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Ruling

Subject: Deductibility of guarantee payment

Question 1

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the guarantee payment you made?

Answer:

No.

Question 2

Is the amount of the guarantee payment allowable as a capital loss?

Answer:

Yes.

This ruling applies for the following period

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ending 30 June 2013

The scheme commenced on

1 July 2009

Relevant facts

You applied for and obtained an ABN to set up a business to provide guarantees in return for a fee in relation to debt funding for projects that you were connected with.

The property development projects were developed through the use of separate special purpose incorporated entities.

A company was established for the purpose of a development project. The land acquired to develop the project was partly financed with a loan.

The directors of the company were required to provide personal guarantees as part of the security for this loan.

The directors of the company entered into an agreement with the company to provide personal guarantees to the bank for a fee.

There was an expectation at that point in time that the provision of this personal guarantee would be the first of many given the fact that the project development managers were actively seeking other project opportunities and also at a future date the company would need debt finance which would require the provision of further personal guarantees.

The company paid your guarantee fee and you included this in your business income in your income tax return.

The company entered into an agreement with a bank and another entity to provide finance.

The debt finance was for completion of the project.

The new debt facility included payout of the existing bank loan facility.

Personal guarantees to each lender were provided from each of the directors.

The directors entered into an agreement with the company to provide personal guarantees for the new loans for a fee.

The directors agreed that the guarantee fee would only be payable upon completion of the project.

Due to a variety of reasons the company was placed into the hands of a Receiver and Manager by the bank.

Consequently, all proceeds of sale from the project were directed to the bank. There were no proceeds available to make payment to the guarantee providers in terms of the agreement.

The directors' personal guarantee fees were included in the statement of assets and liabilities provided to the Receiver and Manager and the Liquidator.

The bank filed a Statement of Claim in the courts, commencing proceedings against the directors to enforce the personal guarantees.

You entered into a Deed of Settlement and Release with the bank which required you to make a payment in settlement of the personal guarantee.

You made the payment within the terms of the agreement.

The liquidator of the company has advised that there is little to no likelihood of a dividend to ordinary unsecured creditors or to those creditors who have invested in the project.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 104-25

Reasons for decision

Summary

In your case, your expenses were to fulfil your obligations as guarantor for the debt of an associated private company.

Payments of guarantee expenses incurred by shareholders or directors who act as guarantors to company borrowings are capital in nature and therefore not deductible under section 8-1 of the ITAA 1997.

By entering into an agreement to act as guarantor, you have acquired a capital asset (the right to indemnity against the company). On payment of the guarantee amount the right becomes enforceable as a debt against the company. However, as the liquidation of the company constitutes a release and disposal of this asset for no consideration, you are entitled to claim a capital loss for the amount you paid as part of the guarantee.

Detailed reasoning

Is the guarantee payment allowable as a deductible expense?

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 except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

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. and Tongkah Compound N.L. v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431).

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).

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 providing guarantees.

Essentially, the payment of an amount by a guarantor gives rise to a debt owed by the company to the guarantor (paragraph 37 of TR 96/23).

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 (1999) 99 ATC 4738; 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 Q39 83 ATC 171; (1983) 26 CTBR (NS) Case 103 the taxpayer was a chartered accountant, and also a director and shareholder of a nominee company incorporated for the purpose of holding various blocks of land for nominated beneficiaries, being principally family members. The taxpayer received fees for his accountancy work for the company. The company borrowed moneys for the acquisition and development of a block of land, and the taxpayer guaranteed the loan. The taxpayer became obliged to make a payment pursuant to the guarantee, which he claimed as a deduction. He argued that his circumstances were similar to Jennings case (see above). However, the board distinguished that case, concluding that the giving of the guarantees was not incidental to the carrying on of the taxpayer's accountancy business having regard to the minimal number of occasions when guarantees were given in respect of transactions entered into at arm's length (i.e. with respect to persons or companies outside the taxpayer's family), and the fact that the giving of guarantees was not an act commonly engaged in by chartered accountants. The Chairman also referred to a line of Board cases stretching from 1946 which concluded that payments under such guarantees are capital in nature.

In Case V115 88 ATC 733; AAT Case 4501 (1988) 19 ATR 3697 a deduction was not allowed for payment made by the taxpayer who was a director and shareholder of a land development company and who was a creditor of the company under a guarantee given by the taxpayer in respect of the company's liabilities.  

Where a director incurs a loss as a consequence of guaranteeing borrowings of a company, the promise of a fee was considered to be an inducement to undertake a risk of a capital nature: Case V117 88 ATC 741; AAT Case 4503 (1988) 19 ATR 3708.

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.

Taxation Ruling TR 97/11 provides the Commissioner's view of the factors used to determine if you are in a business for tax purposes.

The factors that are considered important in determining the question of business activity are:

· whether the activity has a significant commercial purpose or character

· whether the taxpayer has more than just an intention to engage in business

· whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

· whether there is regularity and repetition of the activity

· whether the activity is of the same kind and carried on in a similar manner to that of ordinary trade in that line of business

· whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit

· the size, scale and permanency of the activity, and

· whether the activity is better described as a hobby, a form of recreation or sporting activity.

TR 97/11 states the indicators must be considered in combination and as a whole and whether a business is being carried on depends on the 'large or general impression gained' from looking at all the indicators and whether these factors provide the operations with a 'commercial flavour.

Application to your circumstances

In your case, you gave guarantees on behalf of an associated company and you were subsequently called upon by a lending institution to fulfil your obligation under one of these guarantees. You paid an amount as a consequence of the loan guarantee.

Even if you were rewarded with the payment of a fee for the provision of the personal guarantee(s), the providing of guarantees to an associated entity does not amount to the carrying on of a business. You have provided no evidence indicating that you provided the guarantees as part of a wider business (of providing guarantees), to arms-length clients (that is, with respect to persons or companies not associated with you), or that you would have a reasonable expectation of profit from your activities.

Rather, in your capacity of director, you provided the guarantees as security for an associated company to obtain loans and you were subsequently called upon by the bank to fulfil your obligation under this guarantee.

Your outgoings did not have the requisite nexus to your personal earning of assessable income. The 'fee' is considered to be an inducement to undertake a risk of a capital nature.

Therefore, the expenses you incurred in relation to the guarantee are considered to be capital in nature and not deductible under section 8-1 of the ITAA 1997.

Is the guarantee payment allowable as a capital loss?

Section 104-25 of the ITAA 1997 states that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset:

· being redeemed or cancelled; or

· being released, discharged or satisfied; or

· expiring; or

· being abandoned, surrendered or forfeited; or

· if the asset is an option - being excised; or

· if the asset is a convertible interest - being converted

The time of the event is:

· when you enter into the contract that results in the asset ending; or

· if there is no contract - when the asset ends.

Some examples of an intangible asset include a debt, a lease, a right to indemnity, a patent, a trademark or a copyright.

Taxation Ruling TR 96/23 at paragraph 30 explains that:

On entering into a contract of guarantee, the guarantor acquires an asset which is a right to be indemnified by the principal debtor. That right of indemnity arises by way of an express or implied term in the contract of guarantee, if the contract is a tri-partite agreement. Otherwise, the right of indemnity arises under an implied contract of indemnity between the principal debtor and the guarantor on entry into the contract of guarantee.

In these instances, the asset is taken to have been acquired for a cost base equal to the amount which the guarantor pays, or is required to pay, under the guarantee.

On payment by the guarantor under the guarantee, the right of the indemnity is enforceable as a debt against the principal debtor. As the right of indemnity is in the nature of a debt, it may give rise to a capital loss if it ends without any consideration being received.

In some situations, there may be no likelihood that the principal debtor will pay the debt owing to the guarantor. This may be the case when a company goes into liquidation. The liquidation of a company (the debtor) constitutes a release and thus a disposal of the debt by the guarantor for no consideration.

In your case, you acquired a CGT asset (the right to indemnity) when you entered into a contract (whether real or implied) to provide a personal guarantee to the bank as part of the security for the company's loan. Subsequently, the company went into liquidation and you were called on (as a guarantor under contract) to make a payment to the bank. At the time of the payment, the 'right to indemnity' became enforceable as a debt against the company. However, the liquidation of the company constitutes a release and disposal of your right to indemnity against the company as there is no likelihood that the company will repay its debt to you.

Accordingly, CGT event C2 has occurred (the release of your right to indemnity) and, as you received no consideration for the release of your right, you have made a capital loss equal to the amount paid as part of your personal guarantee.

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