Edited version of your private ruling

Authorisation Number: 1012488197459

Ruling

Subject: Capital loss on loan

Questions and Answers:

1. Does your loan ('the Loan') made to your relatives (the 'Debtors') have the features of a traditional security or commercial debt (but not a personal use asset), which is a capital gains tax (CGT) asset for tax purposes?

Yes.

2. Can you treat previously received interest on the Loan as a return of capital (principal repayments)?

No

3. If you restructure the loan, so future loan repayments are considered as repayments of principal, will the loan become a personal use asset?

Yes.

4. Can you claim a capital loss for the amount of unpaid principal (capital) from the Loan?

No.

5. If the Loan is forgiven for reasons of natural love and affection, would the forgiveness of commercial debts operative rules not apply and, where the Debtors remain solvent, would the forgiveness of the Loan given rise to capital proceeds equal to the face value of the Loan and therefore not result in a capital loss?

Yes.

6. Is interest on the Loan owed to you but not paid (that is, not received) assessable income?

No.

This ruling applies for the following periods:

Year ended 30 June 2003

Year ended 30 June 2004

Year ended 30 June 2005

Year ended 30 June 2006

Year ended 30 June 2007

Year ended 30 June 2008

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

The scheme commences on:

1 July 2002

Relevant facts and circumstances

You lent funds ('the Loan') to the Debtors several years ago, with a verbally mutually agreed interest rate. The debtors used the money in an investment. An amount equating to around 50% of the loan principal has been paid to you in Loan interest repayments, which you included in your relevant income tax returns as assessable income.

Recently, the Debtors have made a request to restructure the Loan, so the past interest payments are considered to be principal repayments (return of capital) and so future Loan payments are considered to be principal repayments.

You are not aware of any evidence that suggests the Debtors are insolvent or have a general incapacity to repay the loan.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 26BB 

Income Tax Assessment Act 1936 Section 70B

Income Tax Assessment Act 1936 Section 159GP

Income Tax Assessment Act 1997 Section 100-20

Income Tax Assessment Act 1997 Section 104-5

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 108-20 

Income Tax Assessment Act 1997 Section 116-30

Income Tax Assessment Act 1997 Section 245-40

Reasons for decision

1. Your loan is a CGT asset

Section 108-5 of the Income Tax Assessment Act 1997 (ITAA 1997) is about CGT assets and specifically includes 'debts owed to you' as a CGT asset.

The CGT provision of section 108-5 of the ITAA 1997 can be contrasted with the revenue deduction provision of section 25-35 of the ITAA 1997, which allows a revenue deduction when a bad debt is written off as bad, in respect to a debt that was previously returned as assessable income or lent in the ordinary course of a business of lending money.

Section 26BB of Income Tax Assessment Act 1936 (ITAA 1936) is about traditional securities. It includes in its definition of a 'traditional security' a security that is or was acquired by a taxpayer after 10 May 1989 and does not have an eligible return. Section 159GP of the ITAA 1936 includes in its definition of the term 'security' a secured or unsecured loan or any other contract, whether or not in writing, under which a person is liable to pay an amount or amounts, whether or not the liability is secured. Following the definition of the term 'eligible return' found in section 159GP of the ITAA 1936, a loan that merely receives interest (and was not issued at a discount, does not bear deferred interest or is not capital indexed) will not have an eligible return.

Sections 26BB and 70B of the ITAA 1936 explain when gains and losses on disposal or redemption of traditional securities are accounted for on revenue account or, alternately, when gains and losses on disposal or redemption of traditional securities are accounted for as capital gains and losses.

Subsection 70B(4) of the ITAA 1936 prevents a revenue loss where the disposal or redemption of a traditional security is attributable to the inability or unwillingness of the issuer to discharge its obligations to make payments under the security.

Similarly, subsection 70B(5) of the ITAA 1936 prevents a revenue loss where a loss incurred on a traditional security is due to forgiveness of the security debt obligation.

Section 108-20 of the ITAA 1997 provides losses from personal use assets must be disregarded and includes, as a personal use asset, a debt arising other than in the course of gaining or producing your assessable income.

In your case, the Loan is not a personal use asset because it is a debt from which you earn assessable income. Although your loan has the superficial features of a traditional security, any loss you make on it will always fall on capital account due to the operation of subsections 70B(4) and (5) of the ITAA 1936. As you also do not carry on a business of money lending and because the loan amount is not that which would be returned as assessable income, your loan will always be a CGT asset for tax purposes.

2. Capitalising previously received interest

In law, principal and interest are distinct debts, which may be separately recovered (Dickenson v. Harrison (1817) 146 ER 465). The question as to whether components of a payment represent principal or represent interest is decided by the rules of appropriation.

The rules governing the appropriation of payments were summarised in the Federal Court of Australia case of Re Walsh; Ex parte Deputy Commissioner of Taxation (NSW) (1982) 60 FLR 355; (1982) 42 ALR 727; (1982) 13 ATR 40; (1982) 82 ATC 4223. Here, Lockhart J said:

A debtor who owes two debts to a creditor is entitled to appropriate a payment which he makes to his creditor to one debt rather than to the other. If he omits to do so, the creditor may make the appropriation. If neither makes any appropriation, the law appropriates the payment to the earlier debt. If there is specific appropriation by the debtor cadit quaestio. In the absence of a specific appropriation it is a question of fact whether there was any appropriation by the debtor. To constitute an appropriation there must be more than an intention to appropriate by the debtor.

Where there is the absence of any actual or express appropriation by the debtor or the creditor and a debtor owes both interest and principal, a payment is treated as applicable to interest in priority to principal. In the High Court of Australia case of Falk v Haugh (1935) 53 CLR 163 applies, Rich, Dixon, Evatt & McTiernan JJ said (at pp172-173):

It has long been a rule that when payments are received generally on account of a debt, which is in part interest and in part principal, they are treated as applicable to interest in priority to principal.

The rule affords only a presumption in the absence of any actual or express appropriation by the debtor or the creditor.

In your case, an actual appropriation of payments was made by the Debtors under the loan contract, where it was agreed interest would be paid to you on an annual basis, which you returned as interest income in your annual income tax returns. As such, the interest paid by the Debtors and received by you has the character of interest income in your hands, which, due to the rules of appropriation, cannot be changed retrospectively into principal (capital).

3. Restructuring the loan

Section 108-20 of the ITAA 1997 provides losses from personal use assets must be disregarded and includes, as a personal use asset, a debt arising other than in the course of gaining or producing your assessable income.

In your case, the Debtors have requested to restructure the loan so that future loan repayments will be considered as principle repayments. If this occurs, the Loan would become a personal use asset because it would be a debt arising other than in the course of gaining or producing your assessable income. Any subsequent capital loss in relation to the loan would have to be disregarded.

4. Capital losses

Section 100-20 of the ITAA 1997 states you can make a capital gain or loss only if a CGT event happens.

Section 104-5 of the ITAA 1997 lists a summary of the CGT events. In relation to the CGT asset of a debt owed to you, relevant CGT events may include disposing of (selling) the debt (CGT event A1), the ending of the debt (CGT event C2) or the transferring of the debt to a trust (CGT event E2).   

Most often, when non-payment occurs, the ending of a debt (CGT event C2) will occur where a trustee in bankruptcy, receiver or liquidator advises a creditor of the amount expected to not be recovered (Taxation Ruling TR 92/18, paragraph 4).

However, Taxation Ruling TR 92/18, which as about bad debts, at paragraphs 31 and 32 3, also explains a debt may be considered to have become bad (and thus come to end by being written off) in any of the following circumstances:

(a) the debtor has died leaving no, or insufficient, assets out of which the debt may be satisfied;

(b) the debtor cannot be traced and the creditor has been unable to ascertain the existence of, or whereabouts of, any assets against which action could be taken;

(c) where the debt has become statute barred and the debtor is relying on this defence (or it is reasonable to assume that the debtor will do so) for non-payment;

(d) if the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the whole debt, or the part claimed as a bad debt;

(e) where, on an objective view of all the facts or on the probabilities existing at the time the debt, or a part of the debt, is alleged to have become bad, there is little or no likelihood of the debt, or the part of the debt, being recovered.

…as a practical guide a debt will be accepted as bad under category (e) above where…

i. reminder notices issued and telephone/mail contact is attempted;

ii. a reasonable period of time has elapsed since the original due date for payment of the debt. This will of necessity vary depending upon the amount of the debt outstanding and the taxpayers' credit arrangements (e.g. 90, 120 or 150 days overdue);

iii. formal demand notice is served;

iv. issue of, and service of, a summons;

v. judgment entered against the delinquent debtor;

vi. execution proceedings to enforce judgment;

vii. the calculation and charging of interest is ceased and the account is closed, (a tracing file may be kept open; also, in the case of a partial debt write-off, the account may remain open);

viii. valuation of any security held against the debt;

ix. sale of any seized or repossessed assets.

In your case, a CGT event has not occurred in relation to the Loan because necessary circumstances for the ending of the Loan, such as explained in Taxation Ruling TR 92/18, have not occurred. It follows you cannot claim a capital loss for the amount of unpaid capital from the Loan.

5. Debt forgiveness

Section 245-40 of the ITAA 1997 provides the forgiveness of commercial debts operative rules do not apply if the forgiveness of a commercial debt is for reasons of natural love and affection.

However, if you forgive a debt owed to you, the market value substitution rule in section 116-30 of the ITAA 1997 will apply to deem you to have received market value for the disposal of the debt.

Taxation Ruling TR 96/23 states at paragraph 27 that the market value of a debt is its face value if the person who is released from repaying it is solvent.

In your case, in the current time, forgiving the Debtors from the Loan will not result in a capital loss because there is no current evidence the Debtors are insolvent.

6. Derivation of interest income

Taxation Ruling TR 98/1, which is about the determination of income, provides the general principle is that interest is only derived, or arises, when it is received or credited. (Exceptions to the general rule include, but are not limited to, interest from a business of money lending.)

In your case, the derivation of interest income follows the general principle that interest is only derived, or arises, when it is received or credited.

Conclusion

In your case, the Loan to the Debtors is a CGT asset. A capital loss on the loan can only occur when a CGT event happens in the circumstance where the Debtors are unable to repay the loan (for example, due to insolvency) or when you have exhausted all reasonable legal avenues of recovering the Loan principle.