Edited version of your private ruling

Authorisation Number: 1012602115479

Ruling

Subject: CGT Forfeited Deposit

Question 1

Are you entitled to a deduction for the value of the forfeited deposit under section 8-1 of the Income Tax Assessment Act 1997 (ITAA1997)?

Answer

No

Question 2

Are you entitled to a deduction for the value for legal expenses under section 8-1 of the ITAA1997?

Answer

No

Question 3

Are you entitled to a deduction for the interest costs incurred in borrowing to meet your liability to the insurer under section 8-1 of the ITAA 1997?

Answer

No

Question 4

Are you entitled to a capital loss, for the value of the forfeited deposit in the income year ended 30 June 2014?

Answer

Yes

Question 5

Can the Legal costs be included as part the reduced costs base under section 110-35 of the ITAA 1997?

Answer

Yes

Question 6

Will the money recovered from the settlement with the vendor be included as part of the capital proceeds for a Capital Gains Tax (CGT) event under section 116-20 of the ITAA 1997?

Answer

Yes

Question 7

Can the interest expense incurred in borrowing funds to meet your liability to the insurer be included as part of the reduced cost base under Section 110-35 of the ITAA 1997?

Answer

No

This ruling applies for the following period(s)

Year ended 30 June 2014

The scheme commences on

3 July 2008

Relevant facts and circumstances

The arrangement that is subject of the private ruling is described below. This description is based on the following documents. These documents form part of, and are to be read with this description. The relevant documents are:

• your private ruling application

• you private ruling application

• letter from solicitors.

In relation to any inconsistency the information provided in the above documents we have treated the letter from your solicitor as the correct statement of the facts as per your instructions.

In 20XX you entered into a written contract to buy a unit off a development plan. The contract required payment of a XX% bond. You did not pay the deposit instead you provided the vendor with a bond issued by an insurer in the amount of the deposit.

The terms of the deposit bond provided that if the insurer was required to the pay the vendor pursuant to the deposit bond, you were required to indemnify the insurer for both the deposit amount and their costs in pursuing you.

In 20XX, you terminated the contract before completion. You did not pay the purchase price. You demanded return of the deposit bond. The vendor treated your termination of the contract as a repudiation of the contract, and elected to accept that repudiation and accordingly considered itself entitled to the deposit. You commenced legal proceedings to determine ownership of the disputed deposit. The vendor brought a counter-claim against you, seeking damages in addition to the deposit it sought to forfeit.

In 20XX, the insurer paid the deposit bond to the vendor.

You reached a settlement with the insurer in 20XX, whereby you agreed to pay the insurer $X (being $X as reimbursement of the deposit amount and $X in relation to costs). You have borrowed funds to meet this settlement offer and have incurred interest in relation to the loan.

In 20XX, you settled the legal proceedings in relation to the disputed deposit. Pursuant to this settlement, you recovered $X of the deposit. The vendor retained the balance ($X) and agreed to drop its counter-claim against you. You incurred legal costs in relation to this proceedings totalling $X from three separate invoices from your legal representative.

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

Income Tax Assessment Act 1997 Section 110-35

Income Tax Assessment Act 1997 Section 110-55

Income Tax Assessment Act 1997 Section 116-20

Reasons for decision

Summary

Deposit Bond

When you made a voluntary election to terminate the contract, consequently enabling the vendor to exercise their contractual right to hold the deposit bond, a CGT event occurred. As such a capital loss has occurred, which can only be offset against a capital gain made in this or a subsequent financial year.

The relevant event is CGT event C2 in that you have surrendered ownership of an intangible asset being your contractual rights to proceed with the sale. The timing of this event in your circumstance is when you entered into the settlement deed with the vendor surrendering your rights under the original contract in mid 2013.

Legal Expenses

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. These expenses may be included as part of the reduced cost base in relation to the above CGT event.

Interest

The interest expense incurred on the amount borrowed to meet your liability is not deductable as the purpose of borrowing was not to pay a deposit but rather to meet a liability that arose after you choose to terminate the contract with the vendor. The borrowing occurred at a point well and truly after any intention to purchase the unit and derive rent had ended, consequently there is no nexus between the borrowing and an income earning activity.

The interest is a cost of holding the property and cannot be included in the reduced cost base.

Detailed reasoning

Deposit Bond

As a result of you entering into a contractual arrangement with the vendor to purchase the unit you acquired contractual rights. These contractual rights are CGT assets for the purpose of Paragraph 108(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997).

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

Taxation Ruling TR 1999/19 provides the commissioners view on the capital gains tax implication of when a deposit is forfeited in a prospective sale. Paragraph 20 provides:

Application of the contractual rights approach to a defaulting purchaser may give rise to a capital loss in certain circumstances. Whether a capital loss arises depends on the amount of the cost base of the purchaser's ownership of those rights.

Further at Paragraph 35 it defines a deposit:

Contracts for the sale of real estate normally provide for the payment of a deposit (usually 10%, although other amounts may be agreed), payable at the time of entering into the contract and the balance of the purchase price being payable on completion or by instalments. The deposit paid by a purchaser under a binding contract for sale servers several purposes. It is an earnest given to bind the bargain; it is a guarantee that the purchase means business; and, on completion, it becomes part payment of the purchase price (see Howe Smith 27 Ch D 80 at 1001; Brien v Dwyer and Another (1978) 141 CLR 378 at 392.

Although a deposit bond does not strictly meet the definition of deposit listed above as it does not form part of the purchase price, your factual circumstance where you have had to indemnify the insurer after they had to pay the deposit in light of you terminating the contract will still meet the definition of CGT event C2. In that you have surrendered your contractual rights acquired under the contract.

Section 104-25(3) of the ITAA 1997 provides that you make a capital loss if the capital proceeds from the ending are less than the asset's reduced cost base. Whilst section 104-25(2) of the ITAA 1997 provides that the time of this event is when you enter into the contract that results in the asset ending or if there is no contract that results in the asset ending when the asset ended. In this instance the contract that results in the asset ending is the settlement deed, so consequently the timing of the event will be when you signed the settlement deed in 20XX.

Interest

Section 8-1 of the ITAA 1997 allows a deduction for interest where it can be demonstrated that the interest is incurred by the taxpayer in gaining or producing assessable income and the loss or outgoing is not capital, private or of a domestic nature.

The courts have generally held that the determination of the deductibility of interest is determined through examination of the purpose of the borrowing and the use the borrowed funds are put to (Fletcher & Others v FC of T 91 ATC 4950, Kidston Goldmines Limited v. FC of T 91 ATC 4538).

The commissioner's view on the deductibility of interest expenses incurred prior to assessable income in contained in Taxation Ruling TR 2004/4 in the wake of the decision of Steele v. FC of T 99 ATC 4242. Paragraph 9 provides:

It follows from Steele that interest incurred in a period prior to the derivation of relevant assessable income will be 'incurred in gaining or producing the assessable income' in the following circumstance:

• the interest is not incurred 'too soon', is not preliminary to the income earning activities, and is not a prelude to those activities;

• the interest is not private or domestic;

• the period of interest outgoings prior to the derivation of the relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost;

• the interest is incurred with one end view, the gaining or producing of assessable income; and

• continuing efforts are undertaken in pursuit of that end.

In your circumstances you have not borrowed money to pay a deposit rather you have borrowed money to meet a liability to the insurer that has arisen solely due to your voluntary election to terminate the contact.

Although you may have had intentions of using the property to derive rental income from the unit, the borrowing occurred in 20XX, three years after you decided to terminate the contract to purchases the unit. Any intention to own the property and derive rental income had well and truly expired, consequently there is no nexus or connection between the expenditure and any income earning activity.

Additionally the interest expense cannot be included as part of the reduced cost base as the third element being the costs of owning the CGT asset are excluded from the reduced cost base under section 110-55(2) of the ITAA 1997.

Legal Expenses

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 expense is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstorms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634). The nature or character of the legal expenses follows the advantage that is sought to be gain 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). Where, however, the expenditure is devoted towards a structural rather than operation purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspaper Ltd v FC of T (1938) 61 CLR 337).

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.

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 assert or that relate to a CGT event. The term 'incidental' is defined in subsection 110-35(2) of the ITAA 1997 to include remuneration for the services of a legal adviser.

Settlement from Vendor

The general rule under section 116-20 of the ITAA 1997 is that the capital proceeds from a CGT event are the sum of money received by the taxpayer in respect of the event happening. Therefore the money received under the settlement will from part of the capital proceeds as it is a payment received in relation to surrendering your contractual rights.

Conclusion

With the exception of the interest expenses all of the above expenses and receipts are relevant to the single CGT even that occurred when you entered into the settlement deed. The amount received under the settlement form the developer will form part of the capital proceeds. The payments made to the insurer will form element one of the reduced cost base and the legal expenses will be included under the second element. If you make a capital loss it can only be offset against a capital gain made in that or any subsequent year.