Edited version of your private ruling

Authorisation Number: 1012559915552

Ruling

Subject: Deduction for director penalty notice and debt guarantee

Questions and Answers:

1. Are you entitled to a deduction for payments made under a Directors Penalty Notice (DPN)?

No.

2. Are you entitled to a deduction for the payment of outstanding corporate credit card debt due to a director's guarantee over the debt?

No.

3. Does the liquidation of a principal debtor to who you have a right of indemnity give rise to a capital loss?

No.

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2011

The scheme commences on:

1 July 2009

Relevant facts and circumstances

You are the managing director and an ultimate shareholder of a private company that provides corporate advisory services and turnaround and capital restructuring services. In carrying out these services, you are often appointed as a director of distressed companies.

While acting in the capacity of director of a distressed company, in choosing to not liquidate the company but, instead, continuing to trade, you were issued a DPN to recover unpaid PAYG withholding debts. You were also required to provide a personal guarantee for the corporate credit card and became liable to paying the guarantee when the company failed.

You, personally, did not specifically charge a fee for guaranteeing the debts of the distressed company. Instead, your private company receives fees on your behalf for your general services.

Your remuneration from distressed companies was/is set as director fees and hourly rate consulting, paid to your private company or paid in shares to your related entities, such as your family trust and private superannuation fund.

Your income tax returns lodged show you only received income from your private company and not from the distressed companies you serviced.

Financial reports of distressed companies you serviced show your remuneration was based on the number of board meetings you attended.

Financial reports of distressed companies you serviced show any large amounts of income earned from your work was from shares issued by or investments made in those distress companies to your related entities, such as your family trust and private superannuation fund.

Financial reports of distressed companies you serviced show, when a company was successfully turned around, you promptly sold the shares in those companies you controlled (rather than hold those shares long term for dividend income).

Relevant legislative provisions

Taxation Administration Act 1953 Section 269-20 

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 25-5

Income Tax Assessment Act 1997 Section 26-5

Income Tax Assessment Act 1997 Section 108-20

Reasons for decision

Summary

There is no provision in the Australian taxation legislation that allows a deduction for DPN's or for any an amount payable, by way of penalty, under an Australian law or a foreign law.

You cannot claim a deduction for your guarantee outgoings because you were not personally carrying on a business of or charging a fee for giving guarantees. Instead, you were an employee in receipt of employment income and provided guarantees on behalf of your employer.

Further, your loss on your guarantee outgoings do not give rise to a capital gains tax loss because your asset (debt owed to you) acquired from paying the guarantee was a personal use asset, for which capital gains tax loss is to be disregarded.

Your asset was a personal use asset because it was not related to your earning of dividend income as a shareholder since you personally did not hold any shares in the relevant company. Instead, you become a guarantor as a personal favour to your employer.

Detailed reasoning

Director Penalty Notice

Section 26-5 of the ITAA 1997 is about the non-deductibility of penalties. It states you cannot deduct under this Act an amount (however described) payable, by way of penalty, under an Australian law or a foreign law. The only exception it provides is it does not apply to an amount payable, by way of penalty, under Subdivision 162-D of the GST Act.

Division 269 of Schedule 1 to the Taxation Administration Act 1953 (TAA) provides directors can incur penalties equal to their company's unremitted PAYG withholding liabilities or SGC or unpaid estimates of those liabilities. Section 269-20 in the Division specifically classifies the liability as a 'penalty'.

Subsection 25-5(1) of the ITAA 1997 provides a deduction for certain tax related expenses, including to the extent that it is for managing your tax affairs or complying with an obligation imposed on you by a Commonwealth law, insofar as that obligation relates to the tax affairs of an entity.

However, subsection 25-5(2)  of the ITAA 1997 explicitly prohibits a deduction under section 25-5 for tax or an amount withheld or payable under Part 2-5 or Part 2-10 in Schedule 1 to the TAA.

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.

Taxation Ruling IT 149 deals with the deductibility of legal expenses incurred for fines and/or breaches of the law in the course of carrying on a business. Although IT 149 states it has become a fairly well established principle that deductions are not allowed for fines incurred for breaches of the law committed in the course of carrying on a business, IT 149 does provide some scope for the deductibility of related legal expenses.

IT 149 makes reference to the principle established by the Full High Court of Australia in the case of Herald & Weekly Times Ltd v FCT (1932) 48 CLR 113 (Herald & Weekly Times Ltd), where the taxpayer, the proprietor and publisher of an evening newspaper, claimed outgoings (for legal advice, defence costs and damages awarded) in connection with libels the newspaper had published. A majority of the Full High Court allowed the deduction, as publishing the newspaper was both the source of income and cause of the liability and, secondly, the risk of libel was a regular and almost unavoidable incident or inherent risk of publishing.

IT 149 provides the example of a dairy company, of good repute, prosecuted for a minor breach of cleanliness involving the work of one employee. There was no indication that the company had adopted a practice of ignoring its responsibilities under the law or taking a calculated risk with prosecutions. It rather appeared that the company, quite by accident, had been held responsible for the casual negligence of one person.

IT 149 contrasts the above mentioned cases with taxpayers, such as transport operators, who, as a calculated risk, persistently take liberties with the law and incur speeding and other traffic fines, regularly, in the interests of the efficient operation of their business.

In your case, in contrast to Herald & Weekly Times Ltd, a specific provision, namely, section 26-5 of the ITAA 1997, prohibits you a general deduction under section 8-1 of the ITAA 1997 for your DPN liability, which section 269-20 of the TAA explicitly defines as a 'penalty'.

Alternately, if a DPN was the payment of 'tax' (rather than the payment of a 'penalty'), subsection 25-5(2) of the ITAA 1997 would prohibit a deductible for the payment of such a tax.

Although not relevant to the penalty liabilities you incurred (since it is only relevant to associated legal expenses), IT 149 supports the view, that, the very nature of the services you choose to provide to distressed companies results in you taking a calculated risk of incurring director penalty notices.

To conclude, because a DPN is a penalty under an Australian law, the specific provision under section 26-5 of the ITAA 1997 denies you a general deduction under section 8-1 of the ITAA 1997, regardless of the circumstances.

Credit card debts

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 your assessable income or necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income except where the outgoings are of a capital, private or domestic nature.

Section 995 of the ITAA 1997 states a business includes any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

Where a loss or outgoing is of a capital nature, section 108-20 of the ITAA 1997 states in working out your net capital loss for the income year, any capital loss you make from a personal use asset is disregarded. A personal use asset includes a debt arising from a CGT event in which the CGT asset the subject of the event was a debt arising other than in the course of gaining or producing your assessable income or from your carrying on a business.

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

Paragraph 45 of TR 96/23 states a payment by a guarantor is deductible if the giving of the guarantee, the guarantor's payment under the guarantee and the incurring of the loss or outgoing are acts done in gaining or producing assessable income or in carrying on business for that purpose - provided the loss or outgoing is not of a capital, private or domestic nature.

Paragraph 137 of TR 96/23 explains 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; that in Case Q39 83 ATC 171 at 173; (1983) 26 CTBR (NS) Case 103 at 694, Mr K P Brady, Chairman, referred to a line of Board cases stretching from 1946 which concluded that payments under guarantees are capital.

Paragraph 138 of TR 96/23 explains 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.

Paragraph 45 of TR 96/23 also states if the payment under the guarantee is not deductible, the guarantor needs to consider whether a capital loss is incurred. That is, whether the debt which came to be owed to the guarantor on payment under the guarantee is not a 'personal-use asset'.

Paragraph 47 of TR 96/23 explains the test of what is a 'personal-use asset' requires a finding that the debt came to be owed for a primary purpose other than that of gaining or producing income or in the carrying on of a business. Therefore, if the debt which came to be owed as a consequence of entering the contract of guarantee was expected to promote and enhance the income-earning activity of the guarantor, or came to be owed in the carrying on of the business, the debt would not be a personal-use asset and a capital loss would be allowed.

Paragraph 155 of TR 96/23 explains whether or not a shareholder can be said to have entered into a guarantee of the company's liabilities in order to assist the company in earning profits to be distributed in due course as dividends to (inter alia) the shareholder will be a question to be answered by a careful consideration of the overt facts and circumstances. If the amount of a dividend which the shareholder could expect to receive was completely disproportionate to the amount of his/her liability under the guarantee there would be a prima facie inference that this shareholder did not have the requisite purpose.

Also, paragraph 156 of TR 96/23 explains if a guarantor has received a fee for agreeing to guarantee a debt and pays out the creditor under the guarantee, then it is usual that the debt of the guarantor came to be owed in the course of gaining or producing the (fee) income and would not be a personal use asset. However, if the amount of the fee is not commensurate with the risk undertaken by the guarantor, there would, again, be an inference that the gaining or producing of the fee was not the purpose of the giving of the guarantee.

Paragraph 158 of TR 96/23 provides the following example:

Red Mercedes is a director of a real estate agency which had set up a land development company, ABC Ltd. Red held shares in the company. Red lent money to the company and arranged loans to the company from a finance company to carry out a development project. The finance company made it a condition of the loan entered into in October 1994 that Red as director provide personal guarantees in relation to both principal and interest. Before the project was completed, ABC Ltd suffered financial difficulty, ultimately defaulting on the loan payments and Red was served with a claim by the finance company for $200,000. ABC Ltd later went into receivership. Red paid the finance company $50,000 in full settlement of its claims on 1 July 1995. Red claimed a deduction for the $50,000 under subsection 51(1) or a capital loss.

No deduction is allowable under subsection 51(1). Even if it might be thought that the loss or outgoing should satisfy the first limb, it would fail subsection 51(1) because of the capital nature of the expense. For the purposes of the second limb of subsection 51(1), Red did not carry on any business, either as an employee of ABC Ltd or as a director of the company. The payment of $50,000 to settle claims would not be incurred in carrying on a business, or would be of a capital nature (as being akin to loan or share capital) and, therefore, would not be deductible under subsection 51(1).

However, for capital gains tax purposes, the debt which came to be owed to Red Mercedes in respect of the guarantee payment, is not a personal-use asset for subparagraph 160B(1)(b)(ii) because it can be objectively determined that the primary purpose in entering into the guarantee was the expectation of promoting the future flow of dividends to Red as a shareholder. A capital loss would be allowable under paragraph 160Z(1)(b).

In your case, you did not personally carry on a business of being a guarantor. Further, you did not personally receive any explicit fees for being a guarantor. Instead, your private company receive fees for the services you provided. As a director of those distressed companies, you assumed the role of a guarantor as an employee of your private company. Therefore, you cannot claim a deduction for losses and outgoings incurred on paying credit card debts as a guarantor because you became a guarantor on behalf of your private company, which was the entity earning assessable income.

Similarly, you did not make a capital loss in relation to your guarantee payments because they were not explicitly related to you directly enhancing your personal income earning activity. Personally, your income earning activity was from salary and wages paid to you by your private company.

Your modus operandi with various distressed companies indicates your indirect remuneration received was related to the number of board meetings you attended. As you stated, your remuneration was/is set as director fees and hourly rate consulting. As indicated in various distressed company reports, there is no evidence of any correlation between the quantum of revenue or profit earned by these distressed companies (when they were turned around) and the quantum of your remuneration paid by them.

Unlike the principle found in paragraph 155 of TR 96/23, your being a guarantor did not have any salient relationship to assisting the turnaround company in earning profits to be distributed to you in due course as dividends as a shareholder. Instead, shareholdings you controlled were held by your (discretionary) family trust and superfund. Taxation Ruling IT 2385 and the decision in ATO ID 2002/362 provide the Commissioner does not allow deductions to beneficiaries incurred on behalf of discretionary trusts and private superannuation funds, which is supported by Draft Taxation Ruling TR 2004/D25, which provides a member of a superannuation fund is not treated as if they are absolutely entitled for CGT purposes to the assets of the fund or to assets held in the member's account.

Further, even if you were a direct shareholder of these turnaround companies, the principle found in paragraph 155 of TR 96/23 would deny or significantly reduce any deduction because any dividend you would have received would have be completely disproportionate to the amount of your liability under the guarantee. In other words, you would have incurred an outgoing under the guarantee not exclusively for your earning of dividend income but, instead, for the benefit of all shareholders (refer to Federal Commissioner of Taxation v. Munro (1926) 387 CLR 153, which denied deductions for the shareholder expenses that benefited other shareholders).

Also, an impression gained is you generally sold shares you controlled for capital gains rather than held them long term for dividend income. Therefore, following the principle in paragraph 156 of TR 96/23, the amount of any short term dividends earned would not be commensurate with the risk undertaken by the guarantor. There would, again, be an inference that the gaining or producing of short term dividends was not the purpose of the giving of the guarantee.

In summary, your guarantee was a personal use asset. Your guarantee was akin to doing a 'personal favour' for your employer. The example in paragraph 158 of TR 96/23 shows a guarantee is not a personal use asset when it is related to a shareholder rather than related to an employee or director of a company.

In conclusion, you cannot claim a deduction or a capital loss for your guarantee payments.

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