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Ruling

Subject: Interest on loan and capital loss

Question 1

Are you entitled to a deduction for a capital loss from your investment?

Answer

Yes.

Question 2

Are you entitled to a deduction for interest incurred on the business related portion of your loan after the business has ceased?

Answer

Yes.

This ruling applies for the following periods

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ending 30 June 2012

Year ending 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

The scheme commenced on

1 July 2008

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.

You and your spouse are shareholders in a private company.

The company operated a business.

You and your spouse borrowed funds and on-lent a portion of the funds to the company. The loan was secured against your family home.

You borrowed additional funds over a number of years. Some funds were for personal use and others were on-lent to the company to be used to pay expenses.

You have only claimed the interest expense for the business related portion of the loan.

The company ceased trading. At that time there was an outstanding balance of the funds lent to the company.

After the company ceased trading you refinanced your loan.

You state that:

§ you do not have the capacity to repay the business portion of the loan in full or in part

§ you have not made any investments or personal superannuation contributions since the company ceased trading

§ you have not entered into any salary sacrifice agreements with any employer

§ your only liability is the current loan which includes your house mortgage and the loan to the business.

The company has been wound up.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 102-25

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Division 110

Income Tax Assessment Act 1997 Section 116-30

Reasons for decision

Question 1

Summary

The definition of a capital gains tax (CGT) asset includes a debt, or right to repayment. Section 102-20 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that you may make a capital loss if a CGT event happens to a CGT asset. In the present case, CGT event C2 is most appropriate to the circumstances.

Subsection 116-30(3A) of the ITAA 1997 provides a special rule relating to CGT event C2. The effect is that the difference between the capital proceeds - which is nil - and the cost base of the loan will give rise to a capital loss.

Detailed reasoning

Section 108-5 of the ITAA 1997 provides the definition of a CGT asset. It states in subsection 108-5(1) of the ITAA 1997 that a CGT asset is any kind of property or a legal or equitable right that is not property. One of the examples given in the notes to section 108-5 of the ITAA 1997 is 'debts owed to you.' Therefore, a debt, or right to repayment, is an asset for CGT purposes.

Section 102-20 of the ITAA 1997 provides that you make a capital gain or capital loss if and only if a CGT event happens. The gain or loss is made at the time of the CGT event. If more than one CGT event could apply to the situation in question subsection 102-25(1) of the ITAA 1997 states that the one which you use is the one that is the most appropriate.

In this case, if your right to receive the balance of the loan from the company is properly characterised as an asset, the disposal of the asset will constitute a CGT event. It then becomes necessary to determine which CGT event is most applicable.

CGT event C2 is entitled 'Cancellation, surrender and similar endings' and is fully described in section 104-25 of the ITAA 1997 as follows:

'(1) CGT Event C2 happens if your ownership of an intangible CGT asset ends by the asset:

(a) being redeemed or cancelled; or

(b) being released, discharged or satisfied; or

(c) expiring; or

(d) being abandoned, surrendered or forfeited …'

Subsection 104-25(2) of the ITAA 1997 states that the time of C2 event is when the contract ending the asset is entered into or, if none, when the asset ends.

Subsection 104-25(3) of the ITAA 1997 provides that when CGT event C2 happens, the capital gain is the capital proceeds from the disposal less the asset's cost base. The capital loss is the asset's reduced cost base less the capital proceeds.

Division 116 of the ITAA 1997 deals with modifications to the general rule. You received no capital proceeds (that is, no consideration was received for forgiveness of the debt). However, the market value substitution rule in subsection 116-30(1) of the ITAA 1997 provides that you are taken to have received the market value of the CGT asset that is the subject of the event if there were no capital proceeds from a CGT event.

However, there is a special rule relating to CGT event C2. Subsection 116-30(3A) of the ITAA 1997 provides that if you need to work out the market value of a CGT asset that is the subject of CGT event C2, it is worked out as if the event had not occurred and was never proposed to occur.

Tax Determination TD 2 looks at the CGT consequences for the lender when a debt is waived and elaborates as follows:

'The market value of the debt at the time of its disposal is worked out as though the debt was not waived and was never intended to be waived…'

In the present case, it is necessary to determine the market value of the asset at the time that the company was wound up. If the character of the loan is a contractual promise by the private company to pay the amount of the loan to you as creditor, can a market value exist for such a promise? Taxation Ruling TR 96/23 discusses this in a slightly different context, being the promise a creditor makes to a guarantor that it will advance funds to a principal debtor. However, the reasoning at paragraph 73 has application in the present case:

'We cannot envisage that a market value exists for such a promise, in the sense of a value determined by an open and unrestricted market of willing (but not anxious) informed, independent buyers and sellers. In O'Brien (Inspector of Taxes) v. Benson's Hosiery (Holdings) Ltd [1978] 3 All ER 1057 … the UK Court of Appeal determined that 'there can be no market for what is unsaleable.' As the creditor's promise to a guarantor to make a loan to a third party lacks the commercial character of transferability, although technically assignable … , we accept that the market value of the promise made to the guarantor is nil.'

Similarly in your case, although technically you could have assigned your right to receive income under the loan, realistically there would be no market for the sale of such a right. The loan was an arrangement between you and your private company. Any examination of the circumstances by an informed buyer would no doubt have indicated scant likelihood of repayment and therefore nil market value.

The other element necessary to determine the extent of any capital loss is the cost base. Broadly speaking, the cost base of an asset is the money paid to acquire it plus any incidental costs relating to its acquisition, including indexation where appropriate (subdivision 110-A of the ITAA 1997). Generally, the cost base of a debt to the lender is the amount of the loan with the reduced cost base appropriately adjusted.

Subdivision 110-B of the ITAA 1997 provides the rules about the reduced cost base of a CGT asset. Items of expenditure can only be included in your reduced cost base if they fit within the five elements described in the subdivision. The reduced cost base of a CGT asset is made up of:

1. money or property given for the asset

2. incidental costs of acquiring the CGT asset or that relate to the CGT event

3. any balancing adjustment amount that is assessable because of a balancing adjustment for the asset or that would be assessable if certain balancing adjustment relief were not available

4. capital costs to increase or preserve the value of your asset or to install or move it

5. capital costs of preserving or defending your title or rights to your asset.

These elements are the same as those included in the cost base in Subdivision
110-A of the ITAA 1997 with the exception of element three.

In this case, the reduced cost base of the loans includes the amount of the funds loaned less any principal repaid both prior to winding up and during the winding up process under element one of the reduced cost base. Any borrowing expenses incurred in setting up the loans can be included in your reduced cost base under element two. Any interest expenses incurred in relation to providing the loans are not a part of the reduced cost base as such costs are not part of any balancing adjustments for the asset.

From the information available to us, we consider that you have disposed of the debt in circumstances which fall within the description of a C2 event in section 104-25 of the ITAA 1997. The difference between the capital proceeds - nil in this case - and the cost base of the loan will give rise to a capital loss.

Question 2

Summary

You are entitled to a deduction for the interest expense on that portion of the loan which was on-lent to your company as the expense relates to your former income earning activities and you are unable to payout that loan.

Detailed reasoning

Section 8-1 of the 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, or relate to the earning of exempt income or a provision of the taxation legislation excludes it.

As a general rule, an outgoing will not be deductible unless it is incurred in gaining or producing the assessable income of the taxpayer who incurs it (FC of T v. Munro (1926) 38 CLR 153 (Munro)).

However, in FC of T v. Total Holdings (Aust) Pty Ltd 79 ATC 4279, (1979) 9 ATR 885 (Total Holdings), a parent company was allowed a deduction for interest paid on money it had borrowed and on-lent interest-free to a wholly owned subsidiary. The Full Federal Court allowed the deduction on the basis that the loan was intended to make dividends and interest from the subsidiary in future.

The Commissioner accepts that the principle in Total Holdings is correct in law and, that where the facts of a case are substantially similar to the facts in Total Holdings, a deduction for interest is allowable under section 8-1 of the ITAA 1997.

However, it has been suggested by the courts that the principle in Total Holdings is based on the second limb of section 8-1 of the ITAA 1997 (which only applies to taxpayers who are carrying on a business) and/or only applies where a parent company/subsidiary company relationship.

In Economedes v. FC of T [2004] AATA 1249, 2004 ATC 2353, (2004) 58 ATR 1046 (Economedes) a taxpayer and his wife borrowed money from the bank and on-lent it to the company controlled by him and his wife. There was no loan agreement between the company and the taxpayer and his wife. The company made loan payments directly to the bank. The company ceased trading and was wound up. The taxpayer and his wife were required to pay back the loan which they did over seven years. The taxpayer sought a deduction for interest incurred on the bank loan, however the Commissioner disagreed and subsequently disallowed the deduction.

The taxpayer objected and sought review of the Commissioner's decision at the Administrative Appeals Tribunal (AAT). The Commissioner's decision was set aside by the AAT as the taxpayer had an expectation, when on-lending the borrowings to the company, that the borrowing would result in interest and dividend income being received from the company at least equal to the interest expense incurred in repaying the loan. It was common commercial practice for small business clients to borrow funds from a bank and on-lend them to a family company to enable the company to operate a business. It was common commercial practice for such loans to be undocumented. There was a sufficient nexus between the on-lending and the expectation of profit.

As per the Total Holdings case on which the taxpayer relied, it was not relevant whether the income was actually derived from the business but whether there was a reasonable expectation that income would be derived in the future. Moreover it was clear from the nature of the relationship between the taxpayer and the company that the purpose of the on-lending was to manage an income-producing enterprise. The judgement in Munro, on which the Commissioner relied, centred not on the fact that the loan was inherently capable of being categorised as having been made for the purpose of gaining or producing assessable income of the taxpayer, but rather that nine-tenths of the money was applied directly or indirectly for the benefit of third parties.

In your case, you and your spouse loaned funds to your private company over its trading life to assist with its operations. When loaning the funds you had a reasonable expectation that income would be derived from the company in the future.

Your situation is similar to that in Economedes. Thus, the interest expense associated with the funds on-lent to your company is a deductible expense.

Taxation Ruling TR 2004/4 provides the Commissioner's view on the deductibility of interest where the income-producing asset has been disposed of and the taxpayer is still liable on the balance of the loan.

In general, the interest expense will continue to be deductible where:

§ the taxpayer borrowed money to acquire an income producing asset

§ the income producing asset has been disposed of

§ the proceeds from the disposal have been applied against the loan and not used for personal or non-income producing purposes

§ the taxpayer does not have the legal power to repay the loan or does not have the financial resources to repay the loan fully, and

§ is unable to avoid incurring ongoing interest liabilities.

In this situation, a nexus will continue to exist between the interest outgoings and the relevant income earning activities at least until the end of the period during which the interest cannot be avoided.

However, where it can be inferred that a taxpayer has:

§ kept the loan on foot for reasons unassociated with the former income earning activities, or

§ made 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 and the relevant income-earning activities will be broken.

In your situation, you and your spouse have borrowed funds and on-lent them to your company to be used in its business activities. Thus, the funds borrowed were effectively used to earn the assessable income of the company.

However, the arrangement is similar to that in Economedes in that you have borrowed funds and on-lent them to a family company controlled by yourself and your spouse. As such, it is considered that the borrowings relate to the earning of your assessable income, being the interest expense and dividends you would have expected to have received from the company.

We have determined that you are entitled to claim deductions for the interest expenses for that portion of your loan which relates to the amount on-lent to your company.

The obligation to pay the interest expense arose from the loan to your company. The connection with the income earning activities has not been broken because the business has ceased or the earlier loan was refinanced.

You have not kept the loan on foot for reasons unassociated with your former income earning activities. Nor have you made a conscious decision to extend your loan to gain an ongoing commercial advantage. You have not had the financial means to pay out the loan.

However, consideration must also be given to any reductions of principal made to this portion of the loan, or indeed the whole loan. It is not generally possible to apply a repayment solely to a particular purpose within a mixed purpose loan, rather such a repayment is applied proportionately to each purpose: Taxation ruling TR 2000/2.

Simply put, where say 10% of a loan was drawn for business purposes and the other 90% for private purposes, any repayments made to that loan are applied to each purpose in the same ratio.

To conclude, it is accepted that you are entitled to claim a deduction for the interest expense on that portion of the borrowed funds which relates to the amount on-lent to your company, with its principal being reduced by any periodical repayments made to the loan.