Edited version of private ruling

Authorisation Number: 1011824793216

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Ruling

Subject: Interest expense and capital loss

Question 1

Are you entitled to a deduction for your share of the interest expense incurred on funds on-lent in order to earn assessable income?

Answer

Yes, until the date the loan was repaid in full.

Question 2

Are you entitled to your share of the capital loss for the loan funds not reimbursed after the borrower went into liquidation?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2009

Year ended 30 June 2010

The scheme commences on:

1 July 2008

Relevant facts and circumstances

Several years ago you and your spouse borrowed a sum of money from a financial institution in both you and your spouses' names, and on-lent the funds to the Company.

The Company purchased a property and developed a multi unit building on the site.

The terms of the loan were outlined in a signed loan agreement.

The repayment of the loan was to occur when the properties were sold. In addition to the repayment of the principal, you and your spouse were also to receive 12.5% of the profit from the development.

A feasibility study for the development showed an expectation of profit.

The units were completed and a small number were sold; however due to the economic downturn the remainder would not sell.

The Company went into receivership and was declared insolvent. Further, the two guarantors listed in the loan agreement are both bankrupt.

You received a statement from the liquidators of the Company, confirming that no distribution would be paid in the liquidation of the Company, and that any outstanding claim against the Company should be written off for taxation purposes.

You have not received, nor do you expect to receive, any income from the failed investment.

You were forced to borrow another amount to pay for the interest that was accruing on the investment loan.

The loan account was only used for investment purposes.

You sold your house in the 20XX-XX financial year and used the funds to fully pay out the investment loan.

You are not in the business of lending money.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1,
Income Tax Assessment Act 1997 Section 25-35,
Income Tax Assessment Act 1997 Section 102-20,
Income Tax Assessment Act 1997 Section 104-25,
Income Tax Assessment Act 1997 Paragraph 108-5(1)(b),
Income Tax Assessment Act 1997 Section 108-20,
Income Tax Assessment Act 1997 Section 110-25, and
Income Tax Assessment Act 1997 Section 118-10.

Reasons for decision

Interest on Loan

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except to the extent that they are of a capital, private or domestic nature.

Taxation Ruling TR 2004/4 states as follow:

10. Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and income earning activities (whether business or non business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing the assessable income if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

12. An outgoing of interest in such circumstances will not fail to be deductible merely because:

· the loan is not for a fixed term;

· the taxpayer has a legal entitlement to repay the principal before maturity, with or without penalty; or

· the original loan is refinanced, whether once or more that once.

13. However, if the taxpayer:

· keeps the loan on foot for reasons unassociated with the former income earning activities, or

· makes a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred,

· the nexus between the outgoings of interest and the relevant income earning activities will be broken.

In your circumstances, you borrowed funds in order to generate assessable income by means of non-business activities. Further, after the borrower became insolvent you did not have the capacity to repay the loan.

The cessation of the investment activity will not sever the nexus of the original purpose of the loan, which was to generate assessable income. Also we consider that you have not kept the loan in such a way that there is an ongoing commercial advantage. Therefore you are entitled to a deduction for the interest on the loan.

Capital Gains Tax (CGT) implications for the loss of on-lent funds

Section 102-20 of the ITAA 1997 provides that a capital gain or loss can only arise when a capital event occurs in respect of a capital asset.

As a result of a taxpayer entering into the contractual arrangement with a debtor, it is considered that the creditor acquires contractual rights. These contractual rights are capital assets (asset A) for the purposes of paragraph 108-5(1)(b) of the ITAA 1997.

Further Taxation Ruling TR 96/23 states that upon entering into a contractual arrangement where a guarantor exists (a contract of guarantee), the creditor acquires a second asset (asset B), being the rights under the contract of guarantee to call upon the guarantor to meet the obligations of the debtor under that contract.

Section 104-25 of the ITAA 1997 provides that a CGT event C2 happens if your ownership of a capital asset ends by the asset being abandoned, surrendered or forfeited.

Capital asset A

You entered into a contractual arrangement by on-lending an amount to the Company. This contractual arrangement is considered a capital asset.

The Company went into liquidation before you received a return from your investment. You have been advised in writing by the liquidators that you will not receive a distribution after the Company is liquidated.

When you were advised that you would not receive a distribution from the company, there is a disposal of the debt by a cancellation, discharge or surrender. As such, a CGT event C2 has occurred and a capital loss arises pursuant to subsection 104-25 of the ITAA 1997.

The cost base or reduced cost base for the debt is the amount of the debt (section 110-25 of the ITAA 1997).

Therefore, you and your spouse are each entitled to claim a capital loss from the disposal of capital asset A of half of the total amount on-lent to the Company.

Capital asset B

As the contractual arrangement with the company lists guarantors, a contract of guarantee exists. This contract of guarantee arrangement is considered a capital asset.

As mentioned above, a CGT event C2 happens if your ownership of a capital asset ends by the asset being abandoned, surrendered or forfeited.

Although both guarantors are bankrupt and it is unlikely that you will recover the amount on-lent from the guarantors, your ownership of the capital asset does not end. It is considered that your ownership of the capital asset will end when the guarantors are released from bankruptcy.

The debt will continue to exist until such time as the bankrupt guarantors are discharged from bankruptcy. The discharge operates to release him from all provable debts in accordance with section 153 of the Bankruptcy Act 1966. A discharge will not occur as a result of a mere statement on the likely outcome of the administration of the bankrupt estate.

With respect to the cost base for asset B, paragraph 14 of TR 96/23 states:

The consideration given by the creditor in respect of the acquisition of the contractual rights under the guarantee is the promise of the creditor to make a loan, or extend or maintain credit, to the debtor. The contractual consideration is 'consideration in respect of the acquisition of an asset' for the purposes of paragraph 160ZH(1)(a), (2)(a) or (3)(a) as defined in subsection 160ZH(4)(b), being 'property other than money'. If the taxpayer has given, or is required to give, property other than money in respect of the acquisition of an asset, the consideration in respect of the acquisition of the asset is the market value of that property at the time of the acquisition.

We consider that there is no market for the creditor's promise to the guarantor to make a loan or extend credit to the debtor. We conclude, therefore, that the market value is nil. The creditor, while obtaining two assets, cannot recover more than the face value of the loan to the debtor, so that the consideration for the guarantee (relevant cost base) is sensibly to be determined as having a nil value.

Any payment that you may receive from the guarantors will result in you deriving a capital gain.

The guarantee, which has a nil cost base, is itself automatically disposed of by release or discharge, on release or discharge of the debt, for no consideration. That is, once the guarantors are released from bankruptcy, the market value of the guarantee would be nil and therefore no capital gain would accrue on discharge of the guarantee.