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Ruling

Subject: Deductibility of interest for guarantor of a company loan

Are you entitled to a deduction for repayments of interest made to meet your obligations under a guarantee to repay the loan of a private company that ceased trading?

No.

This ruling applies for the following period

Year ending 30 June 2009

Year ending 30 June 2010

Year ending 30 June 2011

The scheme commenced on

1 July 2008

Relevant facts

You are one of two directors and shareholders of a company.

A business loan from a bank was advanced to the company and as security you personally guaranteed and indemnified the bank jointly and severably with the other shareholder.

The only other guarantees you provided were to trade creditors. You did not provide any other guarantees that were not associated with this business.

You state that at all material times the funds advanced to the company were used for expenses associated with the business.

You state that the business folded due to high costs. You resigned as directors and the lease was terminated when the company went into voluntary liquidation.

Subsequent to the collapse of the business, you are fulfilling your personal legal obligation by attending to your share of the repayment of the company loan by way of principal and interest repayments.

You have not further extended the loan or kept it on foot for any other reason un-associated with the former income-earning activities.

During the trading of the company, you earned assessable income (wages) and expected dividends from the business.

The company was deregistered.

Reasons for decision

Summary

Interest expenses incurred by shareholders or directors who act as guarantors to company borrowings are capital in nature and therefore not deductible. 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 expenses were to fulfil your obligations as guarantor for the loan of a private company when the company ceased trading. Your outgoings had no nexus to your personal earning of assessable income, such as in the form of wages or expected company dividends. It follows that your interest expenses are not deductible.

Detailed reasoning

Where an individual is guarantor for funds borrowed by 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.

To be deductible, there must be a sufficient connection between the outgoing and the activities which produce or are expected to produce assessable income (Ronpibon Tin N.L.Tongkah Compound N.L. v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 236).

The Commissioner's view about the implications of a shareholder's guarantee to pay a company's debt is found in Taxation Ruling TR 96/23. The ruling states that liabilities arising under contracts of guarantee will not be deductible if the provision of guarantees is not a regular and normal incident of your income earning activities, that is, where you are not in the business of giving guarantees.

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: Jennings (Inspector of Taxes) v. Barfield & Barfield [1962] 2 All ER 957; 40 TC 365 (Jennings' case).

TR 96/23 also refers to a line of decisions of the Administrative Appeals Tribunal and the former Boards of Review which accept that payments made under guarantees by shareholders or directors are not deductible. It also states:

135. The principle in Total Holdings might be considered to apply to a shareholder who guarantees the debts of the company in which he/she holds shares. This principle would then be sufficient to allow one of the two positive limbs of subsection 51(1) to be satisfied. However, a deduction may be denied because the expenditure is found to be on capital account. As the majority in Hooker Rex determined, a guarantee is akin to loan capital….

The Federal Court has confirmed in Bell & Moir Corporation Pty Ltd v. FC of T 99 ATC 4738; (1999) 42 ATR 421 that payments made under guarantees, given to a bank and finance company on behalf of a company in which the taxpayer had a one-third stake, were capital in nature and not deductible. It was found that the advantage sought by the taxpayer in providing the guarantees was the extension of credit facilities to the company. This served to strengthen the base from which the company carried on business so that the taxpayer could continue to trade with it. Such an enduring benefit was ordinarily capital in nature.

In Case L3 (1979) 79 ATC 14 (1979) 23 CTBR (NS) Case 75, a case which is similar to yours, the taxpayer who was a director, shareholder and employee of two companies, gave a number of personal guarantees in respect of each of the company's bank overdrafts. The taxpayer and some of the directors of the companies also guaranteed the performance by each company of its obligations under a number of equipment leasing contracts which the companies had entered into. The companies later went into liquidation and the bank collected judgement from the taxpayer, as one of the guarantors, for the amount owing to the bank. The taxpayer paid $7,500 under the guarantee to the bank and claimed a deduction. The Board of Review held that the payment pursuant to the guarantee was not incurred in gaining or producing assessable income under either the first or second limbs of subsection 51(1) of the ITAA 1936 and even if it did satisfy the requirements of the first or second limbs, it was an outgoing of capital or of a capital nature.

To summarise, the majority of the cases in which deductions have been disallowed because the outgoing was on capital account can be seen to have exhibited one or both of the following characteristics:

1. In several cases the guarantees have been given with respect to loans to companies connected with the guarantor, and the guarantee payments have been treated as being on capital accounts due to their close analogy to loan capital.

2. In other cases guarantees have been given in relation to the establishment or protection of a capital asset, and consequently payments made have attracted a capital character.

In your case, you provided a guarantee on behalf of a company and you were subsequently called upon by a lending institution to fulfil your obligation under this guarantee. The provision of guarantees was not a regular and normal incident of your income earning activities. Rather, in your capacity of director/shareholder, you provided personal guarantees as security for the company to obtain a loan. This guarantee was called upon when the company went into liquidation and you had an obligation to honour the guarantee given.

There is no connection between the guarantee payments and the earning of your assessable income. At the time that the guarantee was called in and you incurred the expense, the company had ceased trading.

Conclusion

You are not entitled to a deduction under section 8-1 of the ITAA 1997 for the guarantor payments as they are not considered to be incurred in gaining your assessable income. The payments were to fulfil your obligations as guarantor for a loan of a private company when that company ceased trading and had no nexus to your personal earning of assessable income, from wages or expected dividends. Taxation Ruling TR 96/23 holds that the expenses of a guarantor are capital in nature.

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