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Ruling

Subject: Deductibility of loan repayments as guarantor

Question

Are you entitled to a deduction for expenses incurred as a guarantor in repaying a loan of a company, now in liquidation, of which you previously were the sole director?

Answer

No.

This ruling applies for the following periods:

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

Year ended 30 June 2017

The scheme commences on:

1 July 2010

Relevant facts and circumstances

You were a sole director of a company.

In your capacity as a director, you entered into guarantee documents for security on loans that the company entered into.

The loans were for the purchase of assets to be used in the business.

The company went into liquidation.

You were pursued to fulfil your guarantor obligations. You have entered into payment terms to repay the debts in line with the company's original loans, including interest.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Reasons for decision

Summary

You are not entitled to a deduction for the payments and interest expenses you incur to repay the company loan, in your capacity as guarantor.

The purpose of your payments as guarantor is not to produce any of your own assessable income, but instead to honour your commitment as guarantor.

The giving of the guarantee and payments under it have no connection with your income producing activities. The payments are considered to be capital in nature and not deductible under 8-1 of the ITAA 1997.

Detailed reasoning

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for expenditure to the extent that it is incurred in the gaining or producing of assessable income, or in the carrying on of a business to gain or produce assessable income.

No deduction is allowable to the extent that the expenditure is capital, private or domestic in nature.

The case of Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153 established the principle that interest on borrowed money will be an allowable deduction only when the money is borrowed for the production of income. A deduction for interest expenses therefore depends upon the purpose to which the principle sum has been applied.

Accordingly, a claim for interest expenses which has arisen as a result of a guarantee, involves an examination of the guarantee in relation to the nature and scope of the taxpayer's income earning activities.

In Ronpibon Tin NL v. Federal Commissioner of Taxation; Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR47; (1949) 4 AITR 236; (1949) 8 ATD 431 the Full High Court found that the loss or outgoing must have a sufficient connection to the earning of assessable income in order to be deductible.

In the courts, it has been held that expenses paid by an individual taxpayer on behalf of a company, of which the taxpayer was a shareholder and/or director, are not deductible. This is because the expenses are not incurred in gaining or producing assessable income in the taxpayer's capacity as a director or shareholder.

In Case L3 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 company's 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 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 former 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.

The Commissioner sets out his view on the deductibility of payments made under a guarantee in Taxation Ruling TR 96/23. 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 losses or outgoings are not regular and normal incidents of the taxpayer's income earning activities. Payments made in these instances will be capital in nature.

Paragraph 158 of TR 96/23 provides an example of a director/ shareholder giving a guarantee and reasoning as to why the liabilities arising from the guarantee are not deductible:

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…

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

Application to your case

You are liable to make principal and interest payments on a loan which has arisen as a result of a guarantee for a company loan. The debts were the company's debts. You will make these payments as the guarantor. The purpose of your payments as guarantor is not to produce any of your own assessable income, but instead to honour your commitment as guarantor.

You are not in the regular business of giving guarantees. You made the guarantee in your capacity as sole director of the company. The guarantee did not bear any direct relationship to any income that you might derive from the company. The loan was taken out to enable the company to purchase assets.

The giving of the guarantee and payments under it have no connection with your income producing activities. Therefore, the loan which has arisen as a result of your guarantee is regarded as having a non-income producing purpose.

As the law has established that interest takes on the same character as the principle, the interest paid by you would also be regarded as having a non-income producing character. The interest was paid, not for the purpose of gaining or producing your assessable income, but for the purpose of satisfying a debt which the company had incurred to purchase assets.

Therefore the payments made under the guarantee, including any interest incurred, are not considered to be incurred in gaining your assessable income. These payments are considered to be capital nature.

As the requirements of section 8-1 of the ITAA 1997 have not been satisfied, you are not entitled to a deduction for expenses incurred in repaying the debts of the company.

Please note

This Ruling only deals with the question asked by you in respect of the deductibility of interest expenses under section 8-1 of the ITAA 1997.

There has been no consideration of the capital gains tax provisions. Taxation Ruling TR 96/23 deals with the capital gains tax consequences of guarantee payments.