Edited version of your private ruling

Authorisation Number: 1012476384937

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Ruling

Subject: Loss on cancellation of loans to employee benefits trust deductibility under section 8-1 of the ITAA 1997.

Question 1

Is the loss made by Company B as a result of the cancellation of the loans it provided to an employee benefits trust deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

This ruling applies for the following periods:

XX/XX/XXXX to XX/XX/XXXX

The scheme commences on:

XX/XX/XXXX

Relevant facts and circumstances

Company B is part of the Company B Group which consists of Company B and the Company B Trust. Company B provides a range of services to the group.

On XX/XX/XXXX, Company B proposed and prepared an employee incentive plan which was adopted on XX/XX/XXXX (Company B Plan).

Company B nominated certain Company B employees and Company B subsidiaries employees to participate in the Company B Plan (Participating Employees).

Under the Company B Plan Company B advanced funds (Company B Loans) to the trustee of the Company B Loan Trust (Trustee). The funds were ultimately used by Company B Loan Trust to acquire Company B securities (Securities).

Company B's recourse in respect of the Company B Loans was in effect limited to the market value of the Securities acquired by the Company B Loan Trust. That is, the Company B Loans could be satisfied in full by surrendering the corresponding Securities.

On XXX occasions between the XXXX and XXXX income years, Company B invited Participating Employees to participate in the Company B Plan.

Typically, Company B would fund the Company B Loan Trust with a Company B Loan in order for the Company B Loan Trust to ultimately acquire the Securities. The Company B Loan Trust issued units in itself to Participating Employees on a one unit to one security basis. As such, the Participating Employees held interests in the Company B Loan Trust and the Company B Loan Trust held the interest in the Securities.

The Company B Loan Trust units were issued at the prevailing market value of the Securities and were funded by an interest bearing loan from the Company B Loan Trust to Participating Employees (Company B Loan Trust Loan). The rate of interest on the Company B Loan Trust Loan was equal to the distribution paid on the Securities. The Company B Loan Trust held the Securities for the benefit of the Participating Employees pending the satisfaction of specified vesting conditions.

When a Participating Employee's employment was terminated prior to the satisfaction of the relevant vesting conditions, the Company B Loan Trust would either:

· Continue to hold the Securities and then reallocate the Securities to a new Participating Employee at a subsequent allocation.

· Sell the Securities on the market and return the proceeds to Company B by repaying a Company B Loan.

On most occasions, the first option was selected. Consequently, the total value of the Company B Loans was less than the Company B Loan Trust Loans because the Company B Loan Trust did not require additional funding to acquire the Securities to hold on behalf of the Participating Employees. Instead, the Company B Loan Trust, reallocated previously forfeited Securities to new Participating Employees.

Vesting and Forfeiture of the Securities

Once the vesting conditions were satisfied, the Participating Employees had the option to purchase the Securities held on their behalf by the Company B Loan Trust at the original price paid by the Company B Loan Trust. Alternatively, the Company B Loan Trust could sell the Securities on the market and the net proceeds would be available to the Participating Employee. In the latter situation, the Company B Loan Trust units would be cancelled and the Company B Loan Trust Loan repaid. Effectively, the value provided to the Participating Employee was equal to the increase in the price of the Securities between the date of allocation and the date of exercise of the option following satisfaction of the vesting conditions.

The Company B Loan Trust was to apply all funds received from the purchase of the Securities toward the full satisfaction of the relevant Company B Loan. As such, where a Participating Employee took up the option to acquire Securities, both the corresponding Company B Loan Trust Loan and Company B Loan were satisfied in full.

In this regard, XXXXX Securities were either acquired by Participating Employees or sold on the market on behalf of Participating Employees.

Where the vesting conditions were satisfied but the Securities were 'out-of-the-money', such that the Participating Employees did not take up the option to purchase the Securities, the Company B Loan Trust continued to hold the Securities on behalf of the Participating Employees until the maturity of the Company B Loan Trust Loan. Following maturity of the Company B Loan Trust Loan, the Company B Loan Trust units were forfeited.

In instances where the vesting conditions were not satisfied, the Participating Employees' interests in the relevant Securities held by the Company B Loan Trust were also forfeited.

The Company B Loan agreement provided that, subject to any obligations imposed on Company B under the Corporations Act 2001 or any other requirement imposed by law, where a Security was forfeited, the Security was to be cancelled and the amount payable on cancellation was to be offset against the corresponding Company B Loan in full.

The trust deed of the Company B Loan Trust permitted the Trustee, in certain circumstances, to either:

· Reallocate forfeited Securities to new Participating Employees; or

· Sell forfeited Securities on-market and apply the net proceeds of the sale to the acquisition of Securities for the benefit of new Participating Employees.

In total XXXXX Securities were forfeited. Of these XXXXX forfeited Securities, XXXXXX were reallocated to new Participating Employees. The remaining forfeited Securities were sold on-market.

Buyback and cancellation of Securities

In XX/XXXX, the Australian Securities and Investments Commission (ASIC) granted in principle relief to permit Management Company (M Co), as the responsible entity of Company B Trust, to buyback the Company B Trust units held by the Company B Loan Trust.

In XX/XXXX at the Company B Annual General Meeting, Company B obtained shareholder approval to conduct a selective buyback of Company B shares in accordance with section 257D of the Corporations Act.

Similarly, in XX/XXXX at the Company B Trust Annual General Meeting, M Co as a responsible entity of Company B Trust obtained unit holder approval conduct a selective buyback of Company B Trust units in the manner outlined in the Explanatory Memorandum dated XX/XX/XXXX.

In XX/XXXX, Company B agreed that it would buy back all remaining Securities from the Company B Loan Trust. The buyback agreement permitted for the transfer of Securities to a nominee of Company B.

On XX/XX/XXXX, the Company B Loan Trust transferred XXXXX Securities to Trust Company Limited as custodian for Company B Investment Trust (Company BIT). The consideration for the transfer was the market value of the Securities as at the time of transfer ($XXX per Security or $XXXXX in aggregate). This amount was offset against the Company B Loans.

The transfer of XXXXX Securities to Company BIT was registered in the share and unit register maintained by Link Market Services.

On XX/XX/XXXX, Company BIT transferred the XXXXX Securities to Company B Trust and Company B which were immediately cancelled.

On XX/XX/XXXX, the Company B Loan Trust Loans matured. The Participating Employees' interests in the Company B Loan Trust units were forfeited. In addition, any Securities that were held by the Company B Loan Trust on behalf of Participating Employees were forfeited.

On XX/XX/XXXX, the Company B Loan Trust transferred XXXXX Securities to Trust Company Limited as custodian for Company BIT. The consideration for the transfer was the market value of the Securities as at the time of transfer ($XXX per Security or $XXXXX in aggregate). This amount was offset against the Company B Loans.

The transfer of XXXXX Securities to Company BIT was registered in the share and unit register maintained by Link Market Services.

On XX/XX/XXXX, Company BIT transferred the XXXXX Securities to Company B Trust and Company B which were immediately cancelled.

Calculation of loss on Company B loans

According to the Company B Loan agreements, a total of $XXXXX was provided under the Company B Loans.

A total of XXXXX Securities were allocated to Participating Employees during the life of the Company B Plan.

However, out of the XXXXX Securities which were allocated, XXXXX Securities did not vest and were forfeited; of the XXXXX forfeited Securities, XXXXX were reallocated to new Participating Employees. That is, it was not necessary for these XXXXX Securities to be funded by new loans as the Securities were already held by Company B Loan Trust and were simply allocated to new Participating Employees.

As such, the Company B Loans were in effect only used to fund the acquisition of XXXXX Securities rather than XXXXX Securities. The remaining XXXXX Securities were simply reallocated from previously acquired Securities.

The total dollar value of the Company B Loans required to fund the acquisition of XXXXX Securities was $XXXXX.

Importantly, this is less than the amount per the Company B Loan agreements and is due to the fact that some of the forfeited Securities were simply reallocated to new Participating Employees and did not need to be funded by a new Company B Loan.

Exercise of options by Participating Employees and repayment of Company B Loans

XXXXX Securities were acquired by Participating Employees and a further XXXXX Securities were sold on-market by the Trustee on behalf of Participating Employees. The total dollar value of these Securities was $XXXXX.

The proceeds from the sale of these Securities were used by Participating Employees to repay the corresponding Company B Loan Trust Loans. Similarly, the Company B Loan Trust repaid a corresponding portion of the Company B Loans in full.

As such, the total balance of the Company B Loans was further reduced from $XXXXX to $XXXXX.

Buyback of Securities

On XX/XX/XXXX, XXXXX Securities were bought back by Company B (although transferred to its nominee) at a price of $X (total buyback price of $XXXXX).

The proceeds from the buyback of these Securities were used to repay the corresponding Company B Loans in full. The face value of these Company B Loans was $XXXXX such that a loss of $XXXXX was made by Company B because of the shortfall in the satisfaction of these loans.

The remaining XXXXX Securities were bought back in XX/XXXX at a price of $XXX per Security (total buyback price of $XXXXX). The balance of the Company B Loans owing in respect of these Securities was $XXXXX.

The proceeds from the buyback of these Securities were used to repay the corresponding Company B Loans in full. As the balance of the Company B Loans was $XXXXX, Company B made a loss of $XXXXX because of the shortfall in the satisfaction of these loans.

As such, the total loss made by Company B as a result of the extinguishment of the Company B Loans was $XXXXX ($XXXXX from the XX/XXXX buyback and $XXXXX from the XX/XXXX buyback).

Relevant legislative provisions

Income Tax Assessment Act 1936, section 63

Income Tax Assessment Act 1936, subsection 51(1)

Income Tax Assessment Act 1997, section 8-1

Income Tax Assessment Act 1997, subsection 8-1(1)

Income Tax Assessment Act 1997, subsection 8-1(2)

Income Tax Assessment Act 1997, paragraph 8-1(2)(a)

Income Tax Assessment Act 1997, paragraph 8-1(2)(b)

Reasons for decision

Summary

Company B will not be entitled to a deduction under section 8-1 of the ITAA 1997 for the losses on the Company B Loans.

Detailed reasoning

Subsection 8-1(1) of the ITAA 1997 is a general deduction provision. It provides:

You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a *business for the purpose of gaining or producing your assessable income.

Subsection 8-1(2) of the ITAA 1997 then provides:

However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your *exempt income or your *non-assessable non-exempt income; or

(d) a provision of this Act prevents you from deducting it.

Losses on loans may be deductible under 8-1 of the ITAA 1997 in certain circumstances

Taxation Ruling TR 92/18 clarifies the circumstances in which a deduction for bad debts/losses on the principal of a loan is allowable. TR 92/18, among other things, considers the deductibility of a bad debt under section 51 of the ITAA 1936¹. Therefore, TR 92/18 applies to the facts of this case.

Specifically, paragraph 10 of TR 92/18 states:

Certain taxpayers who fail to satisfy the requirements under section 63 may be entitled to a bad debt deduction under section 51(1) when incurred. Whether or not a loss occasioned by a bad debt is of a revenue or capital nature depends upon a consideration of the facts and circumstances in each case.

Paragraphs 15 and 16 of TR 92/18 provide that in respect of limited recourse loans, where a security is taken in full satisfaction of the debt, any deficiency between the market value of the security and the amount of the debt may be, depending upon the circumstances, an allowable deduction under section 8-1 of the ITAA 1997.

Loss or outgoing incurred

The first requirement of subsection 8-1(1) of the ITAA 1997 is that there is a loss or outgoing incurred.

Federal Commissioner of Taxation v. James Flood Pty Ltd (1953) 88 CLR 492 provides that in order for a loss or outgoing to be incurred under section 8-1 of the ITAA 1997, the taxpayer must have completely subjected or definitively committed itself to the liability and not be dependent on the occurrence of a future event.

Paragraph 11 of Taxation Ruling TR 92/18 provides that a loss occasioned by a bad debt is clearly incurred when the loan is disposed of, settled, compromised, or otherwise extinguished. Where a debt is not disposed of, settled, compromised or otherwise extinguished, it is accepted that the loss of the debt is incurred under section 8-1 of the ITAA 1997 when it is written off as bad in the same way as required by former section 63 of the ITAA 1936.

If a creditor realises a loss at the time it disposes of, settles, compromises or otherwise extinguishes a debt such a loss will, for the purposes of section 8-1 of the ITAA 1997, be incurred at that time.

Clause 3(iii) of the various Loan Agreements, provide that Company B's recourse in respect of the loans was effectively limited to the market value of the relevant securities acquired by the trust.

Therefore, Company B incurred a loss at the time it extinguished the debt owed to it.

Incurred in gaining or producing assessable income, or carrying on a business for the purpose of gaining or producing assessable income

The second requirement of subsection 8-1(1) of the ITAA 1997 is that the loss has a connection with the gaining or producing of assessable income or the carrying on of a business for the purpose of gaining or producing assessable income.

Company B states that the Company B Loans were made to the Trustee solely to enable the Trustee to acquire shares for the benefit of employees participating in the Company B Plan. Clause A of the Executive Loan Security Plan states that the Company B remuneration policy is designed as an equity incentive plan designed to attract, retain and motivate key executives in Company B and associated companies.

The stated objective of Company B was to provide employees with the opportunity to be rewarded with equity for helping create and maintain long term value for Company B shareholders.

Where a contribution is not referable to specific remuneration but is attributable to rewarding, encouraging loyalty or providing an incentive for employees as a general class, an employer may be entitled to a deduction under section 8-1 of the ITAA 1997 for regular contributions paid to the trustee under an employee benefit arrangement, in certain circumstances. This is because the contribution may be an expense that is 'desirable or appropriate in the pursuit of the business ends of the business' (Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; Magna Alloys and Research Pty Ltd v. FCT (1980) 11 ATR 276).

In deciding whether the contribution made to the trustee of an employee benefit arrangement is 'necessarily incurred' in the sense of 'clearly appropriate' to that business, the following factors must be considered:

· The nature of the business activity (Magna Alloys and Research Pty Ltd v. FCT (1980) 11 ATR 276).

· The business purpose for which the outgoing was incurred (Federal Commissioner of Taxation v. The Midland Railway of Western Australia Ltd)

· The objective circumstances surrounding the incurring of the expenditure (Federal Commissioner of Taxation v. South Australia Battery Makers Pty Ltd).

· The character of the outgoing (John Fairfax & Sons Pty Ltd v. Federal Commissioner of Taxation (1959) 101 CLR 30).

It is a question of fact as to how an outgoing or loss is characterised and it must be considered in the context of the taxpayer's intended or expected outcome. As Dixon J noted in Robert G Nall Ltd v. Federal Commissioner of Taxation (1936) 57 CLR 695:

...the circumstances of the transaction must give it the complexion of money laid out in furtherance of a purpose of gaining income.

This means that the circumstances of the outgoing or loss must be 'conducive to the gaining or producing of assessable income or to the carrying on of a business by the taxpayer' (Magna Alloys and Research Pty Ltd v. FCT (1980) 11 ATR 276). An outgoing or loss is conducive to the conduct of a business to produce income where it can be reasonably seen as 'desirable or appropriate' in the pursuit of the business ends of the business (Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; Magna Alloys and Research Pty Ltd v. FCT (1980) 11 ATR 276)

The Commissioner is of the view that the provision of funds to a trust so that those funds could be invested so that returns on that investment could be paid to arm's length employees (where performance hurdles and vesting conditions are satisfied) is accepted to be desirable and appropriate to the business needs of Company B. Thus, the loss on the Company B Loans can be reasonably seen as being made in the pursuit of the business ends of Company B's business.

Therefore, it is considered that the losses on the Company B loans were necessarily incurred in the carrying on of Company B's business, thus satisfying paragraph 8-1(1)(b) of the ITAA 1997.

Capital or of a capital nature

The only relevant exclusion in section 8-1 of the ITAA 1997 is that the loss on the loans should not be capital or of a capital nature.

A distinction is made for the purposes of section 8-1 of the ITAA 1997 between a capital outgoing and a revenue outgoing.

Whether an outgoing is of capital or revenue in nature can be determined by reference to the test articulated by Dixon J in Sun Newspapers Ltd and Associated Newspapers Ltd. v. Federal Commissioner of Taxation (1938) 61 CLR 337:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay...

The advantage sought by the expenditure is critical in determining its character. This was emphasised in the decision of the High Court in G.P. International Pipecoaters Pty Ltd v. FC of T 90 ATC 4413.

In Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634 Dixon J stated:

What is an outgoing of capital and what is an outgoing on account of revenue depends on what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.

Character of the advantage sought

Whether a loss occasioned by a bad debt is capital or revenue in nature depends upon an examination of the circumstances which occasioned the loss and the relation that these circumstances bear to the taxpayer's income earning activities. If the loss is an ordinary incident of the taxpayer's income earning activities then the loss will be on revenue account. For example, paragraph 67 of TR 92/18 provides that, a bad debt loss incurred by a financial institution would generally be expected to be a revenue loss.

Losses of loan principal are generally capital in nature

Ordinarily, a taxpayer could account for losses on loan principal on revenue account if the taxpayer is carrying on a business as a banker, financier or moneylender or in the limited categories of other cases where the loans represent trading stock of the lender. Those taxpayers who do not fall within the above categories would ordinarily account for the corpus of a loan as capital and any loss in relation to that capital asset is a loss on capital account.

In Avco Financial v. FC of T 82 ATC 4246 the court stated that:

…a loan and the repayment of a loan are generally an affair of capital. And so they are. The money lent, judged from the viewpoint of both borrower and lender, is in general capital; on the other hand, the interest payable on the money lent is generally income in the hands of the lender and a revenue outgoing in the hands of the borrower.

In Federal Commissioner of Taxation v. Marshall and Brougham Pty Ltd 17 FCR 541, Bowen and Jenkinson JJ considered whether a loss by a company of an amount on deposit with a finance company was a revenue or capital loss for the purposes of section 8-1 of the ITAA 1997. The company acted as the banker of a building and construction group of companies and therefore the profit of the company was derived not from the activities of building and construction but from 'management and related charges and interest received from moneys which passed through its hands as 'bankers' for the group'.

Finally, in the recent Full Federal Court decision in Sanctuary Lakes Pty Ltd v FC of T 2013 ATC 20-395, Edmonds J considered the deductibility to Sanctuary Lakes Pty Ltd of a loss on a loan to Sanctuary Lakes Residents Association Limited (SLRA) under 8-1 of the ITAA 1997 and came to the following conclusions:

Accepting for present purposes that the forgiveness of the SLRA debt occurred in the course of Lakes carrying on its business, it is, nevertheless, difficult to identify, on the evidence and the findings thereon, any relevant nexus between that business, irrespective of its scope, and the incurring of a loss by foregoing a debt to an unrelated company (SLRA was a company limited by guarantee).

But even if a relevant nexus can be identified, clearly it is a loss of capital or of a capital nature and not deductible under s 8-1.

Company B has not asserted, in the ruling application, that it is a banker, money-lender or financier. Therefore, based on the cases above, it is considered that Company B's loss is capital or capital in nature and is therefore excluded from deductibility under paragraph 8-1(2)(a) of the ITAA 1997.

Conclusion

The loss is considered to be of a capital nature, as the nature of the advantage sought was to establish the nucleus of a fund which was not intended to be depleted during the life of the Company B Plan. Therefore, the Commissioner considers Company B's loss to be capital or capital in nature and therefore excluded from deductibility under paragraph 8-1(2)(a) of the ITAA 1997.

¹ Subsection 51(1) of the ITAA 1936 is the predecessor to section 8-1 of the ITAA 1997. The reasoning adopted in TR 92/18 is considered to apply to section 8-1.

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