Edited version of your private ruling

Authorisation Number: 1012499213042

Ruling

Subject: Capital Gains Tax

Question 1

Does the forfeiture of the debt owed by the company trigger a CGT event C2 for the Unit Trust?

Answer

Yes

Question 2

If yes, is the Unit Trust entitled to claim a capital loss in its income tax return as a result of CGT event C2?

Answer

Yes

This ruling applies for the following period(s)

01/07/2010 - 30/06/2011

The scheme commences on

01/07/2010

Relevant facts and circumstances

The company, for the purpose of purchasing units in a Unit Trust, took out four loans. These loans were for the acquisition of property and further capital injections into the Unit Trust through additional purchases of units, as a guarantor, the unit trust granted the aforementioned property as a security over these loans.

The company defaulted on the above mentioned four loans. Consequently, the lender called upon the securities over the loans and appointed receivers and managers to enforce the sale of the property. The property was sold and the lender was paid in satisfaction of the full payment of the defaulted loans and accrued interest. A notice of demand for payment was served on the unit trust. The full amount demanded by the lender was paid by the Unit Trust.

Relevant legislative provisions

Income Tax Assessment Act 1936

ITAA 160M(1) [rewritten as ITAA 97 104-10(2); 109-5(1)]

ITAA 160M(3)(b) [rewritten as ITAA 97 104-25(1)]

ITAA 160Z(1)(b) [rewritten as ITAA 97 102-20; 102-22; 104]

ITAA 160ZD(1) [rewritten as ITAA 97 116-20] ITAA 160ZD(1)(a) [rewritten as ITAA 97 116-20]

ITAA 160ZD(2)(a) [rewritten as ITAA 97 116-30]  [rewritten as ITAA 97 116-30(3A)]

Income Tax Assessment Act 1997

Reasons for decision

Question 1

Does the forfeiture of the debt owed by the company trigger a CGT event C2 for the Unit Trust?

Detailed reasoning

Taxation Ruling TR 96/23 Income tax: capital gains: implications of a guarantee to pay a debt states:

The guarantor's right of indemnity

30. 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. Until default by the principal debtor and payment by the guarantor, a guarantor is not entitled to sue on the right of indemnity (whether it is a legal or an equitable right). Of course, the debtor may not default, the debt may be otherwise paid or it may be released.

31. The guarantor is taken to acquire the right of indemnity by paragraph 160M(6B)(a) (disregarding incidental costs incurred) for a cost base equal to the amount the guarantor pays, or is required to pay, under the contract of guarantee (for the purposes of paragraphs 160ZH(1)(a), (2)(a), (3)(a) and (4)(a)).

The guarantor's right of subrogation

32. When a creditor's debt is paid in full (whether or not it is paid in full by the guarantor paying under the guarantee), the guarantor has the right to be subrogated to the rights of the creditor - provided the guarantor's right of indemnity still exists at the time of the payment. The right to be subrogated, a doctrine of equity which has been codified by statute, is a right to stand in the place of the creditor and be subrogated to the creditor's remedies against the principal debtor. The right of subrogation can be invoked by a guarantor against a principal debtor as a way of enforcing the guarantor's right of indemnity. At general law, the right of subrogation is not severable and it is merely a means of enforcing the right of indemnity.

33. The right of subrogation does not arise in all cases (for example, when the creditor's debt is not paid out in full, or if the right of indemnity has been assigned by the guarantor before payment in full). The right of subrogation is an asset created solely by virtue of the guarantor's payment (i.e., there is no assignment of the creditor's rights to the guarantor; the right is a new right which did not previously exist). The asset is deemed to have been acquired by the guarantor under paragraph 160M(5)(b) and the time of acquisition is governed by subsection 160U(5). It is taken to be acquired on payment.

34. The guarantor is taken to acquire the right of subrogation (disregarding incidental costs incurred) for a cost base equal to the amount the guarantor pays, or is required to pay, under the contract of guarantee (for the purposes of paragraphs 160ZH(1)(a), (2)(a), (3)(a) and (4)(a)).

35. We consider that for Part IIIA purposes when the guarantor is subrogated to the rights of the creditor, the guarantor's right of subrogation is in effect subsumed by, or merged into (without there being any disposal), the guarantor's right of indemnity. The right of indemnity and the right of subrogation become co-extensive once payment is made by a guarantor under the guarantee.

40. If there is no likelihood that the principal debtor will pay the debt owing to the guarantor (e.g., because the principal debtor is insolvent), the guarantor must take some action in terms of paragraph 160M (3) (b) to cause a change of ownership, and thus a disposal of the debt in terms of subsection 160M (1).

Personal-use asset

141. If a debt is a personal-use asset, it is a non-listed personal-use asset. The significance of this is that under subsection 160Z(7), the disposal of a non-listed personal-use asset cannot give rise to a capital loss.

142. Paragraph (a) of the definition of 'personal-use asset' in subsection 160B(1) defines personal-use assets broadly as those owned by a taxpayer and used or kept primarily for the personal use or enjoyment of the taxpayer or associates of the taxpayer.

143. Subparagraph (b)(ii) of the definition of 'personal-use asset' in subsection 160B(1) extends the definition in paragraph (a) to a debt owed to a taxpayer which specifically:

came to be owed otherwise than in the course of:

the gaining or producing of income by the taxpayer;

  or

the carrying on of a business by the taxpayer...'

The explanatory memorandum states (at 22):

'...In short the subparagraph applies to debts of a private or domestic nature.'

Paragraphs 30 & 32 of TR 96/23 state that on entering into a contract of guarantee, the guarantor acquires an asset which is a right to be indemnified by the principal debtor and the right of subrogation is an asset created solely by virtue of the guarantor's payment.

The Unit Trust as guarantor acquired the right of indemnity in 2007 when they entered into a deed of guarantee. They acquired the right of subrogation when the debt was paid full in 2011. The right of indemnity existed at the time the full payment was made by the Unit Trust.

Section 104-25 of the ITAA 1997 refers to Capital Gains Tax (CGT event C2) dealing with cancellation, surrender and similar endings of CGT event 2. It states at subparagraph (d) that if an asset (debt) is abandoned, surrendered or forfeited it triggers a CGT event C2.

The whereabouts of the director is unknown and he is facing many court cases against him due to his insolvency. He was declared bankrupt on 2011 by the Supreme Court. Therefore the Unit Trust would be unlikely to recover the loan and they were compelled to forfeit their right to enforce the debt with no consideration in 2011.

Paragraph 142 of TR 96/23 defines a personal use asset as those owned by a taxpayer and used or kept primarily for the personal use or enjoyment of the taxpayer or associates of the taxpayer. Paragraphs 141 states that the disposal of a non-listed personal-use asset cannot give rise to a capital loss. Each loan guaranteed by the Unit Trust was used to purchase units in the trust or to inject capital into the business. The loans were directly related to gaining and producing income and carrying a business. Therefore the loans guaranteed by the Unit Trust were not a personal use asset.

Therefore the payment of the loans on behalf of the company made by the guarantor triggers a CGT event C2.

Question 2

Is the Unit Trust entitled to claim a capital loss in its income tax return as a result of CGT event C2?

Detailed reasoning

Taxation Ruling TR 96/23 Income tax: capital gains: implications of a guarantee to pay a debt states:

14. The consideration given by the creditor in respect of the acquisition of the contractual rights under the guarantee is the promise of the creditor to make a loan, or extend or maintain credit, to the debtor. The contractual consideration is 'consideration in respect of the acquisition of an asset' for the purposes of paragraph 160ZH(1)(a), (2)(a) or (3)(a) as defined in subsection 160ZH(4)(b), being 'property other than money'. If the taxpayer has given, or is required to give, property other than money in respect of the acquisition of an asset, the consideration in respect of the acquisition of the asset is the market value of that property at the time of the acquisition. We consider that there is no market for the creditor's promise to the guarantor to make a loan or extend credit to the debtor. We conclude, therefore, that the market value is nil. The creditor, while obtaining two assets, cannot recover more than the face value of the loan to the debtor, so that the consideration for the guarantee (relevant cost base) is sensibly to be determined as having a nil value.

Guarantor pays the guaranteed amount in full in satisfaction of the debt owing

17. If the guarantor is called on to pay the debt under the guarantee (for example, on default by the principal debtor), there is a disposal of the rights under the guarantee for the purposes of paragraph 160M(3)(b) and subsection 160M(1). The consideration which the creditor receives, or is entitled to receive, in terms of subsection 160ZD(1) on the disposal is the amount the guarantor pays under the guarantee. Therefore, a capital gain accrues to the creditor for the amount of the payment made under the guarantee.

18. Because the guarantor pays the guaranteed amount in full in satisfaction of the debt owing, the debt is taken (by paragraph 160M(3)(b) and subsection 160M(1)) to be disposed of by release, discharge or satisfaction. The principal debtor has nothing to repay to the creditor; therefore, the disposal of the debt by the creditor is for no consideration. Because the principal debt is extinguished on payment by the guarantor, market value of the right to call on the debtor for payment is nil, applying the deemed market value rules in paragraph 160ZD(2)(a) and subsection 160ZD(2A). A capital loss therefore arises on disposal of the debt. The capital loss is incurred under paragraph 160Z(1)(b), equal to the reduced cost base of the debt. This loss offsets the gain accruing to the creditor under the guarantee.

36. Subsection 160ZH(12) applies to determine the cost base for Part IIIA purposes of the merged asset (paragraph 160ZH(12)(a)) or the transformed asset (paragraph 160ZH(12)(b)). The cost base of the merged or transformed asset ('the relevant asset') is determined at the time the event happens which causes the change in the asset, namely, the acquisition of the right of subrogation: subsection 160ZH(13). The relevant cost base of the merged or transformed asset at the time of disposal includes, to the extent reasonable, the relevant cost base of the original asset (being the right of indemnity: see paragraph 31 above) calculated as if there had been a disposal of the right of indemnity when the relevant event occurred (i.e., at the time the right of subrogation arose): subsection 160ZH(13). The cost base of the right of subrogation will never be more than the amount paid under the guarantee (that is, the limit of the guarantor's right of recovery) and the cost base of the merged or transformed asset will likewise never be more than the amount paid under the guarantee. It is reasonable that the cost base of this merged asset does not include the (notional) amount paid or given for the original asset. It follows that the merged asset has a relevant cost base of the amount paid under the guarantee.

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.

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 is disposed of for no consideration.

In some situations, there may be no likelihood that the principal debtor will pay the debt owing to the guarantor. 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 guarantee to security for the loan. Subsequently, you were called on (as a guarantor under contract) to make a payment as guarantor. At the time of the payment, the 'right to indemnity' became enforceable as a debt against the company. However, any attempt to pursue the sole director would have been futile as his whereabouts were unknown and he was facing many court cases against him due to his insolvency.

The sole director was declared bankrupt in 2011 by the Supreme Court. This 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 guarantor.

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