Edited version of private ruling

Authorisation Number: 1011802006407

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Ruling

Subject: Guarantee

Question 1

Is the supplier payment and legal expenses incurred in relation to a guarantee deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Are you entitled to claim a deduction under section 40-880 of the ITAA 1997 for a supplier payment and legal expenses incurred in relation to a guarantee?

Answer

No.

Question 3

Does the payment made under a personal guarantee and related legal costs give rise to a capital loss under Part 3-1 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2010

The scheme commences on:

1 July 2009

Relevant facts and circumstances

You are an Australian resident.

You were previously involved in a business as manager.

You were a director of the trustee company.

You were a beneficiary of the trust.

You left the business and were removed as a director of the company, and beneficiary of the trust.

An administrator was appointed to the business. The business ceased trading on this date.

Prior to you leaving the business, you signed a personal guarantee on a supplier account and were therefore accountable for debts owed to the supplier after the business had been wound up.

You incurred legal costs of in relation to the supplier demand.

The other beneficiaries had to pay 50% of the supplier demand.

The company has not yet been wound up due to an unrelated administrator issue. However, there are no plans to recommence the business.

Relevant legislative provisions

Income Tax Assessment Act 1997 8-1.

Income Tax Assessment Act 1997 Section 40-880.

Income Tax Assessment Act 1997 Section 104-25.

Income Tax Assessment Act 1997 Section 108-5.

Income Tax Assessment Act 1997 Subsection 110-25(2).

Income Tax Assessment Act 1997 Section 110-35.

Income Tax Assessment Act 1997 Section 110-55.

Reasons for decision

Summary

The payment you made, and the legal expenses you incurred, in relation to the guarantee are considered to be capital in nature and therefore not deductible under section 8-1 of the ITAA 1997.

However, both of these amounts can be taken into account in working out your capital loss which can be realised on the deregistration of the trustee company.

As these amounts are taken into account in working out a capital loss, a deduction is not allowable under section 40-880 of the ITAA 1997.

Detailed reasoning

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, or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

However, no deduction is allowed to the extent that the losses or outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.

The expenditure must be incidental and relevant to the gaining or producing of assessable income or the carrying on of a business for the purpose of gaining or producing assessable income.

The guidelines for distinguishing between capital and revenue outgoings were laid down in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. Federal Commissioner of Taxation [1938] ALR 498;[1939] ALR 10;(1938) 12 ALJ 411;(1938) 5 ATD 23;5 ATD 87;61 CLR 337;(1938) 61 CLR 337 (Sun Newspapers case). There it was pointed out that expenditure in establishing, replacing and enlarging the profit-yielding (i.e. business) structure itself is capital and is to be contrasted with working or operating expenses.

The test laid down in the Sun Newspapers case involved three elements, although none is in itself decisive: 

· the nature of the advantage sought

· the way it is to be used or enjoyed

· the means adopted to get it.

As regards to the first two elements, the lasting or recurrent character of the advantage and the expenditure is important. Thus the courts have held that, in the absence of special circumstances, expenditure is capital in nature where it is made with a view to bringing into existence an asset or an advantage (tangible or intangible) for the enduring benefit of the business. In addition, it is the nature of the advantage sought by the taxpayer that is relevant.

The third element involves a consideration of whether the outlay is a periodic one covering the use of the asset or advantage during each period, or whether the outlay is calculated as a single final provision for the future use or enjoyment of the asset or advantage.

Guarantee

The legal system has held firmly, for most purposes, to a distinction between a company as one legal entity, and its promoters or shareholders. The view taken by the Courts and Tribunals is that a guarantee given for the purpose of acquiring, preserving or promoting capital assets or the income earning structure of the taxpayer is of a capital nature.

The Federal Court has confirmed in Bell & Moir Corporation Pty Ltd v. FC of T (1999) 99 ATC 4738; (1999) 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 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.

The Commissioner has set out his views on the deductibility of guarantee payments in Taxation Ruling TR 96/23: 

A payment by a guarantor is deductible if the giving of the guarantee, the guarantors' 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. In essence the loss or outgoing must bear the character of an income producing expense or a working expense of a business.  

If a guarantor is engaged in a business of giving guarantees for reward, a loss or outgoing arising on a failure by a principal debtor to pay the guarantor is more likely to be deductible.  

There are a number of court cases in which it was decided that payments made under guarantees by shareholders or directors are not deductible. For example, in Case V115 88ATC 733, a deduction was not allowed for payment made by the taxpayer who was a director and shareholder of a land development company and who was a creditor of the company under a guarantee given by the taxpayer in respect of the company's liabilities.  

Liabilities arising under contracts of guarantee will not be deductible if the provision of guarantees and the losses or outgoings arising under the guarantees are not regular and normal incidents of the taxpayers earning activities. Once again there are a number of court cases supporting payments under guarantee are capital.

You have not indicated that you were engaged in the business of giving guarantees for a fee. Also, it would not be expected that the giving of guarantees would be a normal and regular incident of the income earning activities of a director or beneficiary. Therefore, the expenses you incurred in relation to the guarantee (both the payment made to the supplier and your legal expenses) are considered to be capital in nature and not deductible under section 8-1 of the ITAA 1997.

Section 40-880 of the ITAA 1997

The object of section 40-880 of the ITAA 1997 is to provide a deduction over five income years for certain business capital expenditure incurred after 30 June 2005 which is not otherwise taken into account or denied a deduction by some other provision. Subsections 40-880(3) to (9) of the ITAA 1997 set out the limitations and exclusions to deductibility under section 40-880.

Paragraph 40-880(5)(f) of the ITAA 1997 provides that an entity cannot deduct anything under section 40-880 of the ITAA 1997 for an amount of expenditure they incur to the extent that it could, apart from section 40-880, be taken into account in working out the amount of a capital gain or capital loss from a CGT event.

You were a director of a trustee company and the beneficiary of a trust which carried on a business. You incurred capital expenditure after 30 June 2005 as a result of a payment made under a personal guarantee to a supplier and you incurred legal expenses as a result of the supplier payment demand.

The payment made under the guarantees will be the first element of the cost base and reduced cost base of the CGT asset that is your enforceable debt against the business. The legal expenses also are included in the cost base as incidental expenses. As the amounts could be taken into account in working out the amount of a capital gain or capital loss from a CGT event, the exclusion under paragraph 40-880(5)(f) of the ITAA 1997 applies. (See below for a more detailed discussion with regards to capital gains tax.)

Subsection 40-880(6) of the ITAA 1997 does not apply to prevent paragraph 40-880(5)(f) of the ITAA 1997 applying because the expenditure was not incurred to preserve the value of goodwill.

As such, none of the expenses incurred in relation to the guarantee are deductible under section 40-880 of the ITAA 1997.

Capital Loss

You make a capital gain or a capital loss if a capital gains tax (CGT) event happens to a CGT asset. Under section 108-5 of the ITAA 1997 a CGT asset can include any kind of property, or a legal or equitable right that is not property such as a debt owed to a taxpayer or a right to enforce a contractual obligation. You will make a capital gain if the capital proceeds from the ending of the debt are more than the debt's cost base, and will make a capital loss if the capital proceeds from the ending are less than the debt's reduced cost base (subsection 104-25(3) of the ITAA 1997).

Under Division 110 of the ITAA 1997 there are five elements which may be included in the cost base and reduced cost base of a CGT asset. The first element of the cost base is the money paid or required to be paid and the market value of any other property given or required to be given in respect of acquiring a CGT asset (subsection 110-25(2) of the ITAA 1997). The second element of the cost base and reduced cost base consist of incidental costs incurred to acquire the asset, or that relate to a CGT event that happens in relation to the asset (subsections 110-25(3) and 110-55(2) of the ITAA 1997). Incidental costs are listed in section 110-35 of the ITAA 1997 and include costs incurred for the services of a legal adviser (subsection 110-35(2)).

Payments made under guarantee

The Commissioner's view on the CGT implications of a guarantee by a shareholder for a private company debt is set out in Taxation Ruling TR 96/23.

On entering a contract of guarantee, a guarantor (director/shareholder) acquires an asset which is a right to be indemnified by the principal debtor (the private company). The guarantor is taken to have acquired this right for a cost base equal to the amount the guarantor pays, or is required to pay, under the contract of guarantee. Until the default of the principal and payment by the guarantor, a guarantor is not entitled to sue on the right of indemnity. (Paragraphs 30 & 31 and 109 of TR 96/23).

When a creditor's debt is paid in full, the guarantor's 'right of subrogation' is created that is, the right to stand in place of the creditor and be subrogated to the creditor's remedies against the principal debtor. The right of subrogation does not arise in all cases for example, when the creditor's debt is not paid out in full. The guarantor is taken to have acquired the right of subrogation for (the first element of) a cost base equal to the amount the guarantor paid under the contact or guarantee. The asset is deemed to have been acquired by the guarantor under section 109-10 of the ITAA 1997 and the time of acquisition is governed by Divisions 104 and 109 of the ITAA 1997. It is taken to be acquired on payment. (Paragraphs 32 to 34 and 112 of TR 96/23).

When the guarantor makes a payment to the creditor under a guarantee, the guarantor's right of indemnity and right of subrogation become co-extensive. That is, they are merged into one asset being an 'enforceable debt' against the principle debtor and the guarantor has the general rights of a creditor. On payment by the guarantor under the guarantee, the right on indemnity (or the merged asset if there is a right of subrogation) is enforceable as a debt against the principal debtor. The amount paid under the guarantee remains the (first element of the) relevant cost base of the merged asset and there are no CGT consequences from the merging of the indemnity and subrogation rights. (Paragraphs 35 to 37 and 84 to 85 of TR 96/23).

It is the disposal/cancellation/surrender, etc of this enforceable debt as a CGT asset within section 108-5 of the ITAA 1997 that may give rise to a capital loss for the purposes of Part 3-1 of the ITAA 1997. (Paragraphs 38 to 44 and 118 to 119 of TR 96/23).

In this case, you were previously a director of a trustee company ATF the trust (the principal debtor). The execution of a guarantee in favour of the creditor created in you the right to be indemnified by the business. The cost base of this right was the amount you were required to pay under the guarantee. You have paid an amount under the guarantee as a result of legal action taken against you by the supplier.

We consider that when the payment under the guarantee was made, your right of indemnity (or the merged asset if there is a right of subrogation) became an enforceable debt against the company acting for the trust. This enforceable debt is a CGT asset within section 108-5 of the ITAA 1997 and the amount you paid under the guarantee is the first element of the cost base of this asset for the purposes of subsections 110-25(2) or 112-25(4) of the ITAA 1997.

The legal costs incurred in defending the court action taken against you as guarantor were in connection with this action and therefore had a direct relationship with the CGT asset. We consider that they are incidental costs that relate to the CGT event and are included in the second element of the asset's cost base and reduced cost base.

Time of event

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens if the ownership of an intangible CGT asset ends because it expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited. A debt which arises under the right of indemnity, (or the merged asset if there is a right of subrogation), once payment has been made under the guarantee, can be disposed of in the following ways in terms of subsection 104-25(1) of the ITAA 1997 and a capital loss may arise, depending on whether the debt is a personal-use asset:

The debt is forgiven at law (or in equity) by the guarantor; a formal deed of forgiveness is required in this situation.

The principal debtor could be discharged from bankruptcy (in the case of an individual); similarly the dissolution of a company will also constitute a release and disposal.

Subsection 108-20(1) of the ITAA 1997 disregards any capital loss made by you on a personal use asset. Subsection 108-20(2) of the ITAA 1997 defines a personal use asset; included in this definition at paragraph 108-20(2)(d) of the ITAA 1997 is a debt arising other than in the course of gaining or producing your assessing income or from your carrying on a business.

You were a director of the trustee company of the trust which conducted the business. You were also a beneficiary of the trust. You were entitled to receive distributions from the trust. In your circumstances it is accepted that paragraph 108-20(2)(d) of the ITAA 1997 would not apply. Therefore, the capital loss will not be disregarded by subsection 108-20(1) of the ITAA 1997.

Your ownership of the debt does not end when a company is placed in to liquidation. (Federal Commissioner of Taxation v. Macquarie Health Corporation Limited & Ors (1998) 88 FCR 451; 98 ATC 5214; (1998) 40 ATR 349) and liquidation of the company is not enough to end your rights in one of the ways contemplated by subsection 104-25(1) of the ITAA 1997. When the company is deregistered in accordance with the Corporations Law it will cease to exist, the company's debt to you will be 'abandoned, surrendered or forfeited' for the purposes of paragraph 104-25(1)(d) of the ITAA 1997and CGT event C2 in section 104-25 of the ITAA 1997 will happen. If no capital proceeds are received for the purposes of subsection 104-25(3) of the ITAA 1997 before the company is deregistered you will make a capital loss when the company is deregistered.

Therefore, there will be no capital loss until the trustee company is deregistered in accordance with the Corporations Law.

The capital loss can be offset against a capital gain or will be carried forward until it can be offset.