Issue
Does subsection 70B(4) of the Income Tax Assessment Act 1936 (ITAA 1936) operate to reduce the amount of a deduction under subsection 70B(2) of the ITAA 1936 for a loss on the disposal of a traditional security where the holder has knowledge that the issuer is unable or unwilling to discharge all liability to pay amounts under the security?
Decision
Yes. Where the other requirements of the subsection are met, subsection 70B(4) of the ITAA 1936 will apply to a holder of a traditional security who has knowledge that the issuer is unable or unwilling to discharge all liability to pay amounts under the security.
Facts
A taxpayer was a director and principal shareholder of a private company. The private company incurred interest in respect of a loan to purchase shares in a public company. Several years later the private company had financial difficulties. As a result of the private company's inability to pay the loan interest the taxpayer borrowed funds from an associate to pay the private company's interest liability on its behalf. Under a right of indemnity the private company became liable to repay the borrowed funds to the taxpayer. The right of indemnity is a traditional security.
As a director and principal shareholder of the private company, the taxpayer was fully aware at all times of the private company's financial status.
Ultimately the private company became insolvent and was not able to meet its liability to the taxpayer under the right of indemnity. The taxpayer sold their right of indemnity to a third party and claimed a deduction for a loss on the disposal of the traditional security.
Reasons for Decision
Subsection 70B(2) of the ITAA 1936 allows a deduction for the amount of any loss on the disposal or redemption of a traditional security.
Where a traditional security is disposed of on or after 1 July 1992, subsection 70B(4) of the ITAA 1936 may operate, in certain circumstances, to deny a deduction under subsection 70B(2) of the ITAA 1936 in respect of so much of the amount of the loss as is a loss of capital or is a loss of a capital nature.
One of the requirements of subsection 70B(4) of the ITAA 1936, contained in paragraph 70B(4)(e) of the ITAA 1936, is the need to draw the conclusion that, having regard to: (i) the financial position of the issuer of the security (ii) perceptions of the financial position of the issuer, and (iii) other relevant matters, the disposal or redemption of the security took place for the reason, or for reasons that included the reason, that there was an apprehension or belief that the issuer was, or would be likely to be, unable or unwilling to discharge all liability to pay amounts under the security.
It has been argued that because subsection 70B(4) of the ITAA 1936 uses the words 'apprehension or belief' the subsection does not apply where the holder had 'knowledge', rather than 'apprehension or belief', that the issuer was unable or unwilling to discharge all liability to pay amounts under the security.
We do not accept that subsection 70B(4) of the ITAA 1936 necessarily requires the holder, in a subjective sense, to have the requisite apprehension or belief. In our view the test is an objective test.
In the present circumstances, as director and principal shareholder of the private company, the taxpayer had knowledge of the private company's financial circumstances. The taxpayer had a level of awareness greater than apprehension or belief.
If regard is had to the taxpayer's understanding of the issuer's financial position - that is, that the private company was unable to pay amounts due - it would be concluded that the disposal occurred for the reason, or for reasons which included the reason, that the private company would be unable to pay amounts due on its security. Accordingly, the deductible loss (if any) on the disposal or redemption of such a security cannot include an amount of capital or of a capital nature.