Edited version of your private ruling

Authorisation Number: 1012536835753

Ruling

Subject: Investment losses

Question

1. Is Company A assessable on interest accrued up to the Repayment Date despite never being received?

Answer: Yes

2. Is Company A assessable on interest accrued after the Repayment Date despite never being received?

Answer: No

3. Can Company A claim a deduction as a bad debt for the loan?

Answer: No

4. Can Company A claim a deduction as a bad debt for interest up to the Repayment Date?

Answer: No  

5. Has Company A made a capital loss on its initial investment and capitalised interest in the year ended 30 June XXXX?

Answer: Yes 

This ruling applies for the following period

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

The scheme commenced on

1 July 2006

Relevant facts

Company A is not in the business of money lending.

Company A loaned money to Company B on arm's length terms.

Company B is an unrelated third party.

The loan was extended under a specific loan agreement (the Agreement) which stipulates that interest was to be capitalised up to the Repayment Date.

No such condition was made for interest accruing on overdue payments after the Repayment Date.

There was a material adverse effect on Company B's ability to comply with its obligations under the Agreement.

Company A received no amount in respect to the outstanding principal or interest.

Company B was deregistered

Relevant legislative reverences

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1936 Section 19

Income Tax Assessment Act 1997 Section 25-35

Income Tax Assessment Act 1997 Section 104-25

Reasons for decision

1. Is Company A assessable on interest accrued up to the Repayment Date despite never being received?

Generally interest is derived when it has been received or when the debt for the interest has been in some way discharged: See eg St Lucia Usines & Estates Co Ltd v. St Lucia (Col Treasurer) (1924) AC 508; Leigh v. IR Commrs (1928) 11 TC 590 and Re Income Tax Act (1897) 23 VLR 312).

The question at issue which you have highlighted is whether there has been a constructive receipt of the interest which was never actually received.

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a taxpayer's assessable income includes the ordinary income derived during the income year. Subsection 6-5(4) of the ITAA 1997 states:

In working out whether you have 'derived' an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.

This is a restatement of section 19 of the Income Tax Assessment Act 1936 (ITAA 1936) which states:

Income or money shall be deemed to have been derived by a person although it is not actually paid over to him but is reinvested, accumulated, capitalized, carried to any reserve, sinking fund or insurance fund however designated, or otherwise dealt with on his behalf or as he directs.

The interpretation of subsection 6-5(4) of the ITAA 1997 is to be consistent with the interpreted of section 19 of the ITAA 1936.

In North Sydney Investment & Tramway Co v. C of T (1898) 19 LR (NSW) 225; R & McG 135, it was stated that there must be some amount which, being income, has come home to the creditor and which, if not actually paid, has been credited or accumulated on the creditors behalf.

In Permanent Trustee Co and Anor (Estate of Frederick Henry Prior) v FC of T (1940) 6 ATD 5 it was explained:

The object is to prevent a taxpayer escaping tax though his resources have actually been increased by the accrual of the income and its transformation into some form of capital wealth or its utilisation for some purpose.

Prior illustrates the point that there will not be a deemed derivation of income unless there is some substance to the transaction.

Comments regarding the reinvestment of interest were also made in Perrot v The Commissioner of Taxation (1922) 23 SR(NSW) 118. Ferguson J said (at p 124)

What that clause contemplates is the case where the taxpayer, though he has not received the money itself, has had the benefit of it, or of something which is substantially equivalent to it. If he is given credit for the amount, for example, in his bank account, he is in the same position as if he had actually been paid the cash and had deposited it in the bank. So with a re-investment, or accumulation, or any of the other dealings mentioned in the section.

It can be seen that by the terms of the agreement interest is constructively capitalised and confers a benefit to Company A which would not have resulted had the interest simply been left unpaid. As such it is concluded that the interest is constructively derived and assessable in the year in which it accrues.

2. Is Company A assessable on interest accrued after the Repayment Date despite never being received?

We do not consider that any interest was derived by Company A after the Repayment Date.

3. Can Company A claim a deduction as a bad debt for the $X loan?

Subsection 25-35(1) states that you can deduct a debt (or part of a debt) that you write off as bad in the income year if it was included in your assessable income for the income year or for an earlier income year. 

As the principal sum was capital and not assessable income, subsection 25-35(1) of the ITAA 1997 has no application in relation to the initial investment.

4. Can Company A claim a deduction as a bad debt for the capitalised interest?

Section 25-35 of the ITAA 1997 relates to a debt included in a taxpayer's assessable income. In other words section 25-35 of the ITAA 1997 relates to a loss of income. The relevant debt in the current case is the capitalised interest of Company A.

The interest reinvested into the Company B project represents consideration and discharged Company B's obligation to pay interest on the invested funds. As such it is considered that the debt owed by Company B to Company A in relation to the interest is discharged in exchange for a capital investment and a new debt of a capital nature.

The lost funds in question (the capitalised interest) are on the capital account and as such Company A is not entitled to deduction for a bad debt under section 25-35 of the ITAA 1997.

5. Has Company A made a capital loss on its initial investment and capitalised interest in the year ended 30 June XXXX?

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens if the ownership of an intangible CGT asset ends because it expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited. A debt which arises under the right of indemnity, (or the merged asset if there is a right of subrogation), once payment has been made under the guarantee, can be disposed of in the following ways in terms of subsection 104-25(1) of the ITAA 1997 and a capital loss may arise, depending on whether the debt is a personal-use asset:

· The debt is forgiven at law (or in equity) by the guarantor; a formal deed of forgiveness is required in this situation.

· A Limitations Act could bar recovery of the debt and the right to recovery therefore expires.

· The principal debtor could be discharged from bankruptcy (in the case of an individual) similarly; the liquidation of a company will also constitute a release and disposal.

Company B was deregistered When a company is deregistered in accordance with the Corporations Law it will cease to exist; the company's debt to you will be 'abandoned, surrendered or forfeited' for the purposes of paragraph 104-25(1)(d) of the ITAA 1997and CGT event C2 in section 104-25 of the ITAA 1997 will happen.

In the case of Company A, as no capital proceeds were received for the purposes of subsection 104-25(3) of the ITAA 1997 before the company was deregistered, Company A makes a capital loss for both the principal and capitalised interest amounts in the XXXX-XX financial year.