Edited version of private advice

Authorisation Number: 1012685671925

Ruling

Subject: Legal expenses

Question 1

Are you entitled to a deduction for a payment to satisfy a guarantee given?

Answer

No

Question 2

Are you entitled to a deduction for legal expenses incurred in relation to the guarantor payment amounts?

Answer

No

This ruling applies for the following periods

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on

1 July 2011

Relevant facts

The company was in business.

You were a director and shareholder of the company.

You were required by suppliers to sign guarantor agreements.

The company went into liquidation and the suppliers enforced the guarantor agreements.

You personally paid the amounts guaranteed to the suppliers.

You incurred legal expenses in relation to the guarantees given.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 108-20

Income Tax Assessment Act 1997 Section 70-10

Reasons for decision

Question 1

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.

Taxation Ruling TR 96/23 discusses the deductibility of payments made under guarantee.

The CCH Macquarie Concise Dictionary of Modern Law defines a 'guarantee' as a contract wherein one party (the surety) gives a second party an undertaking to answer for any debt or default of a third party in respect of a dealing between the second and third parties.

Paragraph 45 states a payment by a guarantor is deductible under subsection 51(1) (now section 8-1) 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 a business for that purpose - provided the loss or outgoing is not of a capital, private or domestic nature.

Paragraph 49 states under a simple scenario of a guaranteed loan agreement there are three parties. One is the principal debtor who borrows an amount of money. The second party is a creditor, usually a bank or financial institution which lends the money to the debtor. The third party is a guarantor who agrees that, if the debtor defaults on the loan, he or she will contribute a part or all the debt owed to the creditor.

Paragraph 50 states a contract of guarantee is a collateral contract to answer for the debt, default or miscarriage of another who is, or is contemplated to be or to become, liable to the person to whom the guarantee is given: Sunbird Plaza per Mason CJ (166 CLR 245 at 254; 77ALR 205 at 207); Re Conley; Ex parte The Trustee v. Barclays Bank, Ltd [1938] 2 All ER 127 at 130-1; and see generally Halsbury's Laws of Australia vol 14, at paragraphs 220-5.

Paragraph 124 states a payment by a guarantor is deductible under subsection 51(1) 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. In essence, the loss or outgoing must bear the character of an income producing expense or a working expense of a business.

The following is an example of where a director/shareholder gives a guarantee:

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(b)(ii) because it can be objectively determined that the primary purpose in entering into the guarantee was the expectation of prompting the future flow of dividends to Red as a shareholder. A capital loss would be allowed under paragraph 160Z(1)(b).

In addition to the above example in Case L3, 79 ATC 14, the taxpayer, a director, shareholder and employee of two companies, gave a number of personal guarantees in respect of each company's overdraft at the bank. When the companies went into liquidation, the bank recovered judgment against the taxpayer as one of the guarantors. The taxpayer claimed a deduction under sec 51(1) for the amount paid by him under the guarantees. The Board held that the claim should be disallowed as the payment was not incurred in gaining or producing the assessable income under the first limb of sec 51(1) and in any event was an outgoing of capital, or of a capital nature.

In this case, as a director of the company you became a guarantor for credit extended by suppliers to the company. When the company went into liquidation you were required to pay the outstanding credit to meet your guarantor obligations. The purpose of the borrowings was not to directly produce assessable income but to fulfil your commitment as a guarantor. The guarantor amount paid by you was an outgoing of capital. As the payment is considered capital it is not deductible under either limb of section 8-1 of the ITAA 1997.

However, for capital gains tax purposes, the debt which was owed to you in respect of the guarantee payment, is not a personal-use asset for section 108-20 of the ITAA 1997 because it can be objectively determined that the primary purpose in entering into the guarantee was the expectation of prompting the future flow of dividends to you as a shareholder. A capital loss is allowed under part 3-1 of the ITAA 1997.

Question 2

Section 8-1 of the ITAA 1997 allows a deduction for all losses or 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.

In determining whether a deduction for legal expenses is allowed 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.  For example, 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. Therefore, to determine the deductibility of the legal expenses, it is necessary to consider the reason for which expenses were incurred.  

Taxation Determination TD 93/29 which considers the deductibility of legal expenses states at paragraph 5:

...if the legal action goes beyond a claim for a revenue item such as wages, and constitutes an action for breach of the contract of employment, the legal costs would not be deductible because they are capital in nature. For example, legal expenses relating to an action for damages for wrongful dismissal are not deductible. 

In this case, you incurred and paid legal expenses to lower the amount owing in relation to your obligations as a guarantor. As previously stated the guarantor payments are considered capital in nature. The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. Here the advantage to be gained is of a capital nature therefore the legal expenses incurred in gaining the advantage will also be of a capital nature.   

As the legal expenses you incurred are capital in nature you are not entitled to a deduction under section 8-1 of the ITAA 1997.

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