Edited version of private ruling

Authorisation Number: 1011596799019

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Ruling

Subject: Guarantor losses

Are you entitled to a capital loss for a payment you were required to make as a guarantor?

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 guaranteed a loan made by a bank to a company. Your family trust was a shareholder of the company. You are a beneficiary of the family trust and the sole shareholder of the family trust's corporate trustee. The company defaulted on its loan and the bank called upon the guarantee given by you for the loan. You were forced to sell your investment properties and pay the guaranteed amount to the bank during the year ended 30 June 2010. As the company was insolvent, liquidators were appointed. Their appointment did not occur until the following income year.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-20

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

If you were a shareholder of the insolvent company, you may have incurred a capital loss in relation to the company debt you guaranteed (in the income year in which the company is deregistered). This is because it would have been expected you entered into the contract of guarantee to promote and enhance your earning of assessable income.

However, in your case, you were a beneficiary of a discretionary trust, which was a shareholder of the company. As a trust beneficiary in relation to the company income, you did not have an absolute interest in either the company or trust income. As there was not a sufficient nexus between the debt owed to you and your income earning activity, the debt which came to be owed to you as a guarantor is a personal use asset.

Section 108-20 of the Income Tax Assessment Act 1997 (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. It follows any capital loss you made as the guarantor for the debt is to be disregarded and a capital loss is not incurred in any income year.

Detailed reasoning

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 FC of T v. Total Holdings (Australia) 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 the trust.

Taxation Ruling IT 2385, which is about 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 the trust. 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; (1980) 24 CTBR (NS) Case 11 and again by Administrative Appeals Tribunal Case U44 87 ATC 318.

In your case, you were the beneficiary of a discretionary family trust, which was a shareholder of the insolvent company. The debt owed to you by the insolvent company is a personal use asset because your entering the contract of guarantee was not expected to promote and enhance your income earning activity. There was an insufficient nexus between your guaranteeing the loans and your earning of trust income because, as a beneficiary of a discretionary family trust, you did not have an absolute interest in either the company or trust income.

In the alternative case, if you were a shareholder of the insolvent company (of which you are not), if the provisions of TR 96/23 were fulfilled, a capital loss would not have occurred during the year ended 30 June 2010 because the insolvent company was not deregistered during the year ended 30 June 2010.

However, in your case, because the debt owed to you by the insolvent 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.

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