Edited version of your private ruling

Authorisation Number: 1012559574939

Ruling

Subject: loan agreement

Question 1

Are you entitled to a deduction for the amounts not repaid under the loan agreement?

Answer

No.

Question 2

Are you entitled to a deduction for legal expenses or search fees?

Answer

No.

Question 3

Are you entitled to a deduction for a bad debt?

Answer

No.

Question 4

Has there been a capital gains tax event in relation to your loan?

Answer

No.

Question 5

Are you entitled to a capital loss in relation to your loan?

Answer

No.

Question 6

Do the legal expenses and search fees form part of the cost base for capital gains tax purposes?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on:

1 July 2007

Relevant facts

You lent money to entity A. Person B is entity A's sole director and guarantor of the loan.

You had a loan contract drafted by lawyers with specific instruction to protect your interest with the transaction.

One security provision the lawyers included was the option to enforce a caveat on land titles held by entity A.

Under the loan agreement, you were to receive higher than the commercial rate of interest on the principal. The principal and interest were payable 12 months after the date of the loan contract. If the amount is not paid by that date, it would continue to accrue interest until full payment had been received and the debt cleared.

Entity A did not pay after the year had passed and requested more time.

You tried to enforce the caveat, however you were informed that you had to remove the caveat and that the mortgagor would be conducting a sale and seizure of the property and that there would be no funds to compensate you.

You continued to explore other legal avenues and incurred costs for search fees, however, entity A went into liquidation and person B was declared bankrupt.

You were advised that it would cost money for further investigations to be made in relation to the bankruptcy.

Entity A has not been wound up. The liquidator has not given written notice that you are unlikely to receive any further distribution.

You have not received any interest or repayment of principal.

You don't believe that you will receive any repayment, remuneration or other return from your loan.

You are not in the business of providing loans.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 25-35

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 104-145

Income Tax Assessment Act 1997 Section 108-5.

Income Tax Assessment Act 1997 Section 110-25

Reasons for decision

Allowable deductions

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.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

§ it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478), 

§ there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

§ it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

The unpaid principal amount under the loan agreement is a capital sum and therefore no deduction is allowed under section 8-1 of the ITAA 1997.

The expected interest as outlined in the loan agreement has not been received. As there has not been any outgoing by you in respect of the interest amounts no deduction is allowable under section 8-1 of the ITAA 1997.

Legal expenses

For legal expenses to constitute an allowable deduction, it must be shown that they are incidental or relevant to the production of the taxpayer's assessable income or business operations. Also, in determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Legal expenses are generally deductible if they arise out of the day to day income earning activities of the taxpayer (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169 (the Herald and Weekly Times Case)) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. FC of T 80 ATC 4542; (1980) 11 ATR 276).

In order to determine whether your legal fees are deductible under section 8-1 of the ITAA 1997, we first need to look at the reason for the legal fees and why they were incurred.

You have incurred legal expenses in relation to your loan agreement, caveats and trying to recover owed moneys. The expenses do not sufficiently relate to your assessable income.

Legal expenses incurred in defending your ownership rights are not deductible as they are considered to be capital in nature. Similarly, the unpaid amounts under the loan agreement and any search fees incurred in relation to your debt owed are also capital in nature. As such, the expenses and losses are not deductible under section 8-1 of the ITAA 1997.

Bad debts

Section 25-35 of the ITAA 1997 allows a deduction for bad debts in certain circumstances. To qualify for a bad debt deduction under section 25-35, the written off bad debt must be:

§ included in your assessable income for the income year or for an earlier income year, or

§ in respect of money that you lent in the ordinary course of your business of lending money.

As you have not satisfied the requirements under section 25-35 of the ITAA 1997, a deduction for a bad debt cannot be allowed.

Capital gains tax provisions

A debt owed is a capital gains tax (CGT) asset (section 108-5 of the ITAA 1997).

Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens. The gain or loss is made at the time of the CGT event.

When a debt owed to you ends, CGT event C2 happens. The time of a CGT event C2 in relation to a debt owed to you will occur when you enter into the contract that results in the asset ending (for example, a settlement deed) or, if there is no contract, when the asset ends (for example, when it becomes irrecoverable at law).

In your case, you have a loan agreement with entity A. Although entity A is in liquidation, it has not been wound up. It can not be said that your debt is currently irrecoverable at law for CGT event C2 purposes. Also the fact that the guarantor is bankrupt does not mean CGT event C2 has occurred. Therefore, in your case a CGT C2 event has not yet occurred.

Other relevant CGT events are event A1, C1 and G3.

CGT event A1 as outlined in section 104-10 of ITAA 1997 occurs when you dispose of a CGT asset.

CGT event C1 as outlined in section 104-20 of ITAA 1997 occurs when a CGT asset is lost or destroyed.

CGT event G3 as outlined in section 104-145 of ITAA 1997 occurs when a liquidator or administrator declares shares or financial instruments are worthless.

In your case, you have not disposed of or lost your debt, however CGT event G3 is relevant.

In the event of the dissolution (winding up) of a company, a CGT event occurs when the company is wound up. While a company remains in administration or liquidation, the CGT event has not yet occurred and you are not able to make a capital loss or gain at that time.

However, in certain circumstances you can choose to realise a capital loss on worthless shares or financial instruments before the dissolution of a company. CGT event G3 occurs if a liquidator or administrator of a company declares in writing that they have reasonable grounds to believe that there is no likelihood that owners will receive any further distribution from the company in the course of its winding up (subsection 104-145(1) of the ITAA 1997).

If this declaration is made, the owners of the relevant asset can choose to make a capital loss at the time of the declaration (subsections 104-145(2) and 104-145(4) of the ITAA 1997).

Therefore you are entitled to claim the capital loss in an income year when either:

· the administrator makes a declaration that there is no likelihood that you will receive any further distribution AND you choose to realise the capital loss at that time, OR

· when a court orders that the company be dissolved (wound up).

In your case, entity A is now in liquidation. However, entity A has not yet been wound up and the liquidator or administrator has not declared that there is no likelihood that you will receive any further distribution. Accordingly you are not entitled to a capital loss in respect of your loan with entity A.

No other CGT event is relevant in your circumstances. It follows that a CGT event in relation to your loan has not occurred. Therefore you are not entitled to a capital loss.

Cost base of a capital asset

However, when a CGT event occurs in the future in relation to your loan, you need to calculate the cost base and capital proceeds to determine your capital gain or loss.

The cost base of a CGT asset includes the capital expenditure you incurred to establish, preserve or defend your title to the asset, or a right over the asset (subsection 110-25(6) of the ITAA 1997). Therefore the legal costs and search fees in relation to your loan agreement and debt owed to you will form part of the cost base.

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