Edited version of your private ruling

Authorisation Number: 1012468221194

Ruling

Subject: Loss incurred

Question 1

Are you entitled to a deduction for the loss incurred as guarantor?

Answer

No.

Question 2

Are you entitled to a capital loss in relation to the debt incurred as guarantor?

Answer

Yes.

This ruling applies for the following period

Year ended 30 June 2007

The scheme commenced on

1 July 2006

Relevant facts

You were guarantor for a security deposit.

The security deposit was for entity A.

The directors of this company were your relations. You were also listed as a director of the company however you never received any money or benefit from the company and had no dealings with its operation.

The company was declared bankrupt and you had to pay money to honour the guarantee.

You are not in the business of providing guarantees.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-5

Reasons for decision

Allowable deductions

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

§ it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478), 

§ there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

§ it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Taxation Ruling TR 96/23 discusses the deductibility of payments made under guarantee. The ruling states that liabilities arising under contracts of guarantee will not be deductible under section 8-1 of the ITAA 1997 if the provision of guarantees and the losses or outgoings under the guarantees are not regular and normal incidents of the taxpayer's income earning activities. The ruling further states that if the provision of guarantees is not a regular and normal incident of the taxpayers income earning activities, any payments made under those guarantees will be capital in nature.

Directors of a company would not ordinarily be expected to guarantee a business's debts. Debts are normally incurred by a business in relation to their operations and, thus, the earning of the business's assessable income. As highlighted in FCT v. Munro (1926) 38 CLR 153, a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of an entity other than the one who incurs it. That is, where expenses are incurred by the company and paid for by a director or someone else, a deduction is not allowable to the director or that other person.

In your case, you provided a guarantee to entity A. Entity A has since gone into liquidation. You subsequently paid the money as guarantor.

The security deposit was made out in the company's name. The purpose of your action was not to directly produce any assessable income for yourself, but to fulfil your commitment as guarantor. You were not in the business of entering into contracts of guarantee. It is not considered that the provision of guarantees was undertaken by you as a regular and normal incident of your income earning activities.

It is acknowledged that you paid the expenses of the company. However, such expenses do not sufficiently relate to your income earning activities. They more directly belong to the company. That is the expenses belong to the company and you paid the expenditure on behalf of the company. Therefore a deduction for paying the company's debt will not be allowable under section 8-1 of the ITAA 1997 as it relates to the company's affairs and not your assessable income.

Capital gains tax provisions

A debt owed to you is a capital gains tax (CGT) asset (section 108-5 of the ITAA 1997).

When a guarantor repays a debt under guarantee to a primary creditor (such as a financial institution), the guarantor acquires a CGT asset, namely, the debt owed to the guarantor by the debtor (such as a company). If the debtor (company) cannot repay the debt, the guarantor will make a capital loss under section 104-25 of the ITAA 1997 (CGT event C2) due to the cancellation of the debt in the event of the company being wound up.

The time of a CGT event C2 in relation to a debt owed to you will occur when you enter into the contract that results in the asset ending (for example, a settlement deed) or, if there is no contract, when the asset ends (for example, when it becomes irrecoverable at law).

As entity A has been wound up, it can not be said that the company will pay the outstanding debt to you. As the debt is irrecoverable, it is considered that a CGT C2 event has occurred for you. Therefore you are entitled to a capital loss.

Please note that a capital loss can only be used to reduce a capital gain in the same year or if there are no capital gains in that year, they may be used in a future year.