Edited version of your private ruling

Authorisation Number: 1012404124563

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Ruling

Subject: Investment in a Managed Investment Scheme

Question 1

Are the interest expenses incurred by you on the payment of the settled amount deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Does a capital loss arise under section 102-10 of the ITAA 1997 on the disposal of your rights in respect of the scheme?

Answer

Yes.

This ruling applies for the following period:

Financial year ended 30 June 2009

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 purchased a number of farms (Allotments) in the scheme.

You entered into a licence and management agreement in 1999 income year with the manager and the trustee. The agreement allows by way of a licence the use of Allotments for the purpose of carrying on your business of primary production including the cultivation and harvesting of trees. The agreement appointed the manager to provide services in relation to your allotments.

You borrowed money from the lender to help fund your purchase of the allotments. A loan agreement was entered into in the 1999 income year. In the 2000 income year you made repayments on the loan.

You entered into an indemnity agreement with the indemnifier and the lender in the 1999 income year. You paid an indemnity fee per allotment in respect of the loan provided to you the borrower. Under the agreement the indemnifier wishes to indemnify the borrower for any amount owing and payable to the lender subject to certain conditions and upon the occurrence of certain events set forth in the indemnity agreement.

You claimed deductions relating to your interests in the project in your income tax returns for the financial year ended 30 June 1999 and the financial year ended 30 June 2000.

The statement from the lender to you shows an outstanding loan balance.

The plantation stopped being worked in 2003. Information contained in a New South Wales Supreme Court case in relation to this project states that the schemes were terminated at this time.

You were a party to a court case brought by the lender (plaintiff) in which they sued to recover the balance of principal and interest advanced to each of the investors (defendants) under the loan agreements. The court found in the plaintiff's favour.

You entered into a deed of settlement and release with the lender. You agreed to pay a sum to the lender in respect of the lender's claim. The settlement sum consists of the following:

principal outstanding on the loan; and

the interest on the loan

The parties to the deed acknowledged and agreed to the settlement in the terms of the deed and the payment of the settlement sum as provided in the deed as full and final settlement between the lender and the borrower.

In 2009 you paid the settlement sum.

You incurred legal fees to settle the case.

You entered into an agreement with an action group to represent your interests in the project in their discussions with parties associated with this project.

You paid the action group to fund legal costs incurred in relation to your investment in the project.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 102-10

Income Tax Assessment Act 1997 Subsection 104-25(2)

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Subsection 110-25(2)

Income Tax Assessment Act 1997 Subsection 110-25(5)

Reasons for decision

These reasons for decision accompany the Notice of private ruling

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Question 1

Summary

Are the interest expenses incurred by you on the payment of the settled amount deductible under section 8-1 of the ITAA 1997?

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent that they are incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature.

The deductibility of an outgoing is determined by its essential character (Lunney & Haley v. Federal Commissioner of Taxation (1958) 100 CLR 478; (1958) 11 ATD 404; (1958) 7 AITR. The character of interest is determined by the reason it arises, which is usually determined by the purpose to which the borrowing is being applied when the interest arises. Generally, the purpose of a borrowing can be determined from the use of borrowed funds and outgoings of interest ordinarily draw their character from that use (Fletcher v. Federal Commissioner of Taxation (1991) 173 CLR 1; 91 ATC 4950; (1991) 22ATR 613; Kidston Goldmines Ltd v. Federal Commissioner of Taxation (1991) 30 FCR 77; 91 ATC 4538; (1991) 22 ATR 168).

Interest on funds used to purchase a business remains deductible if the occasion of the outgoing is found in the taxpayer's income producing business operations, even if the interest is incurred in a year later than the year in which the income was derived, or the business has ceased to exist, or the assets representing those funds have been lost to the taxpayer. As was stated by the full Federal Court in Placer Pacific Management Pty Ltd v. FC of T 95 ATC 4459 at page 4464:

... provided the occasion of a business outgoing is to be found in the business operations directed towards the gaining or production of assessable income generally, the fact that that outgoing was incurred in a year later than the year in which the income was incurred and the fact that in the meantime business in the ordinary sense may have ceased will not determine the issue of deductibility

In FC of T v. Brown (Brown) 99 ATC 4600, (1999) 43 ATR 1 a deduction was allowed for interest on a loan used to purchase a business. The taxpayer partners borrowed to acquire a delicatessen. After a number of years of trading the business was sold at a loss. The proceeds of the disposal were made over to the bank but were insufficient to satisfy the liability fully. The interest was incurred during a period after the business had been sold. The Federal court considered at page 4606 that it was:

...appropriate to approach the issue of the 'occasion' of the loss or outgoing, being interest paid, by reference to the purpose of the taxpayer and his wife in borrowing the money and the use to which those borrowed funds were put.

An interest expense may cease to be deductible if the period of time since the cessation of business is so long that it indicates that the payment of interest is no longer sufficiently connected to the activities of the business. As was recognised by the Court in Brown:

... there may come a period of time between cessation of business and the payment of interest which is such that, in all the circumstances of the case, the payment is no longer sufficiently proximate to the activities of the business to be deductible under s 51910 with the consequence that those activities no longer provide the occasion for the outgoing.... Answers to such questions depend upon a 'commonsense' or 'practical' weighing of all the factors...

In Guest v. FC of T [2007] FCA 193, 2007 ATC 4265, 65 ATR 815 a seven year period the between the cessation of the business and the payment of the interest was not sufficient to deny an interest deduction. In June 1998 the taxpayer together with 3 other individuals invested in a project to grow blueberries and borrowed $55,000 to fund their investment from a finance company associated with the project which required two payments to be made by a specified date with the expectation of the balance being repaid out of the proceeds of the sale of fruit, without recourse to the borrowers. The project was not successful and Receivers were appointed to the companies involved in 1991. In 1997 the loan was assigned by the finance company to Equuscorp Pty Ltd (Equus). Equus commenced proceedings against the taxpayer in 2002 seeking principal and interest due pursuant to the original loan agreement. The taxpayer admitted liability for the amount owing and agreed to pay $59,000 over six income years. Taxpayer claimed deductions for his one sixth share of the interest accrued on the loan for the 1998 to 2001 income years.

The Federal Court held that, by reason of the failure to pay the two instalments on time, the taxpayer became legally liable for repayment of the full amount of the loan and interest. The interest which accrued under the loan agreement during the relevant years was therefore incurred by him. There was sufficient nexus between the incurring of the interest liabilities in the relevant income years and the blueberry growing business. The nexus was not broken by the failure to repay the loan on the due date or by the taxpayer's failure to accept the receiver's offer in 1996. The court stated that a business related loan did not cease to have that character once an opportunity to repay the loan is not taken, the only exception being where the failure to repay is due to the taxpayer's impecuniosity.

The Court held that the occasion of the borrowing from the finance company and the consequent interest liability was undoubtedly to be found in business operations directed towards the gaining or producing of assessable income. The cessation of the taxpayer's involvement in the business did not in itself retrospectively alter the occasion of the borrowing. In 1987 the taxpayer became obliged to pay interest on a business related borrowing. The obligation arose from his entering into the loan agreement and failing to make the two $5000 repayments on time. In the tax years in question his liability for interest arose under the same obligation. He owed the interest in his capacity as borrower of the same loan to a successor in title of the original lender. The interest liabilities had a real connection with the taxpayers blue berry growing business.

Taxation Ruling TR 2004/4 provides the Commissioner's view on deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities. Paragraph 10 of this ruling state:

Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and relevant income-earning activities have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing 'the assessable income' if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

You entered into loan agreements to fund allotments in the project with the view of gaining or producing an assessable income through the planting and harvesting of trees for the manufacture of the product.

After the collapse of the project you ceased repayments of the loan believing you were indemnified from repayment. A dispute arose and the lender took action against you and other farmers in the project who borrowed funds to invest in the project to recover the rest of the initial loan. After the court made their decision, you entered into a deed of settlement and release with the lender and paid a settlement sum to settle the matter. The settlement sum consisted of repayment of principal and interest incurred on the loan.

The Commissioner accepts that the interest you paid as part of the settlement was a liability incurred as a result of borrowing funds which were used to purchase your former business. The interest you paid as part of the settlement is deductible under section 8-1 of the ITAA 1997.

Under the loan agreement you incurred interest on the loan which would be paid from the income of your business. Any interest which is not paid by 30 June of any year from the borrower's business will be capitalised and form part of the principal sum outstanding.

A loss or outgoing may be incurred for the purposes of section 8-1 even though no money has actually been paid out. In W Nevill & Company Ltd v. FC of T (1937) 56 CLR 290 at 302 it was said:

the word used is 'incurred' and not 'made' or 'paid'. The language lends colour to the suggestion that, if a liability to pay money as an outgoing comes into existence [the section is satisfied] even through the liability has not been actually discharged at the relevant time... it is only the incurring of the outgoing that must be actual; the section does not say in terms that there must be actual outgoing -a payment out.

This proposition was confirmed by the High Court in FC of T v. Energy Resources of Australia Limited 96 ATC 4536; (1996) 33 ATR 52 (Energy Resources) when, quoting from FC of T. James Flood Pty Ltd (1953) 88 CLR 492 , it said (ATC at 4539; ATR at 56):

Section 51(1) "has been interpreted to cover outgoings to which the taxpayer is definitively committed in the year of income although there has been no actual disbursement".

Whether there is a presently existing pecuniary liability is a question which must be determined in light of the particular facts of each case, and especially by reference to the terms of the contract or arrangement under which the liability is said to arise (Nilsen Development Laboratories Pty Ltd & Ors v. FC of T 81 ATC 4031; 11 ATR 505; FC of T v James Flood Pty Ltd (1953) 88 CLR 492; Ogilvy and Mather Pty Ltd v. FC of T 90 ATC 4836; 21 ATR 841; and FC of T v.Woolcombers (WA) 93 ATC 5170)

The loan agreement you entered into required you to pay interest on the loan. The liability to pay the interest was incurred on an annual basis. The agreement allowed you to offset the interest you incurred against the income of your business. The interest you paid as part of the settlement was interest which had been incurred on an annual basis, which under the loan agreement was calculated monthly in advance on the principal sum then outstanding and became due and payable by 30 June of each year. The interest you paid as part of the settlement is attributable to each income year from the third year you entered the loan agreement until the loan agreement was terminated when you entered into the deed of settlement and release. The interest incurred will need to be apportioned over those income years.

Question 2

Summary

Does a capital loss arise under section 102-10 of the ITAA 1997 on the disposal of your rights in respect of the scheme?

Detailed reasoning

Legal expenses

In accordance with general principles, legal expenses are deductible under

section 8-1 of the ITAA 1997 if incurred in gaining or producing assessable income, or if necessarily incurred in carrying on a business for the purposes of 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. In general, the cases establish that if the advantage that is sought to be gained by incurring the legal expenses is of a revenue nature, the expenses will also be of a revenue nature and if the advantage that is sought to be gained is of a capital nature, the expenses will also be of a capital nature.

In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, 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 of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Also for legal expenses to constitute an allowable deduction, it must be shown that they were incidental or relevant to the production of the taxpayer's assessable income, (Ronpibon Tin NL & Tong Kah Compound NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 4 AITR 236; (1949) 8 ATD 431). 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) 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. FC of T (1980) 11 ATR 276; 80 ATC 4542). However, where the expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 87; (1938); 1 AITR 403).

Legal expenses incurred in fending off the threatened extinction of the profit-yielding subject or business is not deductible under section 8-1 of the ITAA 1997. The agreement you entered into with the action group was to protect your investment in the project by authorising them to negotiate on your behalf to prevent the termination of the project and to ensure that no event the action group were incurred in protecting the underlying profit yielding structure or assets of the business and rights associated with the indemnity agreement and are considered to be capital in nature and not deductible under section 8-1 of the ITAA 1997. The payments to the law firm to represent you in court proceedings is capital as the advantage sought relates to an enduring advantage which was to have your liability to repay the loan extinguished. The payment of legal costs incurred in arranging a deed of settlement is capital. By entering into the deed of settlement the advantage sought was to obtain the freedom from further legal action, which constitutes an enduring benefit that attaches to the release.

Capital Gains Tax

When you entered the scheme upon the payment of the application fee you entered into a licence and management agreement which granted you a right to use the allotment to carry on your business and appoint the manager to provide services in relation to your business. You also on the payment of a fee entered into an indemnity agreement to indemnify you against the requirement to repay the loan you used to enter into the project. The interest you purchased in the managed investment scheme and the indemnity agreement are CGT assets under section 108-5 of the ITAA 1997.

You entered into the licence and management agreement and indemnity agreement in the 1999 year of income. Based on the deed of settlement and release and evidence referred to in the court case you ceased to carry on business as a result of a force majeure event under the licence and management agreement. The project was terminated by operation of the project's trust deed in 2003. We consider that a C2 CGT event occurred at this time when your interest in the project came to an end (subsection 104-25(2) of the ITAA 1997).

To calculate whether you have made a loss from the ending of your interest in the managed investment scheme in the 2003 financial year you will need to identify the cost base. Expenditure you have incurred does not form part of the cost base of an asset to the extent that you have deducted or can deduct it. The acquisition cost of your interest in the project does not include the amounts you paid for the licence fee and management fees.

Contributions you made to the action group which was expended on negotiations with stakeholders to prevent the termination of the project will form part of the cost base for CGT purposes. Expenditure incurred in attempting to preserve or defend your title to the asset or a right over the asset forms part of the cost base under subsection 110-25(5) of the ITAA 1997.

Legal costs incurred by you in funding litigation to attempt to have the indemnity agreement applied which if successful would have excused you from repaying the amounts owing to the lender and the legal costs incurred in reaching settlement with the lender will form part of the indemnity agreement cost base for CGT purposes. Expenditure incurred in attempting to preserve or defend your title to the asset or a right over the asset forms part of the cost base under subsection 110-25(5) of the ITAA 1997. We consider that a C2 event occurred in 2009 when you entered into the deed of settlement and release with the lender.

To calculate whether you have made a loss from the ending of your interest in the indemnity agreement in the 2009 financial year you will need to identify the cost base. Expenditure you have incurred does not form part of the cost base of an asset to the extent that you have deducted or can deduct it.