessable income under section 8-1 of the ITAA 1997, the market value as at 30 June of shares it is required to acquire to close out its short position.

The taxpayer's business activities include entering into short sale share transactions.

Under the short sale share transactions the taxpayer 'borrows' shares from a securities lender and sells them to a buyer. The taxpayer is then required to cover the short at a later date by buying, and returning to the securities lender, an equivalent number and type of shares.

The taxpayer's income year ends on 30 June.

Paragraph 8-1(1)(b) of the ITAA 1997 allows a taxpayer to deduct from its assessable income any loss or outgoing to the extent it is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

Whilst the term 'incurred' is not statutorily defined, paragraph 5 of Taxation Ruling TR 97/7 provides that, as a broad guide, an outgoing is incurred at the time a present money debt that cannot be escaped is owed. This broad guide is further qualified by a number of propositions emanating from court decisions considering the meaning of the term.

In New Zealand Flax Investments Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 179; (1938) 5 ATD 36; (1938) 1 AITR 366, Dixon J indicated the term 'incurred' meant more than defrayed, discharged or borne. It also included encountered, run into or fallen upon but did not include expenditure that was no more than impending, threatened or expected.

In Federal Commissioner of Taxation v. James Flood Pty Ltd (1953) 88 CLR 492; (1953) 5 AITR 579; (1953) 10 ATD 240, a deduction was denied for a liability for expenditure that was subject to a variety of contingencies. The court also determined that a taxpayer must be completely subjected to an outgoing in order for it to be deductible. However, as indicated at subparagraph 6(c) of TR 97/7, a presently existing liability may exist even though its amount cannot be precisely ascertained, providing it is capable of reasonable estimation (based on probabilities).

In Nilsen Development Laboratories Pty Ltd v. Federal Commissioner of Taxation (1981) 144 CLR 616; (1981) 81 ATC 4031; (1981) 11 ATR 505, it was held that in order for an outgoing to be incurred it is clearly necessary that there must be a presently existing liability. Furthermore, in the situation where there is no accrued obligation to make payment there can be no loss or outgoing incurred.

Prior to acquiring the shares required to be returned to the securities lender, the taxpayer does not have a present money debt. The taxpayer only has an obligation to return shares to the lender. Until acquiring the shares, no liability to pay money has yet come into existence. The liability is no more than impending, threatened or expected.

Furthermore, the amount of liability is indeterminate. It is contingent upon the price of those shares at the time of acquisition and, prior to that point in time, cannot be ascertained either precisely or by reasonable estimation. Until the time of acquisition, it cannot be said there is a pecuniary outgoing to which the taxpayer is completely subjected.

As the shares required to be returned to the securities lender have not been acquired by 30 June in the relevant income year, no amount is considered to be incurred for the purposes of section 8-1 of the ITAA 1997.