Edited version of private ruling

Authorisation Number: 1011845654338

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Ruling

Subject: Capital gains tax implications of a guarantee to pay a debt

Question 1

Can a guarantor claim a capital loss for their share of payments made in relation to a contract of guarantee?

Answer

Yes

This ruling applies for the following period:

The 2009-10 income year

The scheme commences on:

1 July 2009

Relevant facts and circumstances

The rulees were the directors and shareholders of a company.

The company signed a lease for a commercial property.

A personal guarantee was a requirement of the lease contract. The rulees signed this lease as guarantors.

The company utilised the commercial property in a business.

The company was wound up and a liquidator was appointed.

Civil action was commenced against the rulees. This was eventually settled out of court.

A payment was made by the rulees for settlement.

Settlement covers all claims arising out of the lease.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 102-25(3),

Income Tax Assessment Act 1997 Section 109-5 and

Income Tax Assessment Act 1997 Section 110-25.

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Summary

The guarantors together have a capital loss. This needs to be divided between each of the guarantors in such a way that reflects the amount that each guarantor contributed towards the settlement.

Detailed reasoning

On entering into a contract of guarantee, the guarantor acquires an asset which is a right to be indemnified by the principal debtor. Section 110-25 of the ITAA 1997 discusses the cost base. This provision determines that the cost base for this right is equal to the amount the guarantor pays, or is required to pay, under the contract of guarantee. The time of acquiring this asset is when the contract of guarantee is entered into.

Until default by the principal debtor and payment by the guarantor, a guarantor is not entitled to sue on the right of indemnity.

There is no right of subrogation unless the guarantor's right of indemnity from the principal debtor existed at the date of payment of the principal debt by the guarantor, or immediately thereafter (Scholefied Goodman and Sons Ltd v. Zyngier [1984] VR 455). Similarly, if a guarantor assigns the right of indemnity before paying a creditor under the guarantee, the guarantor no longer has any recourse against the principal debtor.

Providing the contract of guarantee is valid and enforceable at the time the creditor enforces the contract, the guarantor acquires the right of subrogation for a cost base equal to the amount the guarantor pays, or is required to pay under the contract. This occurs at the time the guarantor pays the creditor.

At general law, the right of subrogation is not severable from the right of indemnity and it is merely a means of enforcing the right of indemnity.

Taxation Ruling TR 96/23 discusses the implications of a guarantee to pay a debt. Paragraph 114 of TR 96/23 explains that the amount the guarantor can recover from the principal debtor is limited to the amount that the guarantor has paid under the guarantee (Sunbird Plaza Proprietary Limited v. Maloney and Another (1988) 166 CLR 245; 77 ALR 205). Therefore the cost base of the merged asset is the amount of the payment under the guarantee; it cannot exceed the amount paid or given for the original asset.

The right of indemnity becomes an enforceable debt on payment. The Court of Appeal in Re A Debtor [1937] 1 All ER1 (Debtors Case) confirmed that the debt due to the guarantor by the debtor does not arise until the guarantor has been called on to pay, and does pay, the creditor under the guarantee. Further comments in Debtors Case indicate that the undertaking to indemnify is an undertaking to reimburse the guarantor.

Paragraph 101 of TR 96/23 states that a guarantor has a right to be indemnified by the principal debtor to the extent of the amount paid under their contract of suretyship (A E Goodwin Ltd v. A G Healing Ltd (1979) 7 ACLR 481).

Because the right of indemnity on payment by the guarantor is in the nature of a debt, it may give rise to a capital loss if it is disposed of for no consideration. A capital loss will not arise on the disposal of a personal use asset.

There may be no likelihood of payment by the principal debtor to the guarantor. The guarantor must take some action in order to dispose of the debt.

The liquidation of a company constitutes a release and disposal. The debt is disposed of by the guarantor for no consideration.

Any capital loss is reduced by any entitlements to contributions from co-guarantors.

The guarantors together paid the total settlement. CGT event D1 occurred at this time with the creation of the right to enforce the indemnity against the company under section 109-5 of the ITAA 1997.

As the company was liquidated, the debt was disposed of for no consideration. This resulted in a capital loss for the guarantors. This capital loss is to be reduced by any contributions from co-guarantors.

In your circumstances, the guarantors each have a right to be indemnified to the extent of their payment, amounting to the total settlement amount. The capital loss would need to be divided between the guarantors in a way that reflects the amount that each guarantor contributed to the settlement.