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Ruling

Subject: Exit payment

Question 1

Can you claim a deduction for your exit payment under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

No

Question 2

Is your exit payment a capital gains tax (CGT) loss?

Answer:

Yes

Question 3

Can you claim a deduction or a capital loss for interest expenses incurred on borrowings to finance your exit payment?

Answer:

No

This ruling applies for the following period

Year ended 30 June 2012

The scheme commences on

1 July 2011

Relevant facts and circumstances

You were one of two director/shareholders of a company that carried on a business. Due to the global financial crisis, business profitability declined. You decided to leave the business however the other director/shareholder decided to remain.

As the business debts and liabilities exceeded the business assets you agreed to pay an exit sum. The business debts and liabilities included borrowings by the company from a commercial bank, for which you served as guarantor, with your private home used as security.

You borrowed the exit amount from a bank to fund the exit payment. Both the company and the commercial bank released you from your obligations in relation to the debts and liabilities and the bank guarantee.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 104-5

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Section 110-35

Income Tax Assessment Act 1997 Section 110-40

Income Tax Assessment Act 1997 Section 110-55

Income Tax Assessment Act 1997 Section 40-880

Reasons for decision

Deductibility under section 8-1

Section 8-1 of the ITAA 1997 allows a general deduction for 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 where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

The following characteristics are accepted as an indication that an outgoing is on capital account (Sun Newspapers Ltd and Associated Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938) 1 AITR 403):

· the expenditure is related to the business structure itself, that is, the establishment, replacement or enlargement of the profit yielding structure rather than the money earning process, or

· the nature of the advantage has lasting and enduring benefit, or

· the payment is 'once and for all' for the future use of the asset or advantage rather than being recurrent and ongoing.

In the case Kennedy Holdings and Property Management Pty Ltd v. Federal Commissioner of Taxation (1992) 39 FCR 495; (1992) 92 ATC 4918; (1992) 24 ATR 321, a payment by a lessor to the lessee to terminate the lease in order to grant a new and more profitable lease to a new tenant, was held to be capital in nature and not deductible. The payment secured a permanent advantage, that is, the surrender of the lease with the option to renew.

In your case, your exit payment is capital in nature, as it was not incurred in gaining or producing your assessable income. Instead, your exit payment was paid to extinguish debts and liabilities owed by you in your capacity as guarantor for company borrowings. Further, your exit payment indemnified you against any claims for liabilities, which the company and bank could potentially make against you. It follows your exit payment provided you with an enduring benefit of being free from debt and liability obligations. As the nature of the advantage gained from your exit payment has a lasting and enduring benefit, it is capital in nature.

Also, your exit payment cannot serve as the basis for a revenue deduction because it represents losses already incurred and deducted by your former companies. To deduct your exit payment would result in a double deduction, i.e., to both yourself and your former companies. In short, your exit payment indirectly represents the repayment of principal for borrowings. Repayments of principal for borrowings are not deductible amounts.

To conclude, your exit payment, being capital in nature, is not deductible under section 8-1 of the ITAA 1997.

CGT loss

The Commissioner's view about the implications of a guarantee to pay a debt is found in Taxation Ruling TR 96/23. Paragraph 30 of TR 96/23 states:

On entering into a contract of guarantee, the guarantor acquires an asset which is a right to be indemnified by the principal debtor.

Section 108-5 of the ITAA 1997 states a right to enforce a contractual obligation is a CGT asset.

CGT event D1 under section 104-35 of the ITAA 1997 happens if you create a contractual right or other legal or equitable right in another entity.

Subsection 104-35(3) of the ITAA 1997 states you make a capital gain if the capital proceeds from creating the right are more than the incidental costs you incurred that relate to the event. You make a capital loss if those capital proceeds are less.

CGT event C2 under section 104-25 of the ITAA 1997 happens when the ownership of an intangible CGT asset ends by cancellation, surrender, release or similar endings.

Subsection 104-25(3) of the ITAA 1997 states you make a capital gain if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base.

Section 110-35 of the ITAA sets out the categories of incidental costs, which can form the 2^nd element of a cost base and reduced cost base of a CGT asset. The 10^th incidental cost is termination or other similar fees incurred as a direct result of your ownership of a CGT asset ending.

Termination fees and other similar fees, such as exit fees, are contractual fees imposed by one party on the other as a result of the second party breaking a contract. For example, in the context of the irrigation industry, a termination fee is typically any fee or charge payable to an operator for either terminating access or surrendering a water delivery right.

In your case, when you entered into a contract of guarantee with the commercial bank for the debts and liabilities of the company, you created a right in the commercial bank and you acquired a right to be indemnified by the company. When you made your exit payment, you ended your right to be indemnified by the company, which was CGT event C2 under section 104-25 of the ITAA 1997. Your exit payment was a termination fee, i.e., an incidental cost under section 110-35 of the ITAA 1997. It follows your exit payment will form part of your reduced cost base under subsection 104-25(3) of the ITAA 1997. It other words, your exit payment will be a CGT loss.

Interest expenses not deductible

Section 8-1 of the ITAA 1997 allows a general deduction for 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 where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

Taxation Ruling TR 96/23 is about the implications of a guarantee to pay a debt. Paragraph 30 of TR 96/23 states:

On entering into a contract of guarantee, the guarantor acquires an asset which is a right to be indemnified by the principal debtor.

Paragraphs 137 and 138 of TR 96/23 state:

Liabilities arising under contracts of guarantee will not be deductible…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.

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.

Taxation Ruling TR 2004/4 allows deductions for interest expenses incurred following the cessation of relevant income earning activities. Here, in relation to a private company, interest expenses are deductible when a company director/shareholder borrowed funds and on-lent those funds to finance the operations of a company. In others words, the guidance in TR 2004/4 does not apply to when a director/shareholder is guarantor for company borrowings.

In your case, you acquired a right to be indemnified by the company and made a payment to terminate that right. As provided for in TR 96/23, unlike in the case of a solicitor, the provision of guarantees was not a regular incident of your income earning activities. It follows a deduction for interest on personal borrowings to terminate your right of indemnity under the guarantee is not available to you under section 8-1 of the ITAA 1997 because the interest expense is related to your ending a CGT asset rather than related to your gaining or producing assessable income.

Interest expenses not a capital loss

Section 100-40 of the ITAA 1997 provides, for the purpose of working out a capital loss, costs are called the reduced cost base of the asset.

Section 110-55 of the ITAA 1997 states all of the elements of the reduced cost base of a CGT asset are the same as those for the cost base (under section 110-25), except the third one, which includes interest on money borrowed to acquire the asset. Thus, interest on money borrowed to acquire a CGT asset cannot be included in a reduced cost base under section 110-55.

In your case, you made a capital loss under section 104-25, in which your incidental costs form part of a reduced cost base. It follows section 10-55 of the ITAA 1997 prohibits you from including your associated interest expenses in the reduced cost base.

Interest expenses not deductible over five years

Section 40-880 of the ITAA 1997 is a provision of last resort which allows a deduction over five income years for certain business capital expenditure incurred after 30 June 2005 which is not otherwise taken into account or denied a deduction by some other provision.

Subsection 40-880(2) of the ITAA 1997 states you can deduct, in equal proportions over a period of five income years starting in the year in which you incur it, capital expenditure you incur:

1. in relation to your business; or

2. in relation to a business that used to be carried on; or

3. in relation to a business proposed to be carried on; or

4. to liquidate or deregister a company of which you were a member, to wind up a partnership of which you were a partner or to wind up a trust of which you were a beneficiary, that carried on a business.

In relation to a business another entity carries on, subparagraph 40-880(4)(b)(i) of the ITAA 1997 provides you can only deduct the expenditure, for a business that another entity used to carry on or proposes to carry on, to the extent that the expenditure is in connection with your deriving assessable income from the business.

Taxation Ruling TR 2011/6 is about core issues in relation to section 40-880 of the ITAA 1997. Paragraphs 86 to 91 of the ruling provide the following two theoretical examples:

Wayne and Blayne are shareholders in X Pty Ltd. As their personal relationship deteriorates Blayne considers whether or not to sell his shares and incurs capital expenditure on professional advice. The sale does not proceed because they resolve their relationship issues. Blayne's expenditure is not in relation to the business for the purpose of paragraph 40-880(2)(a).

XYZ Pty Ltd carries on a medical research and supply business. The shareholders' involvement in the business includes providing medical expertise and services to the company. Because of other commitments one of the shareholders has been and will continue to be unable to devote resources to the business. The directors of XYZ Pty Ltd decide that in the interests of the business the ownership of the company should be restructured to replace the inactive shareholder with a private equity investor with the business acumen to push the company forward and inject capital for the purpose of future growth. To facilitate the restructure XYZ Pty Ltd paid $200,000 to the shareholder as an incentive to agree to the sale of his shares to the equity investor. The expenditure is capital expenditure of the company in relation to the business for the purpose of paragraph 40-880(2)(a).

In your case, your associated interest expenses does not satisfy subparagraph 40-880(4)(b)(i) of the ITAA 1997 for at least three reasons. First, your capital expenditure did not place you in a position to derive assessable income from the company. Second, your capital expenditure was not in relation to a business another entity (i.e., the company) used to carry on or proposes to carry on. Instead, your payment was in relation to a business currently being carried on. Third, your exit payment, whilst being capital expenditure, was not business capital expenditure for the purpose of section 40-880. The relevant business is carried on by the company rather than you. Similar to the example in paragraph 86 of TR 2011/6, your exit payment was personal capital expenditure to essentially repay your personal debt obligations under a bank guarantee.

Interest expenses: conclusion

Your associated interest expenses in relation to your exit payment are not deductible nor can they be included in a CGT cost base under any taxation provision.

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