Edited version of your private ruling

Authorisation Number: 1012440301786

Ruling

Subject: Guarantee expenses

Question 1

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for a guarantee payment made to meet your obligations under a guarantee to repay a debt of a private company?

Answer

No.

Question 2

Will the amount of the guarantee payment be allowable as a capital loss?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2007

The scheme commenced on

1 July 2006

Relevant facts

Several years ago one of the directors of a company approached you to invest in a project.

The property development project was to be developed through the use of a separate special purpose incorporated entity.

The company was to be established for the purpose of a development project. The directors were trying to raise finance.

You agreed to invest by guaranteeing the loan for the borrower company on the basis that you would receive a percentage of the profit from the project.

The project had already achieved presales and construction was well under way but things went wrong.

You wanted to limit your losses so you sold one of your properties and paid an amount to be released from your obligations under the guarantee and forfeit your right to any profit from the project.

You also paid legal fees to solicitors representing the company.

Shortly after the developer was put into receivership by the primary funder.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Subsection 104-25(1)

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

Income Tax Assessment Act 1997 Section 110-25

Income Tax Assessment Act 1997 Subsection 108-5(2)

Reasons for decision

Summary

In your case, your expenses were to fulfil your obligations as guarantor for the debt of a private company.

Payments of guarantee expenses incurred by guarantors to company borrowings are capital in nature and therefore not deductible.

However, you will be entitled to claim a capital loss when CGT event C2 happens if the capital proceeds you receive are less than the reduced cost base of the debt, resulting in a capital loss for you.

Detailed reasoning

Question 1

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.

To be deductible, there must be a sufficient connection between the outgoing and the activities which produce or are expected to produce assessable income (Ronpibon Tin N.L. and Tongkah Compound N.L. v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431).

Only if a taxpayer acts as guarantor to such a degree as to amount to his or her usual practice, say, as a solicitor, in the ordinary course of business will the payments be deductible as a revenue outgoing and not of a capital nature: Jennings (Inspector of Taxes) v. Barfield & Barfield [1962] 2 All ER 957; 40 TC 365 (Jennings case).

The Commissioner's view about the implications of a shareholder's guarantee to pay a company's debt is found in Taxation Ruling TR 96/23. The ruling states that liabilities arising under contracts of guarantee will not be deductible if the provision of guarantees is not a regular and normal incident of your income earning activities, that is, where you are not in the business of providing guarantees.

Essentially, the payment of an amount by a guarantor gives rise to a debt owed by the company to the guarantor (paragraph 37 of TR 96/23).

TR 96/23 also refers to a line of decisions of the Administrative Appeals Tribunal and the former Boards of Review which accept that payments made under guarantees by shareholders or directors are not deductible. It also states:

135. The principle in Total Holdings might be considered to apply to a shareholder who guarantees the debts of the company in which he/she holds shares. This principle would then be sufficient to allow one of the two positive limbs of subsection 51(1) to be satisfied. However, a deduction may be denied because the expenditure is found to be on capital account. As the majority in Hooker Rex determined, a guarantee is akin to loan capital….

The Federal Court has confirmed in Bell & Moir Corporation Pty Ltd v. FC of T (1999) 99 ATC 4738; 42 ATR 421 that payments made under guarantees, given to a bank and finance company on behalf of a company in which the taxpayer had a one-third stake, were capital in nature and not deductible. It was found that the advantage sought by the taxpayer in providing the guarantees was the extension of credit facilities to the company. This served to strengthen the base from which the company carried on business so that the taxpayer could continue to trade with it. Such an enduring benefit was ordinarily capital in nature.

In Case Q39 83 ATC 171; (1983) 26 CTBR (NS) Case 103 the taxpayer was a chartered accountant, and also a director and shareholder of a nominee company incorporated for the purpose of holding various blocks of land for nominated beneficiaries, being principally family members. The taxpayer received fees for his accountancy work for the company. The company borrowed moneys for the acquisition and development of a block of land, and the taxpayer guaranteed the loan. The taxpayer became obliged to make a payment pursuant to the guarantee, which he claimed as a deduction. He argued that his circumstances were similar to Jennings case (see above). However, the board distinguished that case, concluding that the giving of the guarantees was not incidental to the carrying on of the taxpayer's accountancy business having regard to the minimal number of occasions when guarantees were given in respect of transactions entered into at arm's length (i.e. with respect to persons or companies outside the taxpayer's family), and the fact that the giving of guarantees was not an act commonly engaged in by chartered accountants. The Chairman also referred to a line of Board cases stretching from 1946 which concluded that payments under such guarantees are capital in nature.

In Case V115 88 ATC 733; AAT Case 4501 (1988) 19 ATR 3697 a deduction was not allowed for payment made by the taxpayer who was a director and shareholder of a land development company and who was a creditor of the company under a guarantee given by the taxpayer in respect of the company's liabilities.  

Where a director incurs a loss as a consequence of guaranteeing borrowings of a company, the promise of a fee was considered to be an inducement to undertake a risk of a capital nature: Case V117 88 ATC 741; AAT Case 4503 (1988) 19 ATR 3708.

To summarise, the majority of the cases in which deductions have been disallowed because the outgoing was on capital account can be seen to have exhibited one or both of the following characteristics:

1. 1 In several cases the guarantees have been given with respect to loans to companies connected with the guarantor, and the guarantee payments have been treated as being on capital accounts due to their close analogy to loan capital.

2. 2 In other cases guarantees have been given in relation to the establishment or protection of a capital asset, and consequently payments made have attracted a capital character.

Application to your circumstances

In your case, you gave a guarantee on behalf of a company and you were subsequently called upon by a lending institution to fulfil your obligation under the guarantee. You paid an amount as a consequence of the loan guarantee.

Even if you were rewarded with the payment of a fee for the provision of the personal guarantee(s), the providing of guarantees to one entity does not amount to the carrying on of a business. You have provided no evidence indicating that you provided the guarantee as part of a wider business (of providing guarantees), to arms-length clients (that is, with respect to persons or companies not associated with you), or that you would have a reasonable expectation of profit from your activities.

We do not consider that you were carrying on a business of providing guarantees. Rather, we consider that you were induced to undertake a risk of a capital nature.

Therefore, the expenses you incurred in relation to the guarantee are considered to be capital in nature and not deductible under section 8-1 of the ITAA 1997.

Question 2

A debt is an intangible CGT asset and is specifically listed as an example of a CGT asset in Note 1 to subsection 108-5(2) of the ITAA 1997.

On entering into a contract of guarantee, the guarantor acquires an asset which is a right to be indemnified by the principal debtor. Because the right of indemnity on payment by the guarantor is in the nature of a debt, it may give rise to a capital loss if a CGT event happens in relation to the debt and the capital proceeds you receive are less than the reduced cost base of the debt, unless it is a "personal use asset".

Section 110-25 of the ITAA 1997 discusses the cost base. Providing the contract of guarantee is valid and enforceable at the time the creditor enforces the contract, the guarantor acquires the right of subrogation for a cost base equal to the amount the guarantor pays, or is required to pay under the contract. The time of acquiring this asset is when the contract of guarantee is entered into.

The right of indemnity becomes an enforceable debt on payment. The Court of Appeal in Re A Debtor [1937] 1 All ER1 (Debtor's Case) confirmed that the debt due to the guarantor by the debtor does not arise until the guarantor has been called on to pay, and does pay, the creditor under the guarantee. Further comments in Debtor's Case indicate that the undertaking to indemnify is an undertaking to reimburse the guarantor.

Paragraph 114 of TR 96/23 explains that the amount the guarantor can recover from the principal debtor is limited to the amount that the guarantor has paid under the guarantee.

CGT event C2 in section 104-25 of the ITAA 1997 occurs if a taxpayer's ownership of an intangible CGT asset ends in certain ways, including because the asset expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited. The time of the event is when a taxpayer enters into the contract that results in the asset ending. If there is no contract, the event happens when the asset ends (subsection 104-25(2) of the ITAA 1997).

CGT event C2 will happen to a debt, for example, when a debtor company is deregistered. However, the mere writing off of a debt by a taxpayer is insufficient to constitute a cancellation, release, discharge, surrender or abandonment at law or in equity for the purposes of subsection 104-25(1) of the ITAA 1997. The debt will continue to exist until such time as the company is deregistered.

Where a guarantor pays the debt in full and there is no likelihood an insolvent company will pay the debt owing to the guarantor, paragraph 42 of TR 96/23 provides a capital loss will arise when the insolvent company is deregistered. The deregistration of the insolvent company constitutes a release and thus the disposal of the debt in terms of section 104-25 of the ITAA 1997 (CGT event C2) because the debt owed to the guarantor becomes irrecoverable at law.

Prior to deregistration of the company, including during the period of administration by a liquidator, the debt to the guarantor remains recoverable and thus does not cease to exist in terms of section 104-25 of the ITAA 1997. Advice from a liquidator of the company that there was no likelihood of all or any of the amount that you paid to the bank being repaid by the company is not enough to end your rights in one of the ways contemplated by subsection 104-25(1) of the ITAA 1997. If further funds became available to the liquidator, you may be entitled to a distribution. However, when a company is deregistered in accordance with the Corporations Law it ceases to exist. That is the company's debt to you will be 'abandoned, surrendered or forfeited' for the purposes of paragraph 104-25(1)(d) of the ITAA 1997.

A debt will not be extinguished if it is merely forgiven or abandoned without any legal impediment imposed on its collection.

Application to your circumstances

In your case the debt is not a personal use asset as it was expected to enhance your income-earning activity in the form of a percentage of profits.

You paid a sum of money as settlement of your obligations under the guarantee. CGT event D1 occurred at this time with the creation of the right to enforce the indemnity against the borrower company under section 109-5 of the ITAA 1997.

It is only when the borrower company is deregistered, that this will constitute a release and disposal and this will be the time at which CGT event C2 happens and the relevant CGT asset ends, resulting in a capital loss for you.

Any capital loss is reduced by any entitlements to contributions from any co-guarantors.