1 Is the trust entitled to a deduction under section 8-1 of the Income Tax Assessment 1997 (ITAA 1997) for payments made under a guarantee?
1 No. Question 2 If so, is this deductibility extinguished by the deregistration of the original borrower? Answer 2 Not Applicable. Question 3 Is the trust entitled to a capital loss for payments the trust was required to make as a guarantor? Answer 3 No. This ruling applies for the following periods : Year ending DD June 20YY Year ending DD June 20YY Year ending DD June 20YY Year ending DD June 20YY The scheme commenced on: DD July 20 YY
On DD August 20YY the company was established, by individual A and they are the director, secretary and 100% shareholder. Individual A and Individual B were spouses at the time the company was established. In the 20YY income year the company borrowed a sum of money from the bank for business investment purposes. The letter of offer issued by bank to the company had the trust along with several other entities as guarantee in respect of the obligations of the company. Guarantees listed in the letter of offer from Bank: • Company A (Deregistered) • Company B (Deregistered) • Company C • The company (strike off action in progress) • The Trustee for the Trust (self and as trustee of the Trust) First registered mortgage: • Over personal property owned by individual A and individual B. Individual A and individual B separated. Due to a relationship breakdown information on the deregistration process of the company is unable to be provided. The company is still not deregistered. The trust is in the business of café and deli. The trustee of the trust is a company and does not conduct any business in its own right.
Original Directorship, Secretaries and Shareholdings are as follows: Table 1: Original Directorship, Secretaries and Shareholdings Company Directors Secretary Shareholders Units Company E (The Trustee of the Trust) Individual A Individual A Individual A and individual B 6 Shares Each Company C Individual A and individual B Individual A Individual A and individual B 6 Shares Each Company D Individual A Individual A Company E 100 Shares The company Individual A Individual A Company D 100 Shares Company A Individual A Individual A Company D 100 Shares Company B Individual A Individual A Company D 100 Shares Table 2 Original Trustee, Beneficiaries Trust Trustee Primary Beneficiaries as on Deed Changes The Trust Company E Individual A and individual B No changes On DD January 20YY the director, secretary and shareholders of the trustee to the trust changed, individual A was removed from the position of director and secretary and was replaced by individual B, individual B also became 100% shareholder.
Individual A retained directorship of the company, and a number of the entities listed as guarantor. However, each of the entities controlled solely by individual A began to fail and he defaulted on his repayments. A letter was issued by the solicitors of the bank enclosing the letter of demand. The burden of repayments fell to the trust with the repayment amounts being paid from its bank account, action that was undertaken to protect their business assets. The trust has not been a guarantor for any other loans and has received no payments, benefits or rewards for being a guarantor for the company. The trust has not earnt any assessable income from the company. The trust made payments to the bank as guarantor on behalf of the company.
Income Tax Assessment Act 1997 section 8-1 Income Tax Assessment Act 1997 section 102-20 Income Tax Assessment Act 1997 section 103-15 Income Tax Assessment Act 1997 section 104-25 Income Tax Assessment Act 1997 section 108-5 Income Tax Assessment Act 1997 section 110-25 Income Tax Assessment Act 1997 section 110-55 Income Tax Assessment Act 1997 section 116-20
Question 1 Section 8-1 of the ITAA 1997 allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing your assessable income, except where the loss or outgoing is of a capital, private or domestic nature. A number of significant court decisions have determined that for an expense to be an allowable deduction: • it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense ( Lunney v. FC of T ; (1958) 100 CLR 478), • there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income ( Ronpibon Tin NL v. FC of T , (1949) 78 CLR 47), and • it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income ( Charles Moore Co (WA) Pty Ltd v. FC of T , (1956) 95 CLR 344; FC of T v. Hatchett , 71 ATC 4184). Taxation Ruling TR 96/23 Income tax: capital gains: implications of a guarantee to pay a debt
discusses the deductibility of payments made under guarantee. The ruling states that liabilities arising under contracts of guarantee will not be deductible under section 8-1 of the ITAA 1997 if the provision of guarantees and the losses or outgoings under the guarantees are not regular and normal incidents of the taxpayer's income earning activities. The ruling further states that if the provision of guarantees is not a regular and normal incident of the taxpayer's income earning activities, any payments made under those guarantees will be capital in nature. Directors of a company would not ordinarily be expected to guarantee a business's debts. Debts are normally incurred by a business in relation to their operations and, thus, the earning of the business's assessable income. As highlighted in FCT v. Munro (1926) 38 CLR 153, a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of an entity other than the one who incurs it. That is, where expenses are incurred by the company and paid for by a director or someone else, a deduction is not allowable to the director or that other person. Application to your circumstances
A business finance agreement was loaned to the company by the bank. As part of the agreement, the trust agreed unconditionally to offer a personal guarantee to the bank in the event the loan could not be repaid by the company. The company is in the process of strike off. The trust has subsequently paid money to the bank as a guarantor in satisfaction of the loan owed by the company. The purpose of your action was not to directly produce any assessable income for the trust, but to fulfil the trust's commitment under the guarantee. The trust was not in the business of entering into contracts of guarantor. It is not considered that the provision of the guarantee was undertaken by the trust as a regular and normal incident of the trust's income earning activities.
It is acknowledged that the interest the trust incurred arose from paying the expenses of the company. However, such expenses do not sufficiently relate to the trust's income earning activities. The interest was incurred paying expenses which belong to the company and the trust paid the expenditure on behalf of the company. Therefore, a deduction for interest incurred on loans to pay the company's debt will not be allowable under section 8-1 of the ITAA 1997 as it is incurred in the course of earning the assessable income of the company, rather than the trust's assessable income. Furthermore, the expense is capital in nature. Question 2 Not applicable Question 3 Taxation Ruling TR 96/23 is about the Capital Gains Tax (CGT) implications of a guarantee to pay a debt. Paragraph 7 of TR 96/23 states a capital loss is not incurred by a guarantor if a debt arising to the guarantor under a right of indemnity or a right of subrogation, on payment, is a 'personal use asset'. This is because section 108-20 of the ITAA 1997 states, in working out your net capital gain or net capital loss for an income year, any capital loss you make from a personal use asset is disregarded.
Paragraph 47 of TR 96/23 states the test of what is a 'personal use asset' requires a finding that the debt came to be owed for a primary purpose other than that of gaining or producing income. If the debt which came to be owed as a consequence of entering the contract of guarantee was expected to promote and enhance the income earning activity of the guarantor, the debt would not be a personal use asset, and a capital loss would be allowed. This definition of a personal use asset accords with section 108-20 of the ITAA 1997, which states a personal use asset includes a debt arising other than in the course of gaining or producing your assessable income or from your carrying on a business. Where a shareholder of a company guarantees the company's debts to assist the company to continue in business, and thus, to earn profits and to distribute dividends to shareholders, the debt acquired by the guarantor will not be a personal use asset. This outcome is supported by the case of Federal Commissioner of Taxation v. Total Holdings (Aust) Pty Ltd 79 ATC 4279; (1979) 9 ATR 885.
Where a shareholder guarantor pays the debt in full and there is no likelihood the insolvent company will pay the debt owing to the guarantor, paragraph 42 of TR 96/23 provides a capital loss will arise when the insolvent company is deregistered. The deregistration of the insolvent company constitutes a release and thus the disposal of the debt in terms of section 104-25 of the ITAA 1997 (CGT event C2) because the debt owed to the guarantor becomes irrecoverable at law. Prior to deregistration of the company, including during the period of administration by a liquidator, the debt to the guarantor remains recoverable and thus does not cease to exist in terms of section 104-25 of the ITAA 1997. This outcome is affirmed in the case of Federal Commissioner of Taxation v. Macquarie Health Corporation Limited & Ors (1998) 88 FCR 451; 98 ATC 5214; (1998) 40 ATR 349, where, in the context of bankruptcy, it was ruled 'it is the discharge from bankruptcy which extinguishes the debts of a bankrupt'; that if there is no discharge from bankruptcy, it does not follow that the debt ceases to exist.
However, the same tax outcome does not occur when the shareholder of the debtor company is a discretionary trust and the entity guaranteeing the company's debts is a beneficiary of you. Taxation Ruling IT 2385 Income tax: expenses incurred by beneficiaries of discretionary trusts provides beneficiaries of discretionary trusts are unable to show a sufficient nexus between their activities and the receipt of assessable income from a discretionary trust because, at its highest, the beneficiary of a discretionary trust has the mere expectancy of receiving income from you. This is distinguishable from a shareholder of a company or a beneficiary of a fixed trust, who has an absolute interest in the company or trust income. This tax treatment is affirmed by Taxation Board of Review No.3 Case M36 80 ATC 280; Case 11 24 CTBR (NS) and again by Administrative Appeals Tribunal Case U44 87 ATC 318.
In this case, the trust was an unrelated entity of the company. The debt owed to the trust by the company is a personal use asset because the trust entered into the contract of guarantee and was not expected to promote and enhance the trust income earning activity. There was an insufficient nexus between you guaranteeing the loans and the trust earning of income because, the trust did not have an absolute interest in either the company or the company's income. In the alternative case, if the trust was a shareholder of the insolvent company (of which the trust is not), if the provisions of TR 96/23 were fulfilled, a capital loss would not have occurred during the year ended 30 June 20YY because the company was not insolvent or deregistered during the year ended 30 June 20YY. However, in this case, because the debt owed to the trust by the company is a personal use asset, a capital loss does not occur in any income year. Section 108-20 of the ITAA 1997 states, in working out your net capital gain or net capital loss for an income year, any capital loss you make from a personal use asset is disregarded.