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Ruling

Subject: Deductibility of expenses associated with a guarantee

Question

Are you entitled to a deduction for repayments of principal made to meet your obligations under a guarantee to repay the overdraft of a private company that has ceased operating?

Answer

No.

Question

Are you entitled to a deduction for repayments of interest associated with a guarantee to repay the overdraft of a private company that has ceased operating?

Answer

No.

Question

Are you entitled to a deduction for legal expenses associated with a guarantee to repay the overdraft of a private company that has ceased operating?

Answer

No.

This ruling applies for the following period

Year ending 30 June 2011

The scheme commenced on

1 July 2010

Relevant facts

You are a former director and employee of a private company ('the company').

Together with two other former directors, in 20XX you provided personal guarantees to a bank ('the bank') to secure an overdraft to provide working capital for the company.

You state that the guarantees were provided by the guarantors with the 'expectation of harvesting assessable income in the form of sizeable capital gains'. Other funds committed included 'sweat equity' and substantial amounts of cash in the form of loans and investments in shares.

You state that the interest charged by the bank is a direct consequence of the guarantors having provided a guarantee, the purpose of which was 'generation of taxable income'.

At the time of your application, the company was no longer operational and its tangible assets had been sold. The company still owns intellectual property, but would require new capital to become operational.

When you ceased employment with the company early in the 2009-10 financial year you and the other guarantors informed the company and the bank that you wished to sever your liability as guarantors. The company then threatened litigation.

In late 20XX, after pressure from the bank, the company asked creditors to grant a moratorium on all debts. The bank declined.

In early 20XX the bank threatened to force the sale of guarantor assets to pay down the overdraft. A series of payments were then made to the bank to prevent the bank proceeding.

The bank applied these payments to the company's account, which now stands at nil balance.

Interest charges that were accrued by the company subsequently came to be paid for by the guarantors.

You also incurred legal costs for legal advice. The bank has also charged legal costs as part of the settlement.

The company now owes the guarantors the amount paid by them to the bank.

You are not carrying on a business of providing guarantees in return for a fee.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Reasons for Decision

Payments of principal and interest expenses

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

To be deductible, there must be a sufficient connection between the outgoing and the activities which produce or are expected to produce assessable income (Ronpibon Tin N.L. and Tongkah Compound N.L. v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431).

The Commissioner's view about the implications of a shareholder's guarantee to pay a company's debt is found in Taxation Ruling TR 96/23. The ruling states that liabilities arising under contracts of guarantee will not be deductible if the provision of guarantees is not a regular and normal incident of your income earning activities, that is, where you are not in the business of providing guarantees.

Only if a taxpayer acts as guarantor to such a degree as to amount to his or her usual practice, say, as a solicitor, in the ordinary course of business will the payments be deductible as a revenue outgoing and not of a capital nature: Jennings (Inspector of Taxes) v. Barfield & Barfield [1962] 2 All ER 957; 40 TC 365 (Jennings' case).

TR 96/23 also refers to a line of decisions of the Administrative Appeals Tribunal and the former Boards of Review which accept that payments made under guarantees by shareholders or directors are not deductible. It also states:

135. The principle in Total Holdings might be considered to apply to a shareholder who guarantees the debts of the company in which he/she holds shares. This principle would then be sufficient to allow one of the two positive limbs of subsection 51(1) to be satisfied. However, a deduction may be denied because the expenditure is found to be on capital account. As the majority in Hooker Rex determined, a guarantee is akin to loan capital….

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

In Case L3 (1979) 79 ATC 14, a case which is similar to yours, the taxpayer who was a director, shareholder and employee of two companies, gave a number of personal guarantees in respect of each of the company's bank overdrafts. The taxpayer and some of the directors of the companies also guaranteed the performance by each company of its obligations under a number of equipment leasing contracts which the companies had entered into. The companies later went into liquidation and the bank collected judgement from the taxpayer, as one of the guarantors, for the amount owing to the bank. The taxpayer paid $7,500 under the guarantee to the bank and claimed a deduction. The Board of Review held that the payment pursuant to the guarantee was not incurred in gaining or producing assessable income under either the first or second limbs of subsection 51(1) of the Income Tax Assessment Act 1936 (ITAA 1936) (equivalent to section 8-1 of the ITAA 1997) and even if it did, it was an outgoing of capital or of a capital nature.

To summarise, the majority of the cases in which deductions have been disallowed because the outgoing was on capital account can be seen to have exhibited one or both of the following characteristics:

1 In several cases the guarantees have been given with respect to loans to companies connected with the guarantor, and the guarantee payments have been treated as being on capital account due to their close analogy to loan capital.

2 In other cases guarantees have been given in relation to the establishment or protection of a capital asset, and consequently payments made have attracted a capital character.

In your case, you provided a guarantee on behalf of a company to secure an overdraft to provide working capital for the company's business and you were subsequently called upon by the bank to fulfil your obligation under this guarantee. The provision of guarantees was not a regular and normal incident of your income earning activities. Rather, in your capacity of director, you provided personal guarantees as security for the company to obtain the overdraft.

You had a legal obligation to honour the guarantee given and the payments were made to discharge the debts of the company. You did not pay the money with the purpose that it would lead to gaining or producing any income or in connection with income earning activities.

The present case is distinguishable from Willersdorf-Greene v. Federal Commissioner of Taxation [2009] AATA 649; 2009 ATC 10-102; (2009) 76 ATR 688 in that the guarantees related directly to the income earning activities of the company and only related indirectly, if at all, to the income earning activities of the guarantors.

There is no connection between the guarantee payments and the earning of your assessable income. At the time that the guarantee was called in and you incurred the expense, the company had asked creditors to grant a moratorium on all debts to enable the company to continue to trade, but the bank declined.

Legal expenses

In determining whether a deduction for legal expenses is allowed under section 8-1, the nature of the expenditure must be considered: (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is capital in nature, then the expenses incurred in gaining the advantage will also be capital in nature. It is irrelevant whether the legal action is successful or not. It is the nature and character of the expense and the advantage to be gained by incurring it that is important.

Legal expenses are generally deductible if they arise out of the day to day activities of the taxpayer's business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to the taxpayer's income producing activities (Magna Alloys and Research Pty Ltd v. Federal Commissioner of Taxation 80 ATC 4542; (1980) 11 ATR 276).

Legal expenses of companies in resisting winding-up petitions are not deductible as the expenses are directed at forestalling the extinction of the company as a profit-yielding subject and are therefore capital in nature ((1957) 7 TBRD Case G87; (1957) 8 TBRD Case H60; (1964) 14 TBRD Case P55)).

In the present case, you incurred legal expenses for legal advice in relation to the guarantee that was called in when the company could not meet its debts and the bank also charged legal costs as part of the settlement in relation to the guarantee. These legal expenses are similarly capital in nature and not an allowable deduction under section 8-1 of the ITAA 1997.

To conclude, the repayments and associated legal expenses were incurred by you personally to fulfil your obligations as guarantor for an overdraft of a private company when the company could not meet its payment obligations. The repayments and legal expenses had no nexus to your personal earning of assessable income, from wages or expected dividends.

Therefore, you are not entitled to a deduction under section 8-1 of the ITAA 1997 for the guarantor payments and legal expenses as they are not considered to be incurred in gaining your assessable income. Taxation Ruling TR 96/23 holds that the expenses of a guarantor are capital in nature.