Edited version of your private ruling

Authorisation Number: 1012429278668

Ruling

Subject: Bad debts

Question and Answer:

For the year ending 30 June 20XX (but not in former financial years), can you claim a deduction for losses made on second mortgage debt lending in relation to your bankrupted borrowers and their related entities?

Answer:

Yes

This ruling applies for the following periods:

Year ending 30 June 2007

Year ending 30 June 2008

Year ending 30 June 2009

Year ending 30 June 2010

Year ending 30 June 2011

Year ending 30 June 2012

Year ending 30 June 2013

The scheme commences on:

1 July 2006

Relevant facts and circumstances

You were registered as a company and commencing business by engaging in three types of financing, namely: (i) 'mortgage brokering', where you found the best deals for clients from traditional lenders, such the major banks; (ii) 'mortgage management', where you had access to 'warehouse' funds from more expensive finance companies, which you lent as brokers; and (iii) 'mezzanine financing'. At the time, your 'mezzanine financing' did not require any licensing.

The funds for your initial 'mezzanine financing' loans were borrowings from your directors, director's parents and third parties, who were investors. The majority of these investor funds were lent to one borrower and their associated entities, who were engaged in property developments.

Your loan contracts had "higher interest rates" of X% per month, which resulted in earnings margins (differentials) of around X% per annum between the return you paid investors and the return the borrower paid you.

The repayment conditions of the loans included:

Interest shall be payable at the "higher interest rate" per calendar month calculated and capitalised monthly from the date of the advance to the date of payment.

Notwithstanding the above, if the borrower repays the advance and other monies due on or before the due date and the borrower is not otherwise default then the lender shall accept interest payable at the "lower interest rate".

Your client borrowers defaulted on the entire mortgage payments. As a result, you did not get any capital or interest payments back and incurred substantial legal fees.

During the year ended 30 June 200X, your client borrowers were placed into bankruptcy and during the year ended 30 June 20XX, the administration of their bankruptcy was completed, where it was confirmed no dividend would be paid to any creditors.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 25-35

Reasons for decision

Summary

Section 25-35 of the Income Tax Assessment Act 1997 (ITAA 1997) provides you can deduct a debt (or part of a debt) that you write off as bad in the income year if it is in respect of money that you lent in the ordinary course of your business of lending money.

Taxation Ruling TR 92/18, which is about bad debts, provides the question of whether a debt is bad is a matter of judgment having regard to all the relevant facts.

Taxation Ruling TR 98/1, which is about the determination of income using a receipts or an earnings basis, provides interest from a business of money lending is derived on an earnings (accruals) basis rather than on a receipts (cash) basis.

Many court cases have established the circumstances where a taxpayer is or is not carrying on a business of money lending for tax purposes.

In your case, we consider you were carrying on a business of money lending in respect to your mezzanine financing operations. Therefore, you are able to claim a deduction under section 25-35 of the ITAA 1997 in the financial year where you wrote off the relevant debts as bad.

Detailed reasoning

Deduction for bad debts

Section 25-35 of the ITAA 1997 provides you can deduct a debt (or part of a debt) that you write off as bad in the income year if:

(a) it was included in your assessable income for the income year or for an earlier income year; or

(b) it is in respect of money that you lent in the ordinary course of your business of lending money.

Taxation Ruling TR 92/18 is about bad debts. Paragraph 3 of the ruling provides the question of whether a debt is bad is a matter of judgment having regard to all the relevant facts. Generally, provided a bona fide commercial decision is taken by a taxpayer as to the likelihood of non-recovery of a debt, it will be accepted that the debt is bad. The debt, however, must not be merely doubtful.

Guidelines for deciding when a debt is bad are at paragraphs 31-33 of the ruling, which include a debt may be considered to have become bad where the debt has become statute barred; where the debtor has become bankrupt or has executed a deed of assignment or scheme of arrangement; where, if the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the debt; and where a taxpayer has taken the appropriate steps in an attempt to recover the debt.

Carrying on a business

Taxation Ruling TR 97/11 discusses the relevant indicators to consider in determining whether a taxpayer's activities amount to the carrying on of a business. The relevant indicators, which emerge from the case law in this area, to consider are:

· whether the activity has a significant commercial purpose or character;

· whether the taxpayer has more than just an intention to engage in business;

· whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity;

· whether there is repetition and regularity of the activity;

· whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business;

· whether the activity is planned, organised and carried on in a businesslike manner, such that it is directed at making a profit;

· the size, scale and permanency of the activity;

· whether the activity is better described as a hobby, a form of recreation or a sporting activity.

In the ruling, it is accepted that activities conducted on a small scale and for a short time may nevertheless involve the carrying on of a business.

Carrying on a business as a moneylender

The Federal Court of Australia case of Federal Commissioner of Taxation v. Marshall and Brougham Pty Ltd 17 FCR 541, 87 ATC 4522, 18 ATR 859 at ATC p. 4528, ATR p. 866 provided some general guidelines on determining whether a taxpayer is a money-lender, as follows:

It is generally accepted that in order to be regarded as carrying on a business one must demonstrate continuity and system in one's dealings. In the case of money lending it has been said that a person must hold himself out as willing to lend money generally to all and sundry (subject to credit-worthiness): see Litchfield v. Dreyfus [1906] 1 KB 584. It is not decisive whether the lender is a registered money-lender or not, although this will be a factor to take into account. It should be mentioned that it need not be the only business or the principal business of the taxpayer. It will be insufficient, however, if it is merely ancillary or incidental to the primary business. In the end, it will be a question of fact for the court to decide by looking at all the circumstances involved: see Newton v. Pyke (1908) 25 TLR 127.

The Commissioner's view, expressed in paragraph 46 of TR 92/18, is a money lender need not necessarily be ready and willing to lend moneys to the public at large or to a wide class of borrowers. It is be sufficient if the taxpayer lends moneys to certain classes of borrowers provided the taxpayer does so in a businesslike manner with a view to yielding a profit from it.

Court cases about money lending

In the High Court of Australia case of Fairway Estates Pty. Ltd. v. Federal Commissioner of Taxation 70 ATC 4061, it was determined the taxpayer was a money lender. Here, the taxpayer made a loan to a tin mining venture, on which a loss was incurred. Although the taxpayer's memorandum of association included money lending objects, at the time of the loan in question, the taxpayer had not made any other loans, with its sole activity being the purchase, subdivision and sale of land. However, the taxpayer company was associated with an active money lending company and was registered as a money lender. Also, after making the loan in question, the taxpayer made a number of loans to members of the general public and to several associated companies. The court held, at the time of making the loan in question, the taxpayer was carrying on a money lending business; that the loan in question was the first transaction in a money lending business, which the taxpayer intended to carry on. Barwick CJ said:

…in my opinion, there can be a course of business although as yet there is nothing more than an intention to carry on the business and a single transaction carried out in pursuance of that intention. The lending in this case was not for any purpose other than the carrying on of the appellant's business of lending money.

In the High Court of Australia case of Hungier v. Grace 127 CLR 210, Hungier made loans to Grace, who carried on a timber business that supplied large contracts governmental bodies. By paying cash, Grace could obtain a discount of 20%, which Grace and Hungier split with eachother. Here, it was ruled the transactions were indicative of a means of sharing the profits of a business rather than the carrying on of the business of money-lending. However, in his judgment, Barwick CJ concluded it is possible to carry on the business of a money lender with only one borrower.

In Hungier v. Grace, J Walsh also said the fact that loans were made to one borrower only is not decisive against a finding of carrying on of a business of money-lending; that circumstances provide a very strong indication against the carrying on of a business when it is accompanied by the circumstance that it was not the lender who stipulated the terms for repayment of the loans.

In Board of Review case 11 CTBR Case 29, the taxpayer was an ice manufacturer who lent money to vendors of its products to enable them to purchase runs. One vendor defaulted on a loan and, after realising its security, the taxpayer suffered a loss. It was held that although the money was lent in the course of the company's business, that business was ice manufacturing and it was impossible to conclude that the company carried on a money lending business.

In Board of Review case11 CTBR Case 26, a timber and builders merchant financed saw millers in building and equipping mills, with the object of securing supplies of timber. The company was authorised by its Memorandum and Articles of Association to lend money with or without security. It also built houses and financed building operations. The company claimed a deduction for a loan amount made to a particular firm of saw millers, which it wrote off as a bad debt. The Board of Review concluded that lending money was not a mere adjunct to the company's business in the sense that it was relatively unimportant or easily severable from the other operations. The company's money lending activities were to both suppliers and buyers of timber and were on such an extensive scale that they formed an integral part of its operations. The Board concluded that, on balance, the company was carrying on a money lending business.

In Re a Taxpayer (NSW 1933 No 3) (1933) 2 ATD 325, a solicitor was also a registered money lender and had a history of advancing monies to his clients on various securities, such as liens on crops and second mortgages. After a number of years he retired from business and changed his venue to Sydney. He subsequently resumed his practise as a solicitor and again advanced money on security of land on first and second mortgages. However, collapse of the land market resulted in losses. The Court of Review held the taxpayer carried on a money lending business as an adjunct to his business as a solicitor.

Application of law in your case

In your case, we consider you were carrying on a business of money lending. You borrowed funds from investors, which you treated as liabilities in your books of accounts and paid investors interest on, even when not receiving repayments from your borrowers. You on-lent these funds at potentially large interest differentials in the event of the borrower defaulting. Given the borrower was engaged in property development, where cash flows are derived at the completion projects, it would be expected they may commonly default in paying by the due date. Although your primary business was that of loan brokering, the interest differential in your on-lending has the potential to earn you significant income, if the borrower did not make their repayments by the due date. Also, the court cases cited above do not prejudice against a business where a lender has one or few borrowers, such as occurred in your case.

It follows you are able to claim a deduction under section 25-35 of the ITAA 1997 in the financial year where you wrote off the relevant debts as bad.