Edited version of private ruling

Authorisation Number: 1011533024600

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Ruling

Subject: Deductions

Question 1

Whether the taxpayer is entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997(ITAA 1997) for loss incurred on shares and options that were originally declared as income?

Answer

No.

Relevant facts and circumstances

The taxpayer's business includes services to the emerging company sector.

The taxpayer's fee model includes receipt of an equity component as part of settlement of the fee. The equity component is valued dependant on the value of the particular company at the time, an invoice is raised by the taxpayer for services rendered and the invoice is declared as fee income by the company and included as ordinary income of the business as per section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997). The taxpayer then pays 30% tax being the company tax rate on this income.

The shares or options received by the taxpayer as part of the fee income can have conditions attached. For example, the equity maybe escrowed for a period, this could be for a number of years. This results in the taxpayer being unable to sell the equity interest to realise the funds.

It is also common for the taxpayer to receive unlisted options. Generally the exercise price of unlisted options received is higher than the current trading price of the shares. It is not economic for the taxpayer to exercise the options at the time of receipt to enable the options to be sold. This would result in a significant loss to the taxpayer. The taxpayer generally needs to hold for a period before they can realise these options at a profit.

The value placed on the shares or options which is based on the taxation valuation methodology is recorded as ordinary income by the taxpayer as per section 6-5 ITAA 1997. The taxpayer is required to pay tax on the equity at the higher price with the expectation the equity will be realised at a greater value when sold. The equity value declared as part of the taxpayer's taxable income is generally higher than the actual price that can be gained from selling the equity. Therefore it is not in the taxpayer's interest to sell the equity at this time of receipt.

The taxpayer has provided examples of equity which were received as a fee that now has been sold for a loss or options that have expired due to the downturn in the market.

Taxpayer's Contentions

As mentioned above the taxpayer's fee model includes receipt of equity as part of their remuneration. The taxpayer receives equity in the client's business in lieu of cash on the basis there will be a potential increase in the equity received. When a profit is realised the taxpayer will then record the gain as ordinary income (section 6-5 of the ITAA 1997), as the equity was gained via the ordinary business operations of the company and the equity was only ever acquired due to the fee structure of the business. It was never intended for the taxpayer to be an investor in the client's company or to hold the equity on capital account.

Due to the Global Financial crisis, and the market conditions over the last few years the equity has declined dramatically in value, the taxpayer has been unable to realise the equity which was received as part of their fee structure for a profit. Numerous unlisted options which were recorded as ordinary income to the taxpayer have now expired resulting in a loss to the taxpayer or shares have been realised at a loss. To realise this equity at a loss was never the taxpayer's intention.

Reasons for decision

Taxation determination TD 93/234 states that shares received as consideration for providing services (for research and development activities) are assessable income in the hands of an independent contractor pursuant to section 6-5 of the ITAA 1997. That is, the value of the shares constitutes gross income derived by the contractor for the purposes of section 6-5; the amount of assessable income is the value of the shares at the time they are issued.

Position after the amount has been included in assessable income

In a number of cases the Commissioner has sought to tax a second time the consideration received by a taxpayer pursuant to section 21 of the Income Tax assessment Act 1936 (ITAA 1936) when the relevant asset has finally been converted to cash. In Commissioner of Taxes v Union Trustee Co of Australia Ltd the taxpayer, who was a wool grower, participated in a company set up by the Commonwealth and was allotted shares in that company by direction from the Commonwealth but in respect of which he gave no consideration. At the time of the allotment of the shares to him he was assessed upon the value of the shares at the relevant time. Subsequent to this there were a number of reductions of capital of the relevant company, and after distributions of capital to him in excess of the value at which the shares were originally assessed, the Commissioner of Taxation sought to tax the taxpayer on the surplus. The Privy Council found that the amounts received by the taxpayer in respect of the shares were capital distributions and were not taxable in his hands (pre CGT era).

In 9 CTBR Case 51; the taxpayer was allotted 21,088 shares in a company in consideration of the transfer by him to the company of his interest in certain syndicates. As a result the Commissioner assessed the market value of shares at £15,816 and assessed the taxpayer for £4544. Subsequently, the shareholder realised the shares at a price significantly less than that for which he was assessed. It was held that the taxpayer was not entitled to a deduction for the loss, as the relevant profit making scheme pursuant to which the original assessment took place had ended at the time the shares were obtained by him in exchange for this interest.

The Board of Review in this case found support in C 0f T V Union Trustee Co of Australia case. The Board said that the Privy Council had expressed a general rule applicable to all cases where the receipt of property in any form (other than money) constituted the derivation of ''income'', the effect of which was to preclude the price for which the property was ultimately sold by the recipient from being taken into account in the assessment of income of the year of sale. The Board stated that on the facts of the case it thought that the taxpayer's profit-making scheme was concluded upon the acquisition by him of the shares.

In IT Case No 726(1951) 18 SAfTC 90, the taxpayer had received certain shares in consideration of services rendered by him to the company. At the time that the shares were received by him from the company they were worth £300. Subsequently, the taxpayer disposed of the shares for £1880 and the Commissioner sought to assess the taxpayer for the difference. It was held that upon allotment of the shares to the taxpayer they became his property as capital, and unless it could be shown that the taxpayer was carrying on business as a share trader, the disposal at a later date would be a capital accrual. Again this was a pre CGT era.

The principle which appears to emerge from the above decisions is that prima facie the receipt of the asset is likely to be at the end of some income producing activity, and that further accruals will be on capital account. An increase in the value of shares will be a capital gain and conversely a decrease in the value of the shares will result in a capital loss pursuant to section 100-35 of the ITAA1997

The same principle is applicable to options received as consideration in return for services provided.

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