Edited version of your written advice

Authorisation Number: 1051471052715

Date of advice: 9 January 2019

Ruling

Subject: Capital Gains Tax – Debts not repaid due to bankruptcy and legal expenses

Issue 1 – Capital gains

Question 1: Did capital gains tax (CGT) event C2 happen to the debt owed to the Taxpayer by the other individual when they were released from the obligation to pay it on the date the release took effect?

Answer: Yes.

Question 2: Has the Taxpayer made a capital loss due to the other individual being released from the obligation to pay the debt owed to the Taxpayer?

Answer: Yes.

Issue 2 – Legal expenses

Question: Can the Taxpayer claim a deduction for the portion of the legal expenses that relate to the claim against the other individual for interest?

Answer: Yes.

This ruling applies for the following periods:

20XX-XX income year

20XX-XX income year

20XX-XX income year

20XX-XX income year

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

At all relevant times, the Taxpayer carried on (and still carries on) a business that is unrelated to these transactions.

Some years ago, the Taxpayer was involved in an accident and received a material compensation sum that was intended to be used to fund other activities and provide supplementary income. As a consequence of the accident, the Taxpayer cannot work a full week.

For some years, the Taxpayer entered into a number of ventures with another individual (who has now been convicted for fraud) with a view to generating this supplementary income.

The other individual was represented as a highly successful entrepreneur and the Taxpayer effectively engaged them to provide their business skills and experience as an advisor to the Taxpayer to assist the Taxpayer in conducting these ventures.

The trust that the Taxpayer had in the other individual was misplaced with them fraudulently using the funds provided by the Taxpayer for the ventures, for purposes other than what was agreed to. For many of the ventures, the Taxpayer entered with the other individual, the Taxpayer has not been able to verify ownership and/or the existence of various business assets. Similarly, the Taxpayer has not been able to verify the existence of an overseas bank account. In the civil proceedings, the Taxpayer brought against the other individual, they capitulated without proffering further evidence of these matters. However, despite this, some of the activities engaged in by the Taxpayer with the other individual’s assistance had substance as assets were actually acquired.

Legal action against the other individual

The Taxpayer took civil action against the other individual and certain related entities when the Taxpayer became aware of the fraud. During the trial, the other individual capitulated, implicitly confirming that the fraud had been proven. The Supreme Court handed down a judgment in favour of the Taxpayer ruling that:

● The Taxpayer was entitled to the sum sought comprising principal and interest plus costs.

● Certain properties owned by the other individual and associates were subjected to an equitable charge in favour of the Taxpayer.

Subsequently, the other individual declared bankruptcy and later entered into a personal insolvency agreement. The Taxpayer was only able to recover a small proportion of his judgment against the other individual due to this insolvency.

The Taxpayer received some money from the associates as a result of equitable charges over property arising from the judgment.

The Taxpayer received some final amounts from the other individual’s trustee in bankruptcy:

● as petitioning creditor’s costs, and

● as a first and final dividend in relation to the creditor’s claim.

The above amounts are the only amounts the Taxpayer has received from the other individual in relation to the above Supreme Court judgment.

The other individual was released from bankruptcy via a personal insolvency agreement on (the date the release took effect). The effect of the personal insolvency agreement was to release the other individual from the obligation to pay the provable debts in this bankruptcy under subsection 230(1) of the Bankruptcy Act 1966. The Taxpayer’s judgment debt (being a provable debt in this bankruptcy) was extinguished at that time.

The Taxpayer has incurred unitemised legal expenses in pursuit of the action against the other individual.

Summary of the above

As a summary of the above:

● Advances were made by the Taxpayer to the other individual

● The Taxpayer expected these advances to generate assessable income for the Taxpayer

● The other individual has not returned the amounts advanced by the Taxpayer

● The Taxpayer sued the other individual (and certain associated entities) in an attempt to recover the amounts advanced and interest

● The Taxpayer won the case thereby proving the existence of the debt

● The Taxpayer received some money in respect of the amount owed

● The other individual’s debt to the Taxpayer was extinguished when they were released from bankruptcy on the date the release took effect

● The Taxpayer incurred legal expenses in pursuing the return of the advances

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Part 3-1

Reasons for decision

Issue 1

Question 1

Summary

CGT event C2 happened to the debt owed to the Taxpayer by the other individual when they were released from the obligation to pay it on the date the release took effect.

Detailed reasoning

A taxpayer can only make a capital gain or a capital loss if a CGT event happens. Any capital gain or capital loss is made at the time of the event.

CGT event C2 happens if a taxpayer’s ownership of an intangible CGT asset ends due to it being released. The time of CGT event C2 is:

● When the taxpayer enters into the contract that results in the asset ending, or

● If there is no contract – when the asset ends.

In this case, the debt owed to the Taxpayer by the other individual is a CGT asset for capital gains purposes.

The taxpayer’s ownership of the debt ended due to the other individual being released from the obligation to pay it under subsection 230(1) of the Bankruptcy Act 1966.

The release of the debt has not occurred under a contract, so the date the release took effect is the time of the event being the date the debt ended.

Question 2

Summary

The Taxpayer has made a capital loss due to the other individual being released from the obligation to pay the debt owed to the Taxpayer.

Detailed reasoning

A capital loss arises from CGT event C2 if the capital proceeds from the event are less than the reduced cost base of the CGT asset.

The capital proceeds are generally the amount of cash received or receivable or the market value of any property received or receivable. However, the market value of the CGT asset is used instead in most instances where there are no capital proceeds or it is CGT event C2.

Taxation Ruling TR 96/23 considers the market value of a debt and states at paragraph 26:

If the debtor is insolvent, the market value of the debt is nil.

In practical terms, this means that the market value of a debt owed by an insolvent debtor will be equal to any amounts actually received in relation to the debt at or after the time it is extinguished.

The reduced cost base of a debt would generally be expected to be the amount owing on it at the time of the CGT event.

Further, a debt is considered to be a personal use asset unless it arises in the course of gaining or producing the taxpayer’s assessable income or from their carrying on of a business. A capital loss made from a personal use asset is disregarded.

Taxation Ruling TR 96/23 considers when a debt will be considered to be a personal use asset at paragraphs 46 to 47 and 140 to 156.

In this case, the capital proceeds will be equal to the final amounts received by the Taxpayer in respect of the debt. This amount is significantly less than the amount owed to the Taxpayer by the other individual at the time the debt was extinguished. Therefore, the outcome for the Taxpayer from this CGT event is a capital loss.

It was the Taxpayer’s expectation that the funds advanced to the other individual would generate assessable income for the Taxpayer. Therefore, the debt owed to the Taxpayer by the other individual was not a personal use asset and the capital loss is not disregarded.

Note: an expense or outgoing is not included in the reduced cost base of a CGT asset if an income tax deduction is claimable or has been claimed.

Issue 2

Summary

The Taxpayer can claim a deduction for the portion of the legal expenses that relate to the claim against the other individual for interest.

Detailed reasoning

A taxpayer can claim a deduction for any loss or outgoing to the extent that it is incurred in gaining or producing assessable income or with the expectation of producing assessable income. Deductions cannot generally be claimed if they are of a capital nature.

Legal expenses incurred by a taxpayer who initiates a legal matter are considered to have the same character as the advantage sought by that person. The legal expenses must be apportioned where that taxpayer is seeking outcomes that are both capital and revenue in nature.

Taxation Determination TD 93/29 states at paragraph 7 that where a solicitor’s account is not itemised, it is reasonable to apportion legal expenses between revenue and capital components of the claim on the basis of the monetary value of each if it is not possible to apportion on any other basis.

In this case, the legal expenses have been incurred by the Taxpayer in pursuit of a claim that is partly capital in nature and partly revenue in nature.

The legal expenses have not been itemised and it is not possible to undertake a costing of work specifically dedicated to the capital or revenue elements of the claim.

Therefore, it is reasonable in this instance to apportion the legal expenses between the capital and revenue elements on the basis of their relative monetary values. On this basis, the revenue portion of the legal expenses will be revenue in nature and consequently deductible.

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