Edited version of private ruling

Authorisation Number: 1011644588091

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Ruling

Subject: Payment of guarantees and a loan

1. Are you entitled to claim a capital loss for the guarantee that you paid out in respect of company A?

Yes.

2. Are you entitled to claim a capital loss for the guarantee that you paid out in respect of company B?

No.

3. Are you entitled to claim a capital loss for the amount that you cannot recoup from company B?

No.

4. Are you entitled to a deduction for the amount that you cannot recoup from company B?

No.

This ruling applies for the following period:

Year ended 30 June 2009

The scheme commences on:

1 July 2008

Relevant facts and circumstances

You were a director of company A and company B.

Company A was the original company of which you and two others were directors and shareholders. One of the other directors/shareholders was acting fraudulently within the company. Once confronted over this activity, this director walked away from the company, however they remained a shareholder. Company B was created in order to distance yourself and the other director/shareholder from the person who had acted fraudulently.

Company C held a percentage of the shareholding of company A. The remaining percentage is held by unrelated trusts. Company C is owned by you and your spouse.

You as the trustee of a discretionary trust held half of the shareholding of company B. The remaining half was held by unrelated trusts.

Some time after 20 September 1985, you and your spouse entered into a guarantee to a bank in respect of company A.

Some time later, you entered into a guarantee to a bank in respect of company B.

Company B had a contract with a Government department. This contract was the major source of company B's income. It was the intention to grow the company from this base, to eventually sell the shares in the company to realise a capital gain.

You were considering selling company B and had found an interested party who offered to purchase it based on the contract with the Government department continuing.

The Government called for new tenders as a result of changes to legislation. Working capital was required to obtain accreditation and to submit a tender as a prime provider for the whole state.

Company B incurred considerable expense in developing and submitting the tender.

The tender was not successful.

You entered into a loan agreement with company B.

This amount was used to pay out employee's entitlements for those who had been placed with the Government department as once their employment with company B had been terminated, there was a requirement to pay out accrued entitlements.

Company B went into liquidation.

You were advised by the liquidators that the loan was not recoverable.

Both company A and company B have now been fully liquidated and deregistered.

You entered into the loans and guarantees as you expected to receive income from the sale of the business once it was back up and on track. This did not occur due to the global financial crisis and the loss of the contract with the Government department. The loan and guarantees were entered into to build up the business in preparation for sale.

You did not expect to receive dividends from company B.

You were receiving monthly consultancy fees from company B. These fees were paid to you through the discretionary trust.

Company C did receive dividends from company A around the time the guarantee was entered into however there were no dividends in later income years. Company C's income is distributed by way of dividend to you and your spouse as the only shareholders of company C.

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 108-5

Income Tax Assessment Act 1997 Section 108-20.

Reasons for decision

Capital loss

A capital gains tax (CGT) asset can be any kind of property, or a legal or equitable right that is not property. A debt or a right to repayment is a CGT asset.

Taxation Ruling TR 96/23 considers the CGT implications of a guarantee to pay a debt.

On entering into a contract for guarantee, the guarantor acquires a right to be indemnified by the principle debtor. The guarantor acquired the right of indemnity at the time of making the contract and the cost base is equal to the amount the guarantor pays.

On payment by the guarantor, the right of indemnity becomes an enforceable debt. Once this debt becomes unrecoverable because a company becomes deregistered CGT event C2 happens and the guarantor's ownership of the debt ends.

Whether or not the guarantor makes a capital loss at this time depends on whether or not the asset is a personal use asset. The question as to whether or not the asset is a personal use asset is determined at the time that guarantor entered into the guarantee and involves an objective purpose test.

Personal use asset

Section 108-20 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a capital loss that is made from a personal use asset is disregarded.

A personal use asset is a debt arising other than:

· in the course of gaining or producing your assessable income, or

· from your carrying on a business.

Paragraph 47 of Taxation Ruling 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 or in the carrying on of a business. Therefore, 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, or came to be owned in the carrying on of a business, the debt would not be a personal use asset and a capital loss would be allowed.

Therefore, the 'test' of whether the debt is a personal use asset is whether the debt came to be owed otherwise than in the course of gaining or producing your assessable income, or in carrying on a business. The test is an objective purpose test, by examining the surrounding circumstances at the time of making the loan. If the purpose of a shareholder in a company in making a loan to the company, for instance, was to assist the company to continue in business, and thus to earn profits and to distribute dividends to the shareholder, the debt would not be a personal use asset.

When looking at this 'test' in your situation, it is important to recognise that:

· company A

· company B

· company C

· the discretionary trust, and

· you

are all separate and distinct entities.

Guarantee in respect of company A

It is considered that the guarantee that you entered into in respect of company A was entered into for the purpose of gaining or producing assessable income. Company A was paying dividends to company C. You are a shareholder of company C and company C was distributing its income to you in the form of dividends. The income that was being made by company A flowed through to you as a shareholder of company C. Therefore, it can be determined that you entered into the guarantee with the intention of receiving assessable income. Accordingly, the debt owed to you in respect of the guarantee is not a personal use asset and you are entitled to a capital loss.

Guarantee and loan in respect of company B

The guarantee and the loan are personal use assets. We have considered the following factors in reaching our conclusion:

· you were not a direct shareholder of company B. The discretionary trust was a shareholder and any income that you may have received was at the discretion of the trustee of this trust.

· the consultancy fees that you were receiving were paid by company B to the discretionary trust. The trust was then paying you at the trustee's discretion. Therefore, it cannot be determined that you entered into the guarantee and the loan agreement with the expectation of promoting and enhancing your income earning activity. The guarantee and loan may well have promoted or enhanced the income earning activity of the trust, however as previously stated, the trust and you are two separate entities. Furthermore, the income that you received from the trust was dependant upon the trustee exercising their discretion in your favour.

· you may have entered into the guarantee and loan in order to build up the company for sale. However, had the sale occurred any capital gain would have been made by the trust, rather than you. Again, this means that at the time of entering into the guarantee and the loan agreement, it cannot be established that the purpose of doing so was to promote or enhance your income earning activity.

Accordingly, the debt owed to you is a personal use asset and any capital loss must be disregarded.

Deduction

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

However, no deduction is allowed to the extent that the losses or outgoings are of a capital, private or domestic nature.

You loaned an amount to company B. The purpose of the loan was not to directly produce assessable income yourself but to enable company B to produce assessable income.

Therefore, the loan is capital in nature and you are not entitled to a deduction for this amount.

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