Edited version of private advice

Authorisation Number: 1052160052380

Date of advice: 30 August 2023

Ruling

Subject: Deductibility of payment made against director's guarantee

Question

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for your payment to Bank A to discharge your director's guarantee?

Answer

No.

This ruling applies for the following period:

Period Ending on 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

Background

You were employed by Company B as Finance Director and Executive Director receiving an annual salary for both the roles.

Company C in its capacity as trustee for Trust D was one of the three shareholders of Company B holding less than 50% shares.

Trust D is a discretionary trust of which you are the primary beneficiary.

You are also the sole director and 'controlling mind' of Company C.

Your primary streams of assessable income during the relevant period were interest from shareholder loan provided to Company B, salary and dividends received from Company B as an employee and as a primary beneficiary of Trust D.

Guarantee for the first and second business finance loan provided to Company B

You provided guarantee to the loan provided to the company by Bank A the sum of a specified amount in the millions as a general line of credit on a specified date.

On a specified date, Company B entered into a second business finance agreement increasing the total amount of credit.

The other 2 directors provided personal guarantee to the loan as well.

As part of the loan agreement, Company B had to maintain certain covenants as to not breach the terms of the loan facility agreements.

Third loan from Bank A

On a specified date, Company B entered preliminary conversations with Bank A to request an extension to existing loan facility of a specified amount to fund the implementation of the new system. Bank A provided correspondence to Company B on a specified date that outlined their concerns in providing the third loan extension and provided alternative solutions. You provided us with details of the alternative solutions that Bank A provided.

Company B concluded that the provision of additional security to support the third loan facility was the only viable option in the short term that would allow Company Bs business operations to return to normality and to support the expected substantial turnover growth over the coming 5 years.

Family home as guarantee for the third loan

You preliminary agreed to provide additional security on a specified date for the third loan extension by way of your personal family home.

You were the only director to provide additional security. You provided us with details on why the other 2 directors did not provide additional security.

On a specified date, Bank A and Company B formally entered into the third loan extension with Bank A.

On a specified date, Bank A and you entered into a third guarantee and indemnity deed (GID) guaranteeing amounts owing by Company B with the provision of your personal home as additional security.

Directors guarantee charge for guaranteeing the third loan

On a specified date, as part of Company B's director's and shareholder's meeting you raised a matter of compensation for your exposure in providing your family home as additional security to secure the third loan extension with Bank A.

The proposed compensation figure was a once off payment called Directors Guarantee Charge (DGC).

In late 20XX, it was verbally agreed between Company B's directors and shareholders that you were to receive the proposed sum of a specified amount for provision of the property as security for the third loan extension with Bank A.

This agreement was included in an addendum to the board minutes later.

On a specified date, an invoice was raised in Company B's accounts in respect of your DGC payment.

Company B was committed to make this payment to you but did not as you directed the DGC payment be withheld as you determined that the funds were better used as working capital for Company B given the need for the business of the extra funding at the time.

The DGC payment of a specified amount remained unpaid as evidenced by the creditors ledger.

You account for income tax on a cash basis and this amount was not included in your assessable income in the relevant income year.

Company B placed into administration

You provided us with details about what lead Company B to be placed into administration.

Following the realisation of Company B's assets and a distribution to the creditors, there was a shortfall in the amount of a specified amount owing by the company to Bank A from their loan facilities.

Family home sold to get release from the guarantee

At a specified date you entered into a deed of release and settlement in which you would be released from your guarantee and indemnity deed in exchange for proceeds from the sale of your family home.

You and Bank A agreed under the deed that the purchase price for the sale of the property is to be apportioned equally between you and Bank A after deducting selling agent fees and expenses and all amounts including principal, interest, costs, fees and other expenses pursuant to the property loans.

Settlement of the property occurred for a specified amount with a specified amount paid to Bank A as part of the deed.

Relevant legislative provisions

Income tax Assessment Act 1997 section 8-1

Reasons for decision

Detailed reasoning

General deductions

Section 8-1 of the Income Tax Assessment Act 1997 (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 in nature, or relate to the earning of exempt income.

An outgoing is considered to be incurred in gaining or producing assessable income if there is a sufficient connection between the outgoing and the activities which produce or are expected to produce assessable income. The essential character of an outgoing is generally determined objectively. As a general rule, an outgoing will not be deductible unless it is incurred in gaining or producing the assessable income of the taxpayer who incurs it.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

•         it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478),

•         there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

•         it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Directors of a company would not ordinarily be expected to guarantee a business's debts. Debts are normally incurred by a business in relation to their operations and, thus, the earning of the business's assessable income. As highlighted in FCT v. Munro (1926) 38 CLR 153, a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of an entity other than the one who incurs it. That is, where expenses are incurred by the company and paid for by a director or someone else, a deduction is not allowable to the director or that other person.

In Case L3 79 79 ATC 14; (1979) 23 CTBR (NS) Case 9 the taxpayer, a director, shareholder and employee of two companies, gave a number of personal guarantees in respect of each companies overdraft at the bank. When the companies went into liquidation, the bank recovered judgement against the taxpayer as one of the guarantors. The taxpayer claimed a deduction under subsection 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936) 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 assessable income under subsection 51(1) of the ITAA 1936 and in any event was an outgoing of capital or of a capital nature. We note that references to the subsection 51(1) of the ITAA 1936 are to be taken as references to section 8-1 of the ITAA 1997.

The Board said:

The taxpayer did not incur the loss or outgoing of $7500 in carrying on a business; there was no suggestion that at any relevant time he carried on a business involving or including the giving of guarantees...

... the guarantee was given gratuitously, and did not bear any direct relationship to the salary, dividends, directors' fees, or entertainment allowance that he derived from the companies. There may have been an indirect relationship to the salary, dividends, directors' fees, or entertainment allowance that he derived from the companies. There may have been an indirect relationship in the sense that without the guarantees the bank would not have provided funds for payment of the items mentioned or other purposes, but such nexus as that provides between the outgoing and the taxpayer's income is too remote to allow it to be said that the form was incurred in gaining or producing the latter. The payment made by the taxpayer as guarantor did not have the character of a working expense; the guarantees given by him seem to have been no more than one step in a procedure designed to provide the companies, or to ensure that the bank provided them, with working capital.

Payment under guarantee is considered to be capital in nature

Taxation Ruling TR 96/23 Income tax: capital gains: implications of a guarantee to pay a debt (TR 96/23) discusses at paragraph 45 the deductibility of payments made under guarantee. The ruling states that liabilities that arise under contracts of guarantee will not be deductible under section 8-1 of the ITAA 1997 if the provisions of guarantees and losses or outgoings under the guarantees are not regular and normal incidents of the taxpayers' income earning activities. The ruling further states that if the provision of guarantees is not a regular and normal incident of the taxpayer's income earning activities, any payments made under those guarantees will be capital in nature.

TR 96/23 also refers to a line of decisions of the Administrative Appeals Tribunal and the former Boards of Review which accept that payments made under guarantees by shareholders or directors are not deductible. It also states:

135. The principle in Total Holdings might be considered to apply to a shareholder who guarantees the debts of the company in which he/she holds shares. The principle would then be sufficient to allow one of the two positive limbs of subsection 51(1) to be satisfied. However, a deduction may be denied because the expenditure is found to be on capital account. As the majority in Hooker Rex determined, a guarantee is akin to loan capital...

Paragraph 158 of TR 69/23 provides an example of a director/shareholder giving a guarantee and reasoning as to why the liabilities arising from the guarantee are not deductible under section 8-1 of the ITAA 1997:

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 purpose of the second limb 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 a share capital) and, therefore, would not be deductible under subsection 51(1).

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 revenue outgoing and not of a capital nature: Jennings (Inspector of Taxes) v. Barfield & Barfield [1962] 2 All ER 957; 40 TC 365 (Jennings' case).

The Federal Court has confirmed in the case of Bell & Moir Corporation Pty Ltd v. FC of T (1999) 99 ATC 4738; 42 ATR 421 that payments made under guarantees, given to a bank and finance company on behalf of a company in which the taxpayer had a one-third stake, were capital in nature and not deductible. It was found that the advantage sought by the taxpayer in providing the guarantees was the extension of credit facilities to the company. This served to strengthen the base from which the company carried on business so that the taxpayer could continue to trade with it. Such an enduring benefit was ordinarily capital in nature.

Guarantee fees doesn't commensurate with the risk undertaken

Section 156 of the TR 96/23 states that 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. The DGC payment does not commensurate with the standard bank charges, for example: the bank generally charges a much higher guarantee fee.

Even if you were rewarded with the payment of a fee for the provision of the personal guarantee(s), the providing of guarantees to one entity does not amount to the carrying on of a business. You have provided no evidence indicating that you provided the guarantee as part of a wider business (of providing guarantees), to arms-length clients (that is, with respect to persons or companies not associated with you), or that you would have a reasonable expectation of profit from your activities. We do not consider that you were carrying on a business of providing guarantees. Rather, we consider that you were induced to undertake a risk of a capital nature. Therefore, the expenses you incurred in relation to the guarantee are not deductible under section 8-1 of the ITAA 1997.

Furthermore, one cannot include expected future dividend income as payment of guarantee fees as they will receive dividend as a shareholder irrespective of being a guarantor of the loan. In addition, an employee would not provide guarantee against an asset worth millions. Therefore, dividend and salary payment cannot be seen as gaining income from providing guarantee which would have received irrespective of being a guarantor.

Finally, your obligation under the guarantee to settle the loan and the related outgoing/expenses payable to Bank A is not exclusive to your benefit but for the benefit of all the shareholders.

Shareholding

Unlike, the principle found in paragraph 155 of TR 96/23, your being a guarantor did not have any salient relationship to assisting the 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.

Conclusion

In your case, you provided a guarantee on behalf of the company to secure an overdraft to provide working capital for Company B's business and you were subsequently called upon by Bank A to fulfil your obligation under this guarantee. The provision of the guarantee was not a regular and normal incident of your income earning activities. Rather, in your capacity as director, you provided personal guarantees as security for the company to obtain the overdraft.

You had a legal obligation to honour the guarantee given the payment was made to discharge the debts of Company B. You did not pay the money with the purpose that it would lead to gaining or producing any income or in connection with income earning activities.

There is no connection between the guarantee payment and the earning of your assessable income. Therefore, you cannot claim a deduction under section 8-1 of the ITAA 1997 for the guarantee payment.

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