Edited version of private advice

Authorisation Number: 1052118040136

Date of advice: 29 June 2023

Ruling

Subject: Tax consequences of a settlement of on lent loan to company

Question 1

Is the Settlement Payment original loan component included as ordinary income of the Estate under subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Is the Settlement Payment interest component included as ordinary income for the Estate in the year of receipt, under subsection 6-5(1) of the ITAA 1997?

Answer

Yes.

Question 3

Are interest outgoings incurred by the Estate deductible under section 8-1 of the ITAA 1997 in the year they were incurred?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2021

Year ended 30 June 2022

Year ending 30 June 2023

Year ending 30 June 2024

The scheme commenced on:

1 July 2022

Relevant facts and circumstances

Individual A, who recently passed away, was a client of Individual B.

Whilst consulting with Individual B around 20 years ago, Individual B informed Individual A that they had been attempting to negotiate the acquisition of a neighbouring property (the Property). However, Individual B did not have the available funds for the purchase.

Discussion subsequently ensued between Individual B and Individual A, and it was agreed that the Property would be acquired by a company that they both owned as equal shareholders.

A company was subsequently registered (the Company) with Individual A and Individual B, each owning one of the two ordinary shares in addition to being its directors.

Individual A borrowed funds from their bank (the Bank Loan) using their family home as security. Individual A's spouse (Individual C) jointly owned the family home with Individual A.

Individual A and Individual B agreed that the loan principle and accrued interest on both loans were to be repaid upon the sale of the Property with the applicable rate of interest being the home loan variable rate of interest charged on the Bank Loan.

The Company purchased the Property using the on lent amount from the Bank Loan in addition to a further smaller contribution from Individual A's personal savings.

Individual B contributed to the Company for the settlement costs for the Property.

None of the agreements between Individual A, the Company and Individual B were in writing.

Individual C was not party to the agreements with Individual B or the Company.

No monies have been paid by the Company or Individual B for the repayment of the loaned amounts.

The Bank Loan has been an interest only payment mortgage. The interest that Individual A incurred now their Estate continues to incur for the interest on loan, was and now is the home loan variable rate.

Individual A failed to keep accounts of all the interest they incurred on the Bank Loan.

Individual A did not keep records of the interest amount accrued on the outstanding loans to the Company and Individual B.

Individual A also did not recall whether there had been any discussions as to whether the interest which was to be repaid, was to be simple interest basis or compounding interest basis. Individual A was of the view that they should receive compounding interest under the original loan agreement.

Disagreement ensued between Individual A and Individual B with respect to a default on a contract for the sale of the Property, in addition to issues of accounting for rent from the Property. Both of the issues involved related entities of Individual B.

Individual A recently died with these issues unresolved.

Individual C is the administrator of the Estate of Individual A (the Estate) is its sole beneficiary.

Individual C maintains that the Estate is entitled to claim compounding interest from the Company on the basis that it would be reasonably inferred that this was what was agreed to, in the absence of written agreements.

A Deed was entered between the Company, Individual C and Individual B (the Deed) in relation to dealing with the proceeds from a future sale of the Property.

The Deed sets out that Individual C is prepared to accept interest on a simple interest basis and waive additional interest charges related to the sale contract default and the original amount for the purchase of the Property that was provided from Individual A's savings. Acceptance of the deed by Individual C was subject to, and conditional upon, payment to the Estate by the Company, of more than half of the sale proceeds of the Property after deducting:

•                     amounts for the original loan amount

•                     interest on the original loan amount calculated on a simple interest basis

•                     legal, accounting and other incidental expenses in relation to the sale of the Property

•                     payment of all outstanding taxes including CGT

The remaining sale proceeds will be paid to Individual B.

Under the Deed, Individual B agrees to waive and forfeit to the Company the money contributed to settlement of the Property.

Relevant legislative provisions

Income Tax Assessment Act 1936 paragraph 254(1)(c)

Income Tax Assessment Act 1997 subsection 6-5(1)

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 108-5

Reasons for decision

Question 1

Assessable income consists of ordinary income and statutory income (subsection 6-1(1) of the ITAA 1997).

Ordinary income is defined to mean income according to ordinary concepts (subsection 6-5(1) of the ITAA 1997).

The legislation does not provide any specific guidance on what is meant by 'income according to ordinary concepts'.

Taxation Ruling 2006/3 Income tax: government payments to industry to assist entities (including individuals) to continue, commence or cease business considers when a receipt may be ordinary income. Paragraph 84 of the TR 2006/3 states that the characteristics of ordinary income have been developed by case law and generally fall into three categories:

•                     Income from providing personal services.

•                     Income from property.

•                     income from carrying on a business.

TR 2006/3 also provides a summary of the Case law that has established guidelines to assist in determining the nature of a receipt. Relevantly to this case:

•                     The nature of a payment is determined by examining the character of the payment in the hands of the recipient.

•                     Where a recipient provides consideration for a payment, the nature of that consideration is generally taken to be the nature of the payment.

Your assessable income includes your net capital gain (if any) for the income year (subsection 102-5(1) of the ITAA 1997).

Subsection 108-5(1) of the ITAA 1997 defines a CGT asset to be any kind of property, or legal or equitable right that is not property. One of the examples provided in the notes to section 108-5 of the ITAA 1997 is a debt owed to the taxpayer. Thus, an unpaid loan is considered a debt that is owing to the taxpayer.

CGT event C2 in section 104-25 of the ITAA 1997 happens if a taxpayer's ownership of an intangible CGT asset ends in certain ways, including because the asset expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited.

The time of the event is when a taxpayer enters into the contract that results in the asset ending. If there is no contract, the event happens when the asset ends (subsection 104-25(2) of the ITAA 1997).

You make a capital gain if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base - subsection 104-25(3) ITAA 1997.

Application to your circumstances

The repayment of the loan amount is not considered to be ordinary income under subsection 6-5(1) of the ITAA 1997 as it does not have the character or nature of ordinary income established by the courts. It is a repayment of capital amounts loaned to the Company. The payment in Individual A's (and now the Estate's) hands has not resulted from Individual A's activities or services rendered nor has it been derived from property investment.

CGT event C2 will occur upon the repayment of the outstanding loan principle as allowed for in the Deed. However, it is expected that the capital proceeds from the event will equal the cost base being the originally amount lent, resulting in no capital gain or loss.

Question 2

Under paragraph 254(1)(c) of the Income Tax Assessment Act 1936 (ITAA 1936), the executor (or administrator) of the deceased's estate takes over the deceased obligations in so far as the returns shall be the same as far as practicable as the deceased person, if living, would have been liable to make.

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of an Australian resident taxpayer includes ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Interest is in most circumstances of an income nature and is therefore income according to ordinary concepts.

Per paragraph 47 of Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings the general principle (TR 98/1) is that interest is only derived, or arises, when it is received or credited. This general rule is subject to the overall principle that the appropriate method is that giving a substantially correct reflex of income.

Paragraph 28 of TR 98/1 states that:

28. Whether a method gives a 'substantially correct reflex' and therefore is appropriate is a conclusion to be made from all circumstances relevant to the taxpayer and the income. It is necessary, according to Dixon J in Carden's case, F6 to:

'... discover what gains have during the period of account come home to the taxpayer in a realized or immediately realizable form.'

We considered whether the loans made by Individual A to Individual B and the Company could be considered a private arrangement whereby incomings and outgoings resulting from the agreement could be ignored for taxation purposes. However, given the agreements involved the establishment of a Company our view is that they were commercial arrangement, it follows that any payments of interest will ordinary income under subsection 6-5(1) of the ITAA 1997 in the year of receipt.

The interest component of the settlement payment would have been income for Individual A in the year of receipt if they had received it prior to their death. It will now need to be included as assessable income of the Estate in the financial year it is received.

Question 3

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.

To the extent that the borrowed funds are used in gaining or producing assessable income

Whether an interest payment is deductible (and the extent to which it is deductible) is essentially a question of fact and degree determined by looking at:

1.    the use to which the borrowed funds are put; and

2.    the purpose of the borrowing (including, in some cases, the taxpayer's motivation or subjective purpose: Fletcher v FCT (1991) 173 CLR 1; 22 ATR 613.

Taxation ruling TR 97/7 Income tax: section 8-1 meaning of 'incurred' - timing of deductions considers whether incurred has the same meaning for taxpayers who return their income on a receipts basis as it does for those taxpayers who generally return their income on an earnings basis.

To qualify for deduction under section 8-1 a loss or outgoing must have been incurred. As a broad guide, you incur an outgoing at the time you owe a present money debt that you cannot escape. You need not necessarily to have paid or borne a loss or outgoing in order for that loss or outgoing to have been 'incurred' for the purposes of section 8-1.

Application to the client's circumstances

Based on the information availability there is some difficulty in ascertaining what Individual A's purpose was in making the loan to the Company. It is possible that Individual A wanted to assist Individual B in the acquisition of the neighbouring property for purposes related to their personal relationship. However, given the agreements involved the establishment of a Company our view is that they were a commercial arrangement it follows that the Bank Loan interest is deductible under section 8-1 of the ITAA 1997.

In this case the interest expense liability would have arisen on the monthly basis over the term of the loan giving rise to the incurred expenditure for the purpose of section 8-1 of the ITAA 1997. The interest expenses will need to be included as deduction when it was incurred.

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