Edited version of private advice

Authorisation Number: 1052111292065

Date of advice: 26 June 2023

Ruling

Subject: Mortgagee in possession

Question 1

From the Step-In Date, are the expenses, outgoings and other outflows incurred by you in bringing the Development to completion deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

From the Step-In Date, will you derive assessable income under section 6-5 of the ITAA 1997 each time a Right to Payment arises?

Answer

No.

Question 3

Will any amount retained from the sale proceeds (provided it does not exceed the Total Debt Amount) be included in your assessable income?

Answer

No.

Question 4

Are you entitled to a deduction under section 25-35 of the ITAA 1997 in respect of any of the Total Debt Amount that accrued after the Step-In Date which remains outstanding and owing to you?

Answer

No.

Question 5

Do you have an income tax reporting obligations on behalf of the Borrower or ASIC in respect of the development?

Answer

No.

This ruling applies for the following periods:

Financial year ending 30 June 2020

Financial year ending 30 June 2021

Financial year ending 30 June 2022

Financial year ending 30 June 2023

The scheme commenced on:

1 July 2019

Relevant facts and circumstances

You are not in the business of lending money.

You were approached by Company X to assist them refinance existing borrowings on properties they held for the purpose of constructing residential dwellings.

At that time, Company X was carrying on property development activities and had acquired adjacent properties for the purpose of development (collectively referred to as the Property) into apartments of residential properties for sale (the Development).

You loaned Company X an amount for the refinancing of the Property and subsequently made a second loan to fund the Development.

Company X subsequently entered into a building contract with a construction company (the Builder), to complete construction works in respect of the Development (Building Contract).

Both the first and second loan were secured over the Property. The nature of the security required by you included a tripartite deed between you, Company X and the Builder, giving you step-in rights with respect to the Development (the step-in condition).

If you exercised your rights under the security interest by taking possession of, or exercising your power of sale of, the Property and/or the works (as defined in the Building Contract), then:

                    (i)        the Builder agreed to complete the works in accordance with the terms of the Building Contract, as if you (or any subsequent purchaser) were the contracting party - which included the power to direct the nature of the works

                   (ii)        you agreed to comply with all of the obligations of Company X under the Building Contract while in possession of the Property and to make certain payments to the Builder for the cost of work done or materials supplied - with all parties agreeing that any such payments were to form part of the secured moneys owed by Company X to you.

Company X misused the advances made to it by you, it:

•         defaulted under the Building Contract (by failing to make payments to the Builder utilising your advances)

•         failed to proceed with works in the Development

•         permitted further securities to affect its property

•         ultimately failed to repay your loans under the loan agreements by their due date.

Company X and the relevant guarantors acknowledged these failures by entering into a debt acknowledgement deed whereby you were provided with additional security interests.

You did not immediately exercise your step-in rights, as Company X was displaying a sufficient level of cooperation in seeing the Development to practical completion.

The conduct of Company X continued to deteriorate following the above events, you subsequently served a Notice to Pay on Company X to remedy their defaults. Company X failed to comply with this notice, and several months later, you exercised your powers as mortgagee of the Property and took possession of the land (the Step-In Date).

Further on the Step-In Date you entered into a Deed of Novation with the Builder, to continue the development activity. This provided that:

•         you exercised their rights as mortgagee to take possession of the Property and exercise their step-in rights to conduct the Development and bring it to completion

•         you gave the Builder notice that you required novation of the Building Contract and the parties agreed that the Building Contract was novated.

                    (i)        funding to be provided to the Builder in accordance with the Building Contract

•         the Builder will carry out and complete the Building Contract, as if the Builder and you had originally entered into the Building Contract.

Since taking possession of the Property on the Step-In Date, you have directed the continuing conduct of the Development through a manager.

In addition, you have been responsible for paying all expenses in relation to the continuing conduct of the Development.

The Development is near completion, and you intend to sell each of the apartments. Multiple lots of the Development have already been sold.

It is expected that the proceeds of sale of separate lots in the Development will not exceed the amounts outstanding and owing by the Borrower to the Applicant comprising the sum of:

(a)  amounts advanced by the you under the loan agreements before the Step-In Date

(b)  an amount equal to amounts expended by you in completing the Development in exercise of their step-in rights from the Step-In Date

(Collectively, the Total Debt Amount).

Company X was deregistered by ASIC a short time later under section 601AB of the Corporations Act. You did not have the opportunity to appoint a receiver before this occurred.

Your legal representatives informed ASIC that it was in possession of the Property (and another secured property), with a series of exchanges between ASIC and your solicitor detailing the Development being conducted by you (in exercise of your step-in rights) with an intention to sell the residential apartments on the open market on practical completion.

You solicitor informed ASIC that you will provide a full accounting for the sale proceeds, paying any surplus after the mortgagee and any other registered interest have been paid out in order of priority to ASIC as required under subsection 601AD(2) of the Corporations Act 2001.

Consistent with ASIC's publicly published administrative practice, ASIC has not opposed you in enforcing your security to recover debts owed by Company X (and the exercise of your step-in rights).

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 70-30

Income Tax Assessment Act 1997 section 70-35

Income Tax Assessment Act 1997 subsection 70-80(1)

Reasons for decision

Question 1 & 2

Summary

We consider the payment of the expenses, outgoings and other outflows made from the Step-In Date to be capital in nature and therefore not deductible under section 8-1 of the ITAA 1997. We also consider the receipt of the 'Right to Payment' are capital in nature and therefore not assessable under section 6-5 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing to the extent that:

•         it is incurred in gaining or producing your assessable income; or

•         it is necessarily incurred in carrying on a business for the purposes of gaining or producing your assessable income

However, you cannot deduct a loss or outgoing under this section to the extent that:

•         it is a loss or outgoing of capital, or of a capital nature; or

•         it is a loss or outgoing of a private or domestic nature;

•         it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income;

Carrying on a business

Subsection 995-1(1) of the ITAA 1997 defines 'business' as 'including any profession, trade, employment, vocation or calling, but not occupation as an employee'.

The question of whether a business is being carried on is a question of fact and degree. The courts have developed a series of indicators that are applied to determine the matter on the particular facts.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11) provides the Commissioner's view of the factors used to determine if you are in business for tax purposes. In the Commissioner's view, the factors that are considered important in determining the question of business activity are:

•         whether the activity has a significant commercial purpose or character

•         whether the taxpayer has more than just an intention to engage in business

•         whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

•         whether there is regularity and repetition of the activity

•         whether the activity is of the same kind and carried on in a similar manner to that of ordinary trade in that line of business

•         whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit

•         the size, scale and permanency of the activity, and

•         whether the activity is better described as a hobby, a form of recreation or sporting activity.

No one factor is decisive. The indicators must be considered in combination and as a whole.

Application to your circumstances

In this case we do not consider amounts paid after the Step-In Date to bring the development to completion were incurred in in carrying on a business for the purposes of gaining or producing your assessable income. The expenses were incurred to enable you to sell the Property and recoup the loan amount, a capital amount, owed to you. The costs paid by you bring about a 'Right to Payment' or an increase to the Total Debt Amount. The Total Debt Amount or loan is considered a CGT asset.

Your activities do not amount to a business based on the factors from TR 97/11, primarily as we do not consider you have undertaken the activity for the purpose of profit. Rather, based on the various agreements provided, you are attempting to recoup the amounts loaned to the borrower by continuing the development activities. Also, based on the information provided you do not expect the sale proceeds to exceed the 'Total Debt Amount'. Therefore, it is clear there is no prospect of profit from the activities undertaken.

We consider the expenses, outgoing and other outflows made from the Step-In Date to be capital in nature and therefore not deductible under section 8-1 of the ITAA 1997. We also consider the receipt of the 'Right to Payment' are capital in nature and therefore not assessable under section 6-5 of the ITAA 1997.

Question 3

As discussed above, we do not consider the amounts retained from the sale proceeds (provided it does not exceed the Total Debt Amount) to be assessable income under section 6-5 of the ITAA 1997. Therefore, amounts retained by you from the sale proceeds are capital and will contribute to the reduction of the total loan amount.

Question 4

Summary

You are not entitled to a bad debt deduction as you are not in the business of lending money, and you will not include an amount of the debt in your assessable income in this or earlier income years.

Detailed reasoning

You can deduct a debt (or part of a debt) that you write off as bad in the income year under subsection 25-35(1) of the ITAA 1997 if:

(a)  it was included in your assessable income for the income year or for an earlier income year; or

(b)  it is in respect of money that you lent in the ordinary course of your business of lending money.

Application to your circumstances

The Total Debt Amount comprises the sum of:

(a)  amounts advanced by you under the Loan Agreements before the Step-In Date, and

(b)  an amount equal to amounts expended by you in completing the Development in exercise of your step-in rights from the Step-In Date.

Your debt amount before the Step-In Date was not your assessable income and was not previously included in your assessable income. As per the answer to questions 2 and 3, we do not consider that you derive your assessable income each time a Right to Payment arises from the Step-In Date and that the Total Debt Amount or loan is considered a capital asset. You are not in the business of lending money. Therefore, if you write off any of the debt as bad, as neither of the requirements of subsection 25-35(1) of the ITAA 1997 are met, you cannot claim a bad debt deduction for the outstanding money owed in relation to the Total Debt Amount that accrued after the Step-In Date which remains outstanding and owing to you.

Question 5

Summary

As mortgagee in possession, you are not acting as an agent or a trustee for the Borrower or ASIC. As such you do not derive income or gain of a capital nature as trustee. Consequently, you do not have any income tax reporting obligations on their behalf.

Detailed reasoning

Paragraph 254(1)(a) of the Income Tax Assessment Act 1936 (ITAA 1936) makes every agent and trustee answerable as taxpayer '... for the doing of all such things as are required...' by the tax laws for the income or any profits or gains of a capital nature derived by them in their representative capacity or derived by the taxpayer 'by virtue of' their agency.

However, a mortgagee in possession is not a trustee and agent for the mortgager, they have an obligation to account to the mortgagor, but is otherwise not a fiduciary of the mortgagor Commissioner of Taxation v R & D Holdings Pty Ltd [2007] FCAFC 107 (R & D Holdings Appeal Decision).

TD 2012/D7 Income tax: does a receiver who disposes of a CGT asset as the agent for a debtor have an obligation under section 254 of the Income Tax Assessment Act 1936 to retain from sale proceeds sufficient money to pay tax which is or will become due as a result of disposing of that asset? TD 2012/D7 is relevant.

Paragraph 10 of TD 2012/D7 states that section 254 of the ITAA 1936 imposes a number of obligations upon agents and trustees in respect of any income, profits or gains derived by the agent or trustee in their representative capacity.

For agents of mortgagee's in possession, example 2 in TD 2012/7 is relevant:

7. Bianca's Bikes defaults on its mortgage with Large Bank Pty Ltd. Large Bank Pty Ltd takes possession of the mortgaged land. Raymond is appointed to act as agent for Large Bank Pty Ltd. Raymond makes a gain of a capital nature by executing Large Bank Pty Ltd's power of sale as a mortgagee in possession and sells the mortgaged land. In these circumstances Raymond is not the agent for Bianca's Bikes and no income, profit or gain of a capital nature is derived by Raymond as a representative of Bianca's Bikes.

8. Paragraph 254(1)(d) of the ITAA 1936 does not apply to require Raymond to retain an amount from the income he derives as a result of selling the mortgaged land.

Application to your circumstances

As mortgagee in possession, you are not acting as a trustee or an agent for the Borrower or ASIC. As such you do not derive income or gain of a capital nature on behalf of or as trustee. Consequently, you do not have any income tax reporting obligations on their behalf.

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