Edited version of your written advice

Authorisation Number: 1012689734912

Ruling

Subject: Capital loss - guarantor

Question 1

Are you entitled to a capital loss in respect of the payment made to the bank as guarantor for the company in any of the relevant years?

Answer

No

Question 2

Are you entitled to a deduction under section 40-800 of the Income Tax Assessment Act 1997 (ITAA 1997) for the whole or any part of the payment made to the bank as guarantor?

Answer

No

This ruling applies for the following periods

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

The trust held approximately x% of the issued share capital in the company. The trust is a discretionary trust with you and your spouse as primary beneficiaries.

The company carried on the business activity.

You were a director and employee of the company.

As part of the financing arrangements of the company, you and your spouse provided the company's financier with a personal guarantee. That guarantee was secured by way of mortgage over your family home.

You and your spouse were one of several co-guarantors in respect of the bank loan. The other guarantors were individuals related to the majority shareholder of the company.

The company was placed into liquidation in the relevant financial year.

The bank demanded payment of the outstanding amount under the guarantee.

As a result of defaults by the company in relation to the loan, the bank commenced proceedings against, inter-alia, you and your spouse for payment under the guarantee.

By Deed of Settlement, the bank agreed to accept from you and your spouse, $X to be paid on a certain date. The payment was 'in full and final settlement' of proceedings against you and your spouse.

You and your spouse paid the settlement amount at or prior to that date.

You and your spouse have never filed a proof of debt with the liquidator of the company because there was no prospect of recovery. Even if you could prove as debtors, the company was never in any position to pay any dividends to you as unsecured creditors.

To date, the liquidation of the company is still ongoing and the company has not yet been deregistered.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Subsection 108-20(1)

Income Tax Assessment Act 1997 Subsection 108-20(2)

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 40-880

Income Tax Assessment Act 1997 Paragraph 40-880(5)(f)

Income Tax Assessment Act 1997 Subsection 40-880(6)

Reasons for decision

Summary

Because the right of indemnity on payment by the guarantor is a CGT asset, it may give rise to a capital loss if it is disposed of for no consideration when CGT event C2 happens. The time of the event, if there is no contract that results in the asset ending, is when the asset ends.

The company's debt to you will cease to exist when the company is deregistered and CGT event C2 in section 104-25 of the ITAA 1997 will happen. Therefore, no capital loss arises until the company is deregistered.

As the payment under the guarantee could be taken into account in working out the amount of a capital gain or capital loss, a deduction is not allowable under section 40-880 of the ITAA 1997.

Detailed reasoning

Capital loss

A capital gains tax (CGT) asset can be any kind of property, or a legal or equitable right that is not property. A debt or a right to repayment is a CGT asset.

The Commissioner's view on the CGT implications of a guarantee to pay a debt is set out in Taxation Ruling TR 96/23.

On entering a contract of guarantee, a guarantor acquires an asset which is a right to be indemnified by the principal debtor. The guarantor is taken to have acquired this right for a cost base equal to the amount the guarantor pays, or is required to pay, under the contract of guarantee. The guarantor acquires the right of indemnity at the time of making the contract (paragraphs 30 & 31 and 109 of TR 96/23).

When a creditor's debt is paid in full, the guarantor's 'right of subrogation' is created that is, the right to stand in place of the creditor and be subrogated to the creditor's remedies against the principal debtor. The right of subrogation does not arise in all cases for example, when the creditor's debt is not paid out in full. The guarantor is taken to have acquired the right of subrogation for a cost base equal to the amount the guarantor paid under the contact of guarantee (paragraphs 32 to 34 and 112 of TR 96/23).

When the guarantor makes a payment to the creditor under a guarantee, the guarantor's right of indemnity and right of subrogation become co-extensive. That is, they are merged into one asset being an enforceable debt against the principal debtor and the guarantor has the general rights of a creditor. The amount paid under the guarantee remains the relevant cost base of the merged asset (paragraphs 35 to 37 and 84 to 85 of TR 96/23).

In your case, when the payment under the guarantee was made, your right of indemnity became an enforceable debt against the company. This enforceable debt is a CGT asset within section 108-5 of the ITAA 1997 and the amount you paid under the guarantee is the first element of the cost base of this asset for the purposes of subsections 110-25(2) or 112-25(4) of the ITAA 1997.

Because the right of indemnity on payment by the guarantor is a CGT asset, it may give rise to a capital loss if it is disposed of for no consideration, or it may be a 'personal-use asset' as defined in subsection 108-20(2) of the ITAA 1997 so that a capital loss does not arise on its disposal.

Subsection 108-20(2) of the ITAA 1997 defines a 'personal-use asset'; included in this definition at paragraph 108-20(2)(d) of the ITAA 1997 is a debt arising other than in the course of gaining or producing your assessable income or from your carrying on a business.

Paragraphs 47 and 146 of Taxation Ruling TR 96/23 states that the test of what is a personal-use asset requires a finding that the debt came to be owed for a primary purpose other than that of gaining or producing income. Therefore, if the debt which came to be owed, as a consequence of entering the contract of guarantee, was expected to promote and enhance the income earning activity of the guarantor, the debt would not be a personal use asset and a capital loss would be allowed. The test is an objective purpose test, by examining the surrounding circumstances at the time of entering into the guarantee.

You were a director and employee of the company at the time you provided the guarantee. In your circumstances it is accepted that paragraph 108-20(2)(d) of the ITAA 1997 would not apply as it can be objectively determined that the primary purpose in entering into the guarantee was to assist the company to continue in business and enhance your income earning activity with the company. Therefore, the capital loss will not be disregarded by subsection 108-20(1) of the ITAA 1997.

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. The time of the event is when you enter into the contract that, results in the asset ending. If there is no contract, the time of the event is when the asset ends (subsection 104-25(2) of the ITAA 1997).

As outlined in TR 96/23 at paragraph 119, a debt which arises under the right of indemnity, 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:

• There may be no likelihood of payment by the principal debtor - the guarantor must take some action in terms of subsection 104-25(1) in order to dispose of the debt.

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

• 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.

Your ownership of the debt does not end when a company is placed in liquidation. Per Emmett J stated in Federal Commissioner of Taxation v. Macquarie Health Corporation Limited & Ors (1998) 88 FCR 451 at 472; 98 ATC 5214 at 5230; (1998) 40 ATR 349 at 366:

   There is no doubt that the effect of winding up and of sequestration is that there is a restriction imposed on the capacity of a creditor to enforce payment of a debt without the leave of the Court. A creditor will not be entitled to payment from the debtor and if the creditor receives payment, he will be required to repay the amount to the liquidator or trustee in bankruptcy. In that sense, the creditor's remedies are converted into a right to prove in winding up or in the bankruptcy. However, it does not follow, in my view, that the debt ceases to exist. The right to enforce payment is restricted. Nevertheless, the right to prove in the winding up or bankruptcy is a right to prove in respect of the debt which continues to exist.

Therefore as the debt continues in existence, liquidation of the company is not enough to end your rights in one of the ways contemplated by subsection 104-25(1) of the ITAA 1997. When the 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. If no capital proceeds are received for the purposes of subsection 104-25(3) of the ITAA 1997 before the company is deregistered you will make a capital loss when the company is deregistered.

Therefore, as the liquidation of the company is still ongoing, there will be no capital loss until the company is deregistered in accordance with the Corporations Law.

Section 40-880

The object of section 40-880 of the ITAA 1997 is to provide a deduction over five income years for certain business capital expenditure incurred after 30 June 2005 which is not otherwise taken into account or denied a deduction by some other provision. Subsections 40-880(3) to (9) of the ITAA 1997 set out the limitations and exclusions to deductibility under section 40-880.

Paragraph 40-880(5)(f) of the ITAA 1997 provides that an entity cannot deduct anything under section 40-880 of the ITAA 1997 for an amount of expenditure they incur to the extent that it could, apart from section 40-880, be taken into account in working out the amount of a capital gain or capital loss from a CGT event.

The payment made under the guarantee will be the first element of the cost base and reduced cost base of the CGT asset that is your enforceable debt against the company. As the amount could be taken into account in working out the amount of a capital gain or capital loss from a CGT event, the exclusion under paragraph 40-880(5)(f) of the ITAA 1997 applies. (Also refer Taxation Ruling TR 2011/6 paragraphs 253 - 258)

Subsection 40-880(6) of the ITAA 1997 does not apply to prevent paragraph 40-880(5)(f) of the ITAA 1997 applying because the expenditure was not incurred to preserve the value of goodwill.

As such, none of the expenses incurred in relation to the guarantee are deductible under section 40-880 of the ITAA 1997.