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Ruling

Subject: Income Tax: Deduction - Loss made on disposal of shares

Question 1

Is the loss made by the taxpayer on the disposal of shares in Y Pty Ltd deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) to the taxpayer for income tax purposes?

Answer

No

This ruling applies for the following period

Financial year ended 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

X Pty Ltd (the taxpayer) carries on transport service business.

The taxpayer supplied transport services to a remote site for Y Pty Ltd, and previous owners of that site, on a continuous basis.

As a reflection of Y Pty Ltd's cash flow situation, Y Pty Ltd owed money to various suppliers and creditors in 2009 including the taxpayer.

A debt compromise (capital raising) was put to the taxpayer and other key suppliers of Y Pty Ltd.

The taxpayer was invited to subscribe in Y Pty Ltd's proposed equity capital raising as a priority sub- underwriter, by way of an offset against amounts owing by Y Pty Ltd to the taxpayer.

Rather than write off the debt, the taxpayer accepted Y Pty Ltd's proposal and acquired the Y Pty Ltd shares with the intention and expectation of making a profit on their resale.

The taxpayer expected that Y Pty Ltd's financial position would steadily improve due to increasing cash flows, and that the taxpayer would be able to make a profit from the sale of its shares.

After acquiring the shares, the taxpayer monitored Y Pty Ltd's share price closely.

Against expectations, Y Pty Ltd's share price fell. The taxpayer sold the share after 18 months from the date of acquisition to cut its losses and incurred a loss. The taxpayer did not acquire the shares as trading stock.

Reasons for decision

Summary

The losses incurred from the sale of shares are considered as capital loss under subsection 104-10(4) of the ITAA 1997. Therefore, the taxpayer is not eligible to claim deduction under section 8-1 of the ITAA 1997.

Detailed reasoning

The taxpayer supplied transport services to a remote site for Y Pty Ltd. Due to cash flow problem Y Pty Ltd owed money on unpaid invoices to the taxpayer for the services rendered.

Y Pty Ltd put a debt compromise (capital raising) to the taxpayer and the taxpayer was invited to subscribe in Y Pty Ltd's capital raising as a priority sub-underwriter, by way of an offset against amounts owing by Y Pty Ltd to the taxpayer.

The taxpayer earns income from the operation of the transport business. As per the accounting method the 'earnings' method is often referred to as the 'accruals' method or the 'cash and credit' method. Under the earnings method, income is derived when it is earned. The point of derivation occurs when a 'recoverable debt' is created.

The term 'recoverable debt' is used to describe the point of time at which a taxpayer is legally entitled to an ascertainable amount as the result of having performed an agreed task. A taxpayer may have a recoverable debt even though, at the time, they cannot legally enforce recovery of the debt.

In this case a recoverable debt is created and Y Pty Ltd offered shares to offset the debt. The taxpayer accepted the offer from Y Pty Ltd as a priority under-writer and acquired the shares at the market value for the amount of debt that was owed by Y Pty Ltd.

CGT Asset

The taxpayer acquired shares from Y Pty Ltd as a priority sub-underwriter in Y Pty Ltd's proposed equity capital raising in consideration for the trade debt owing by Y Pty Ltd for the supply of transport services.

Shares are considered as CGT asset under subsection 108-5(1) of the ITAA 1997. A CGT event A1 happened under subsection 104-10(1) of the ITAA 1997 when the taxpayer disposes the shares. If the capital proceeds from the disposal of the asset are less than the cost base of the asset the taxpayer will make a capital loss under subsection 104-10(4) of the ITAA 1997.

In this case the taxpayer was allotted shares for moneys owed being the market price for Y Pty Ltd shares on that date in consideration for offsetting Y Pty Ltd's trade debt. The taxpayer sold the shares after 18 months from the date of acquisition and made a capital loss under subsection 104-10(4) of the ITAA 1997.

Deduction

The applicant argued that the taxpayer acquired the shares from Y Pty Ltd in the course of carrying on a business and the shares were offered to the taxpayer as a priority sub-underwriter. Therefore, the losses incurred from the sale of Y Pty Ltd shares are allowable deduction under paragraph 8-1(1)(b) of the ITAA 1997.

Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing to the extent to that it is incurred in gaining or producing assessable income, or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, you cannot deduct a loss or outgoing to the extent that it is a loss or outgoing of a capital, private or domestic nature: subsection 8-1(2) of the ITAA 1997.

Expenses that are 'incidental and relevant' to the taxpayer's income earning activities are considered to be sufficiently connected with the derivation of assessable income and therefore will be an allowable deduction under section 8-1 of the ITAA 1997 (Ronpibon Tin NL & Tongkah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431).

However, it is important to consider why the expenditure was incurred. This is because expenditure tends to take on the quality of an outgoing of revenue or an outgoing of capital from the cause or purpose of the action against which they were taken (Hallstroms Pty Ltd v FC of T (1946) 72 CLR 634, 8 ATD 190). In other words, if the expenses were incurred in relation to action of a capital nature, then the expenses would also take on this character.

In Magna Alloys & Research Pty. Ltd. v. FC of T 80 ATC 4542 at 4548 it was stated:-

" . . . whether expenditure has the character of a capital or of a revenue payment ... the advantage for which the expenditure was incurred must be identified and the manner in which it is to be relied upon or enjoyed must be considered . . ."

The guidelines for distinguishing between capital and revenue outgoings were laid down in Sun Newspapers Ltd and Associated Newspapers Ltd v. FC of T (1938) 5 ATD 87; (1938) 61 CLR 337 (Sun Newspapers). It was pointed out that expenditure in establishing, replacing and enlarging the profit-yielding structure itself is capital and is to be contrasted with working or operating expenses. Where his Honour said:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

As regards the first two elements, the lasting or recurrent character of the advantage and the expenditure is important. Thus the courts have held, in the absence of special circumstances that 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 (British Insulated & Helsby Cables v. Atherton (1926) AC 205).

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.

In FCT v Klan (1985) 16 ATR 176; 85 ATC 4060 the taxpayer, a history teacher, resigned from his position in Australia and took up a post in the United Kingdom. He also undertook research in Germany for a thesis which would enable him to undertake post-graduate studies. The taxpayer was of the view that these activities would help his career when he returned to Australia. In due course he returned to Australia and took up a position as head of a History department at a higher salary than he had previously received. Because of the break in employment, Ormiston J held that although the expenditure may have been relevant, it was not incidental to the earning of income. In essence he found that the expenditure related to the obtaining of a new position. This does not satisfy the temporal connection requirement. Such a requirement is further evidenced in the High Court decision in  FCT v Maddalena (1971) 2 ATR 541; 71 ATC 4161.

In National Australia Bank v. Federal Commissioner of Taxation (1997) 80 FCR 352; 97 ATC 5153; (1997) 37 ATR 378 (National Australia Bank Case), the bank purchased from the Commonwealth government the exclusive right to provide Commonwealth subsidised loans to Australian Defence Force personnel for a period of 15 years. The payment to the Commonwealth was considered to be a marketing expense since it secured 'the practical certainty that most of those ADF personnel who qualified for a subsidy and wanted a home loan would become customers of the Bank'. By granting loans to the ADF personnel the bank also expected to gain revenue from other products provided to the home loan customers. The Full Federal Court found that the payment was made as part of a marketing strategy implemented in the course of conducting the bank's business of selling home loans and other products which generated its interest income.

In this case the facts indicate that the taxpayer acquired the shares with the intention and expectation of making a profit on their sale. The taxpayer did not receive any income from the shares during the period of ownership of the shares and sold the shares at a loss. Also, the facts state that the taxpayer is not a shares trader.

Further, as explained above the shares are CGT asset under section 108-5 of the ITAA 1997. The shares are allotted to the taxpayer by Y Pty Ltd to offset the trade debt that was owed to the taxpayer. As explained above the transaction is not considered as incidental and relevant to the taxpayer's business.

Isolated transaction

For a loss to be incurred in gaining or producing the assessable income 'it is both sufficient and necessary that the occasion of the loss ... be found in whatever is productive of the assessable income or, if none be produced, would be expected to produce assessable income.

Paragraphs 10 - 13 of Taxation Ruling TR 92/14 states that:

10. If an isolated transaction was expected to produce a profit which would be exempt income, a loss incurred in that transaction is not incurred in gaining or producing assessable income and is not deductible under subsection 51(1).

11. If an isolated transaction was expected to produce a capital profit, a loss incurred in that transaction is not deductible under subsection 51(1). Such a loss is expressly excluded from deduction as being a loss of capital or of a capital nature, regardless of whether the transaction also produced, or was expected to produce, income.

12. If an isolated transaction or operation which is essentially private or domestic in character produces a profit, that profit is not income. A loss on such a transaction is expressly excluded from deduction as being a loss of a private or domestic nature.

13. The above reasoning leads to the conclusion that a loss from an isolated transaction is generally deductible under subsection 51(1) if the taxpayer expected the transaction to produce a profit which would have been income assessable under subsection 25(1).

In FC of T v Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693, the taxpayer company made an interest bearing loan to a subsidiary. Three days later, as had always been intended, the taxpayer assigned the right to receive interest income from the loan in return for a lump sum. The Court relied on 2 strands of reasoning in holding that the amount received by the taxpayer was income:

· the amount in issue was a profit from a transaction which, although not within the ordinary course of the taxpayer's business, was entered into with the purpose of making a profit and in the course of the taxpayer's business.

· the taxpayer sold a mere right to interest for a lump sum, that lump sum being received in exchange for, and as the present value of, the future interest it would have received. The taxpayer simply converted future income into present income.

In this case the taxpayer acquired the shares to offset the recoverable debt and made a capital loss from the disposal of shares. Therefore, it is not considered as isolated transaction.

Further in the decision of Whitfords Beach Pty Ltd v. Commissioner of Taxation (1983) 14 ATR 247; 83 ATC 4277 the taxpayer's intension was to develop, subdivide and sell the land. Accordingly, the Full Federal Court concluded that the taxpayer's business of developing, subdividing and selling the land commenced as soon as the intention to take steps for that purpose in relation to the entire land was formed and activities directed to that end were commenced. And it was decided as income.

In this case the taxpayer is in the business of providing transport services and the purpose of the acquisition of shares is to offset the debt. Therefore, the transaction is not considered as an isolated transaction.

Therefore, in this case the Commissioner considers that a deduction is not allowable under section 8-1 of the ITAA 1997 as the shares were acquired by the taxpayer as a capital asset and held for an enduring benefit. As the loss made by the taxpayer is of capital in nature, a deduction is not available under section 8-1 by virtue of paragraph 8-1(2)(a) of the ITAA 1997.