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Ruling

Subject: Investment losses

Question 1

Are you entitled to a capital loss for the value of the missing asset for investment one?

Answer

Yes.

Question 2

Are you entitled to a capital loss for the loss of funds relating to investment two?

Answer

No.

Question 3

Are you entitled to a deduction for legal costs incurred in relation to your investments?

Answer

No.

Question 4

Can the legal costs incurred in relation to your investments, be included as a part of the cost base for capital gains tax purposes?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2013

The scheme commences on:

1 July 2012

Relevant facts and circumstances

You have invested in two activities.

Investment one

To diversify your investments you started to invest in item A. The item was purchased in Australia and shipped overseas for storage, to be sold to other investors or auctioned off at a later date.

After a while in storage you had the item moved to the account of the individual who stored and would sell the item at a later date at a warehousing company.

You remained in contact with the individual until he stopped responding to your queries and ceased all communication with you.

Despite repeated requests for the return of the item, it has not been returned.

You sought help from the local police however they advised that they could not assist you in the matter.

You engaged a solicitor in who sent a letter to the individual's last known address, which was returned to sender. Your solicitor has since been unable to locate the individual. They have advised that further investigation by them is unlikely to result in the return of the item.

You also sought advice from another entity who advised that your only option available was civil legal action. However you believe it is pointless as the individual cannot be found.

You contacted the warehousing company who advised that the item was not in the individual's account.

Your solicitor discovered that the individual's company had been delisted in the overseas country for a number of years.

Approximately one year has elapsed since you last had any communication with the individual.

You now believe that the individual has disappeared with your item and there is no prospect of having it returned to you. Therefore you are no longer going to pursue the recovery of your item.

You incurred expenses in transporting and storing the item, as well as legal costs in attempting to recover your investment.

Investment two

You invested with individual two, which was to start a business.

You entered into a contract to loan funds to the individual two for a specific duration, after which the funds would be returned to you with a share of the income from the business.

Individual two failed to comply with specific clauses in the contract, and you instructed individual two to return your funds as per the contract.

You had been in regular contact with individual two until a short time ago, and despite repeated requests individual two has not returned your funds. You have not tried to contact individual two since he last replied to your contact.

On previous occasions that you attempted to contact individual two they responded to your queries, albeit aggressively.

At approximately the same time you emailed the overseas equivalent of Fair Trading, and a local solicitor to look into the matter on your behalf. However neither of the parties responded to your queries. You have not attempted to contact the parties again since the initial contact.

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 104-20

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Subsection 104-25(3)

Income Tax Assessment Act 1997 Paragraph 108-5(1)(b)

Income Tax Assessment Act 1997 Section 108-20

Income Tax Assessment Act 1997 Subsection 110-35(2)

Reasons for decision

Summary

Deduction for the loss of funds

Capital Gains Tax consequences - investment one

When you were advised by the warehouse that your item could not be located, a CGT event C1 has occurred as the asset is considered to be lost or destroyed. As such a capital loss has occurred, which can be offset against a capital gain made in this or a subsequent financial year.

Capital Gains Tax consequences - investment two

The contractual arrangement with individual two is considered a CGT asset.

As only a short period has passed since non-action from either party, it is considered that the contract has not been abandoned and your rights under the contract remain. Therefore no CGT event has occurred to date, and you cannot claim a capital loss for investment two.

Legal expenses

Deductibility as a general deduction

The legal fees were incurred by you in your capacity as an investor with the object of recovering invested capital. As such, the legal expenses are of a capital nature and are not deductible.

Capital Gains Tax consequences

The second element of the cost base comprises of incidental costs an entity incurs in relation to a CGT asset, such as costs incurred for the services of a legal adviser. Therefore these costs should be included in the second element of the cost base.

Detailed explanation

Capital Gains Tax consequences - investment one

Section 102-20 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a capital gain or loss can only arise when a capital event occurs in respect of a capital asset.

CGT event C1 happens if a CGT asset you own is lost or destroyed (section 104-20 of the ITAA 1997). The timing of the event is when you first receive compensation for the loss or destruction, or if you receive no compensation, when the loss is discovered or the destruction occurred.

In your case your item was stored at a warehouse location in the account of the individual. When you contacted the warehouse you were advised that your item was no longer located in the account, and after further investigation its whereabouts was unknown.

As such the date that you discovered that the item was missing is also the date the CGT event C1 has occurred. As a result a capital loss has occurred, which can be offset against a capital gain made in this or a subsequent financial year.

The capital gain or capital loss arising from this event is calculated by comparing the capital proceeds received as a result of the event with the cost base of the asset. If the capital proceeds are greater than the cost base, then a capital gain has been made. Alternatively, if the capital proceeds are less than the reduced cost base, the result is a capital loss (subsection 104-25(3) of the ITAA 1997).

Capital Gains Tax consequences - investment two

As a result of you entering into the contractual arrangement with individual two, it is considered that you acquired contractual rights. These contractual rights are CGT assets for the purposes of paragraph 108-5(1)(b) of the ITAA 1997.

Section 104-25 of the ITAA 1997 provides that a CGT event C2 happens if your ownership of a CGT asset ends by the asset being abandoned, surrendered or forfeited.

In DTR Nominees Pty Ltd v. Mona Homes Pty Ltd (1978) 138 CLR 423; [1978] HCA 12 it was recognised that a contract can come to an end merely by being treated as being at an end by the parties. It was held in Fitzgerald v. Masters (1956) 95 CLR 420 at 432 that:

Where an inordinate length of time has been allowed to elapse, during which neither party has attempted to perform, or called on the other to perform, it may be inferred that the contract has been abandoned. What is really inferred in such a case is that the contract has been discharged by agreement, each party being entitled to assume from a long-continued ignoring of the contract on both sides that (in the words of Rowlatt J.) the matter is off altogether.

In your situation, only a short period has elapsed since you last had any communication with individual two, and on previous occasions that you attempted to contact individual two he responded to your queries, albeit aggressively.

As there has not been a substantial period of time for non-action from either party, it is considered that the contract has not been abandoned and your rights under the contract remain. Therefore no CGT event has occurred to date, and you cannot claim a capital loss for investment two.

Legal expenses

Deductibility as a general deduction

Section 8-1 of the ITAA 1997 allows a deduction for expenditure to the extent that it is incurred in the gaining or producing of assessable income, or in the carrying on of a business to gain or produce assessable income. No deduction is allowable to the extent that the expenditure is private, domestic or capital in nature.

In determining whether a deduction for legal expenses is allowable 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.

Where the legal expenses arise as a consequence of the day to day activities of a business, the object of the expenditure is devoted towards a revenue end and the legal expenses are deductible (Herald & Weekly Times v FC of T 48 CLR 113; 2 ATD 169). Where, however, the expenditure is devoted towards a structural rather than operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Ltd v FC of T (1938) 61 CLR 337; 5 ATD 87).

In your case, you incurred legal expenses in your capacity as an investor with the object of recovering invested capital. As such, the legal expenses are of a capital nature and are not deductible under section 8-1 of the ITAA 1997.

CGT consequences

Whilst the legal expenses are not an allowable deduction under section 8-1 of the ITAA 1997, the legal expenses may be included in the capital loss calculations.

The cost base and reduced cost base of a CGT asset each consist of five elements. The second element of the cost base and reduced cost base each comprise of incidental costs an entity incurs to acquire a CGT asset or that relate to a CGT event. The term 'incidental costs' is defined in subsection 110-35(2) of the ITAA 1997 to include remuneration for the services of a legal adviser.

In your case, you incurred legal expenses in seeking advice to establish your rights in relation to the investment, while attempting to recover a capital asset from the individual. Therefore these costs should be included in the second element of your cost base.