Edited version of private ruling

Authorisation Number: 1011523226138

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Ruling

Subject: Guarantor interest deductions after the cessation of business

Can you claim interest deductions in relation to your share of personal borrowings that were used to repay the loans of your private company that ceased trading?

No.

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You are one of two sole shareholders of your company. Due to financial difficulties, your company ceased trading during the relevant income year. Towards the end of the relevant income year, you personally borrowed funds to repay your company loans. Your company had large accumulated losses. During its fifteen years of trading, your company never paid you a dividend, including when it was profitable. Your company only paid wages to you.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 110-55

Income Tax Assessment Act 1997 Section 108-5

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Summary

Liabilities, including interest expenses, incurred by shareholders who act as guarantors to company borrowings are capital in nature and therefore not deductible. This is in contrast to when shareholders of private companies borrow funds in their own name and then on-lend those funds to their private companies for the purpose of earning their assessable income in the form of dividend income.

This tax treatment is set out in Taxation Ruling TR 96/23 and has been affirmed by numerous Board of Review and Administrative Appeals Tribunal cases.

In your case, your borrowings were to fulfil your obligations as guarantor for the loans of your private company when your private company ceased trading. Your borrowings had no nexus to your personal earning of assessable income, such as in the form of company dividends. It follows your interest expenses are not deductible. Further, your interest expenses cannot be included in the reduced cost base of the debt owed to you by your company.

Detailed reasoning

Where borrowed funds are on-lent by an individual to a company

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature.

Taxation Ruling TR 2004/4 considers deductions for interest incurred following the cessation of relevant income earning activities. It states:

· Where interest has been incurred over a period after relevant income earning activities have ceased, the outgoing will still have been incurred in gaining or producing 'the assessable income' if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

· Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgment about the nexus between the outgoing and the income earning activities.

· An outgoing of interest in such circumstances will not fail to be deductible merely because the original loan is refinanced, whether once or more than once.

Taxation Ruling IT 2606 provides guidance about principles established in the Full Federal Court in FC of T v. Total Holdings (Australia) Pty Ltd 79 ATC 4279; (1979) 9 ATR 885. It states, as a general rule, interest on money borrowed to acquire shares will be incurred in gaining or producing assessable income where it is expected that dividends or other assessable income will be derived from the investment. However, such an expectation must be reasonable and not a mere theoretical possibility, there must be a prospect of dividends or some other assessable income being received.

IT 2606 also clarifies that in circumstances where no income is derived directly by the taxpayer from the transaction to which the interest expense relates, and there is no obvious connection with the carrying on of a business or other income earning activity of the taxpayer, then the taxpayer's purpose may be relevant to the characterisation of the expenditure.

In your case, your borrowing of funds was not for the purpose of earning your assessable income in the form of company dividends because, at the time you on-lent the borrowings, your company had ceased trading due its financial difficulties. Your borrowing of funds was for the purpose of repaying funds borrowed by another entity, namely, your company, for which you were guarantor. It follows there is no nexus between your interest outgoings and any former (personal) income earning activities. Nor were any of the original loans 'refinanced'. This is because your company borrowed the original loans rather than yourself.

If you had personally borrowed the original funds and on-lent those funds to your company, an interest deduction may possibly have been available to you. (However, your non-receipt of any dividends over fifteen years of trading may have made such a possibility tenuous).

To conclude, your borrowing was not related to the refinancing of loans on-lent by you to your company for the purpose of earning dividend income. Your borrowings were to fulfil your obligations as guarantor for the loans of your private company when your private company ceased trading. It follows a deduction for your interest expense is not available to you under section 8-1 of the ITAA 1997.

Where an individual is guarantor for funds borrowed by a company

Section 8-1 of the ITAA 1997 states a loss or outgoing is not deductible if it is of a capital, private or domestic nature. The Commissioner's view about the implications of a guarantee to pay a debt is found in Taxation Ruling TR 96/23. Paragraphs 137, 136 and 138 of TR 96/23 state:

Liabilities arising under contracts of guarantee will not be deductible under subsection 51(1) if the provision of guarantees and the losses or outgoings arising under the guarantees are not regular and normal incidents of the taxpayer's earning activities. In Case Q39 83 ATC 171 at 173; (1983) 26 CTBR (NS) Case 103 at 694, Mr K P Brady, Chairman, referred to a line of Board cases stretching from 1946 which concluded that payments under guarantees are capital.

Reference may be made, therefore, to a line of decisions of the Administrative Appeals Tribunal and the former Boards of Review which accepts that payments made under guarantees by shareholders or directors are not deductible under subsection 51(1): see Case V115 88 ATC 733; AAT Case 4501 (1988) 19 ATR 3697; Case V117 88 ATC 741; AAT Case 4503 (1988) 19 ATR 3708; Case 56/95 95 ATC 459; AAT Case 10,518 (1995) 31 ATR 1322; also (1979) 23 CTBR (NS) Case 9 (Taxation Board of Review No 2).

In a typical case, reported as Case V115, Senior Member P J Roach did not allow a deduction under subsection 51(1) for payment made by the taxpayer who was a director and shareholder of a land development company and who was a creditor of the company under a guarantee given by the taxpayer in respect of the company's liabilities.

It seems that only if a taxpayer acts as guarantor to such a degree as to amount to his or her usual practice, say, as a solicitor, in the ordinary course of business will the payments be deductible as a revenue outgoing and not of a capital nature.

In your case, following the guidelines in TR 96/23, the provision of guarantees was not regular and normal incident of your income earning activities. Therefore, a deduction for your interest expenses incurred to repay company loans is not available to you under section 8-1 of the ITAA 1997. TR 96/23 holds the interest expenses of a guarantor are capital in nature.

Repayment of company loans resulting in a capital loss

In brief, in relation to the capital gains tax (CGT) provisions, paragraphs 30, 31, 32, 37, 40 and 41 of TR 96/23 provide:

· Section 108-5 of the ITAA 1997 holds a debt owed to a taxpayer is a CGT asset.

· When a guarantor repays a debt under guarantee to a primary creditor (such as a financial institution), the guarantor acquires a CGT asset, namely, the debt owed to the guarantor by the debtor (such as a company).

· If the debtor (company) cannot repay the debt, the guarantor will make a capital loss under section 104-25 of the ITAA 1997 (CGT event C2) due to the cancellation of the debt in the event of the company being wound up.

· A capital loss may not arise under section 104-25 of the ITAA 1997 if the debt is forgiven by the guarantor because subsections 116-30(1) and 116-30(3A) of the ITAA 1997 treat the disposal of the forgiven debt at a market value to be worked out as if the event had not occurred and was never proposed to occur .

However, in such circumstances, interest incurred by a guarantor on personal borrowings to repay company loans will not form part of the CGT reduced cost base of the debt under section 110-55 of the ITAA 1997. For a capital losses made under section 104-25 of the ITAA 1997, subsection 104-25(3) specifically states the capital loss is calculated by using the assets 'reduced cost base'.

The reduced cost base of a CGT asset under section 110-55 of the ITAA 1997 has the same five elements as the cost base under section 110-25 of the ITAA 1997, except for the third element. In brief, the 'reduced cost base' of a CGT asset is defined in section 110-55 of the ITAA 1997 as follows:

· money or property given for the asset

· incidental costs of acquiring the CGT asset or that relate to the CGT event

· balancing adjustment amount, that is, any amount that is assessable because of a balancing adjustment for the asset or that would be assessable if certain balancing adjustment relief were not available

· capital costs to increase or preserve the value of your asset or to install or move it

· capital costs of preserving or defending your title or rights to your asset.

This exclusion of interest expense that forms the third element under section 110-25 of the ITAA 1997 is reinforced by subsection 110-55(5) of the ITAA 1997, which specifically excludes from the reduced cost base any amount that you could have deducted for a CGT asset had you used it wholly for the purpose of producing assessable income.

Conclusion

To conclude, your borrowings were to fulfil your obligations as guarantor for the loans of your private company when your private company ceased trading. Your borrowings had no nexus to your personal earning of assessable income, such as in the form of company dividends. It follows your interest expenses are not deductible under section 8-1 of the ITAA 1997. Nor can they be included in the CGT reduced cost base of the debt owed to you by your company.

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