Edited version of your written advice

Authorisation Number: 1012689761357

Ruling

Subject: bankruptcy

Question

Are you entitled to a deduction under section 36-40 of the Income Tax Assessment Act 1997 (ITAA 1997) for payments made by your Trustee in Bankruptcy?

Answer

No.

This ruling applies for the following period

Year ending 30 June 2005

Year ending 30 June 2006

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

The scheme commences on

1 July 2004

Relevant facts and circumstances

The arrangement that is the 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:

• the application for private ruling dated, and

• the information provided with the application for private ruling.

You were one of several equity partners in a partnership until you retired.

At this point in time you took the indemnities of the continuing partners who continued to trade as a new partnership.

However, you were not released by the various creditors of the old partnership and remained a named tenant on the lease of the firm's premises and a named borrower on the loan document with the firm's banker.

The new partnership collapsed and the indemnities of the continuing partners became worthless.

You were exposed to the liabilities of the old partnership that had not been paid and to the rent and loan liabilities where you remained a contracting party.

For the liabilities of the old partnership, you were jointly and severally liable with you former partners.

For the rent and bank liabilities you were jointly and severally liable with the continuing partners under the relevant lease and banking documents.

Your total liabilities proved to be about $X.

You went into bankruptcy and were discharged automatically some time later.

Before you were discharged you were left a sum of money from a deceased estate.

The amount that was paid from the deceased estate to your Trustee in Bankruptcy was about $X which was almost enough to cover your liabilities.

You Trustee in Bankruptcy incurred expenses of approximately $X and paid out the remaining monies to your creditors.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 36-B

Income Tax Assessment Act 1997 section 36-35

Income Tax Assessment Act 1997 section 36-40

Income Tax Assessment Act 1997 subsection 36-40(1)

Reasons for decision

Subdivision 36-B of the ITAA 1997 deals with the effects of bankruptcy.

Section 36-35 of the ITAA 1997 applies where a taxpayer has incurred a tax loss before becoming bankrupt. The section states that if:

(a) you became bankrupt; or

(b) you were released from a debt by the operation of an Act relating to bankruptcy;

before the income year, you cannot deduct a tax loss that you incurred before the day on which you either became bankrupt or were released.

The section provides that such a tax loss cannot be deducted in any income year subsequent to the bankruptcy or release.

Amounts paid for debts prior to bankruptcy

In relation to claiming a deduction for amounts paid for debts prior to bankruptcy, subsection 36-40(1) of the ITAA 1997 specifies that if:

(a) you pay an amount in the income year for a debt that you incurred in an earlier income year; and

(b) you have a tax loss covered by section 36-35 for that earlier income year;

you can deduct the amount paid, but only to the extent that it does not exceed so much of the debt as the Commissioner is satisfied was taken into account in calculating the amount of the tax loss.

Thus, in order to be eligible to claim a deduction under subsection 36-40(1) of the ITAA 1997, it is necessary for the taxpayer to demonstrate a 'tax loss' covered by section 36-35 of the ITAA 1997.

The legislative purpose of the corresponding Income Tax Assessment Act 1936 (ITAA 1936) provision to section 36-40 of the ITAA 1997 (namely section 80(4A) ITAA 1936) was explained by the then Treasurer, the Right Honourable Sir Arthur Fadden, in the Explanatory Notes circulated by him with the Bill. It is as follows:

It is provided in sub-section (4) of section 80 that a taxpayer who has become bankrupt or has been released from debts by the operation of the Bankruptcy Act shall not be entitled to the deduction of any losses incurred by him prior to bankruptcy or release. Except for this provision, a taxpayer who did not pay his trade debts in full would, in effect, be allowed a deduction for those debts in calculating the losses of previous years.

At present, a taxpayer who voluntarily makes a payment in respect of debts from which he has been released is not allowed any deduction of the amount paid. It is proposed, in the new sub-sections (4A) and (4B) to be inserted by Clause 14, to allow the taxpayer a deduction of any payments to the extent to which the Commissioner of Taxation is satisfied that those payments have been made in respect of a debt that was taken into account in the calculation of a loss incurred prior to bankruptcy or release.

In order that such a taxpayer shall not be placed in a more favourable position than other taxpayers, the following conditions attach to the allowance:

(i) that the debt should have been incurred in one of the seven years preceding the year of payment; and

(ii) that the total deductions under the new sub-section (4A) shall not exceed the total deductions which, but for the prohibition in sub-section (4.), would have been deductible from the taxpayer's assessable income.

Subsection 36-40(1) of the ITAA 1997 is expressed using the phrase "you pay an amount". In light of the legislative purpose of the provision as well as case law, this has been interpreted to mean debts voluntarily paid by the taxpayer.

When you became bankrupt, your property vested in the trustee in accordance with subsection 58(1) of the Bankruptcy Act 1966. The subsequent payments made by the trustee to creditors were not payments made voluntarily by you.

As illustrated in Case U222 (1987) 87 ATR 1229, a bankrupt assigning his part of his business to a trustee under the Bankruptcy Act 1966 resulted in the trustee owning and operating the business for the benefit of the creditors, and not the taxpayer. Therefore, repayments of debt made to creditors after the assignment was not made by the taxpayer or on their behalf, but rather the payment was made by trustee.

In referring to subsection 229(1) of the Bankruptcy Act 1966, a provision which operates to immediately vest a trustee with all the divisible property of the debtor, the Tribunal stated:

The proceeds of the sale of the house, the profits of the business and the losses of the business must accordingly have been received or borne, as the case might be, by the trustee.

In Re Thomas; ex parte Commr of Woods and Forests (1888) 21 Q.B.D. 380 at p. 383, Cave J. considered the effect of the English Bankruptcy Act 1883, and said:

"The property is transferred to the trustee, and the remedies against the person and property of the debtor are taken away; in substitution for those remedies there is a vesting of the property in the trustee, so that he may dispose of it for the benefit of the creditors, and attached to that is the right to disclaim where the property is onerous. Looking at these sections as a whole, their effect is that the creditors cannot any longer get at the property of the debtor, there being substituted a right to prove against the estate, which is vested in the trustee…"

Application to your circumstances

In this case, at the time your property had become vested in the Trustee in Bankruptcy, the trustee took control of the debtor's property under the Bankruptcy Act, owning and operating it for the benefit of the creditors, rather than for you.

The payment to the creditors was made by the Trustee in Bankruptcy. This occurred after you had been discharged from bankruptcy. Under section 19 of the Bankruptcy Act, a trustee of a bankrupt estate has a statutory duty to distribute property amongst the creditors who have proven their claims.

Accordingly, when the Trustee in Bankruptcy paid creditors from the funds received from the deceased estate, the payment of debts to creditors was not made voluntarily by you or on your behalf. The payment was rather a result of the Trustee in Bankruptcy's statutory duty to administer the estate and pay dividends to appropriate creditors.

Since the debts were paid by the Trustee in Bankruptcy rather than by you, and section 36-40 of the ITAA applies to voluntary payments, no deduction is under subsection 36-40(1) of the ITAA 1997.