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Authorisation Number: 1012385619025

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Ruling

Subject: CGT - debit/equity interest

Question and Answer

Does the money you lent to the company pass the equity test under section 974-75 of the Income Tax Assessment Act 1997?

No.

Are you I entitled to claim a capital loss on monies lent to a company on the date the borrowing company became deregistered?

Yes.

This ruling applies for the following period

1 June 2010 to 30 June 2012

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 set up a company and bought a shop.

After a number of months of trading, the business failed due to lack of experience and bad luck.

You contributed around an amount of money to the company.

You and one other person were shareholders of the Company.

The other shareholder left the company.

You received from the company a list, showing most of the contributions made by each shareholder which was signed by both shareholders.

You did not receive any financial consideration (other than shares) from the company for your contribution.

You and your partner had agreed to receive interest on your contributions, calculated from the date the contributions were made, payable when the company became profitable. The contributions could be redeemed for shares in the company upon the contributor's request. You did not put this agreement in writing and you did not discuss what interest rate would apply or redemption rate.

The company made a payment, of a small sum, to you as a part repayment of contributions you had made.

The shop ceased trading.

The company did not trade after the shop ceased.

The company was deregistered.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 26BB

Income Tax Assessment Act 1936 subsection 26BB(1)

Income Tax Assessment Act 1936 Section 70B

Income Tax Assessment Act 1936 subsection 70B(2)

Income Tax Assessment Act 1936 subsection 159GP(1)

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 974-10

Reasons for decision

Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) outlines the tests for debt and equity interests for schemes such as loans made to connected entities.

For Capital Gains Tax (CGT) purposes, whilst the loan amount owed to you by the company is considered a debt, it is not considered a debt as a result of the debt/equity interest tests referred to in Division 974 of the ITAA 1997. Section 974-10 of the ITAA 1997 outlines the specific areas the tests are applicable for, including:

a) identifying distributions that may be frankable and which may be subject to dividend withholding tax; and

b) identifying returns that may be deductible to the company making the return;

c) resolving uncertainty as to the proper tax treatment for debt/equity hybrid interests (interests that have some debt qualities and some equity qualities); and

d) identifying debt capital for the purposes of Division 820 (thin capitalisation rules).

Areas of application do not include CGT. Therefore, Division 974 is not relevant for CGT purposes.

Before considering the application of the CGT legislation we need to consider whether any other provisions of the taxation acts apply.

Section 70B of the Income Tax Assessment Act 1936 (ITAA 1936) provides that certain losses incurred on the disposal or redemption of traditional securities are allowable deductions and this section may be appropriate in your case.

Subsection 159GP(1) of the ITAA 1936 contains a comprehensive definition of security which includes among other things, a secured or unsecured loan. In broad terms, traditional securities are debentures, bonds, secured or unsecured loans and similar investments acquired after 10 May 1989 that does not have a deferred income element (section 26BB of the ITAA 1936). 

It is considered that your loan is a traditional security for the following reasons:

· it was acquired after 10 May 1989,

· it does not have a deferred income element, and

· it does not fall under any other of the exclusions contained in the definition.

The word dispose, in relation to a security, is defined in subsection 26BB(1) of the ITAA 1936 to mean sell, transfer, assign or dispose of in any way.

Taxation Ruling TR 96/14 provides that in considering whether a security has been disposed of, the terms of subsection 70B(2) of the ITAA 1936 require any act of disposal to be an act of the taxpayer who held the security. While a particular security might ultimately cease to exist or become worthless, neither of those consequences means that there has been any act of disposal which has been taken by the taxpayer.

When a traditional security matures and the issuer honours the obligation to pay the promised amount, the security may be said to have been redeemed by the issuer. In some cases the issuer may not be able to redeem a security at the time it matures. This may occur where, for example, the issuer is a company and is insolvent at the time the security matures. In such circumstances the holder has not disposed of the security, in the sense required by subsection 70B(2) of the ITAA 1936.

In your case, the security that you held was not disposed of or redeemed. Therefore, you are not entitled to a deduction under subsection 70B of the ITAA 1936.

Where a loss on the disposal of a traditional security does not qualify for deduction under section 70B of the ITAA 1936, a capital loss may be incurred under the capital gains provisions. The failure to satisfy the strict test of disposal in the traditional security provisions will not prohibit a loss under the capital gains provisions where the definition of disposal is broader.

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens if ownership of an intangible CGT asset ends by the asset expiring or by it being redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited. The time of the event is when the contract is entered into that results in the asset ending, or if there is no contract, when the asset ends.

Taxation Determination TD 2000/7 provides that when a company is deregistered CGT event C2 happens in respect of its shares. When a company is deregistered it ceases to exist. In that case the company's debts, if any, will be abandoned, surrendered or forfeited for the purposes of section 104-25 of the ITAA 1997.

Therefore, as the company has been deregistered your ownership of the debt has ended and CGT event C2 has happened. As such, you are entitled to claim a capital loss under section 104-25 of the ITAA 1997. The time of the CGT event was when the company was deregistered.