Edited version of your written advice

Authorisation Number: 1012720522747

Ruling

Subject: Capital loss- director's loan

Question

Will the taxpayer be able to claim a capital loss in their personal tax return as per section 102-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

This ruling applies for the following period

Year ended 30 June XXXX

The scheme commences on

1 July XXXX

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

In XXXX, Company A (the company) bought a business.

The taxpayer as director and shareholder and the business partner as director, secretary and shareholder of the company loaned the company X amount of dollars to start and operate the business.

The taxpayer advised the Tax Office that there was a written loan agreement in place.

The taxpayer advised the Tax Office that the interest that will be charged on the loaned amount is at, X% per annum subject to the profitability of the business.

The purpose of the loan was to provide funds to the company for the purchase of the business and cash flow.

The taxpayer did not receive salary, interest, director's fees and dividends from the company.

The company ceased operations in July XXXX.

The company has an accumulated loss of X amount of dollars for the income year ended 30 June XXXX.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 108-20

Reasons for decision

General deduction provisions

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent that they are incurred in gaining or producing assessable income or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed to the extent that the losses or outgoings are of a capital, private or domestic nature or are necessarily incurred in gaining or producing exempt income.

The capital component of your loan is not deductible under section 8-1 of the ITAA 1997 because it is capital in nature and so specifically denied.

Timing of loss of capital

With regards to the capital amount of the loan, it is considered that you incurred the loss or outgoing when the business ceased operations. Up until this point, you would have expected the company to pay the loan back to you at some stage in the future when it was profitable. Once the business ceased operations, the funds owed by the company to you were irrecoverable. It was at that time that the loss by you was crystallised since before that time there was an expectation that the company would pay you back when it became profitable.

Capital Gains Tax provisions

Section 102-5 of the ITAA 1997 includes in your assessable income, your net capital gain for the income year. You make a capital gain or capital loss if and only if a capital gains tax (CGT) event happens to a CGT asset.

Subsection 108-5(1) of the ITAA 1997 defines a CGT asset to be any kind of property, or a legal or equitable right that is not property. One of the examples given in the notes to section 108-5 of the ITAA 1997 is debts owed to you. An unpaid loan would be considered to be a debt that is owing to you.

In this case you made a loan to a private company in which you were a director. You acquired a debt which is an asset for CGT purposes.

Forgiving the loan will trigger CGT event C2 in section 104-25 of the ITAA 1997. Paragraph 104-25(1)(b) of the ITAA 1997 provides that CGT event C2 happens if your ownership of an intangible asset ends by the asset being released, discharged or satisfied. An asset comes to an end when CGT event C2 happens as there is no acquisition by another person or entity at that time.

The business ceased operations and, as a result, no part of the loan was recovered by you which resulted in the ending of your right to the asset.

However, subsection 108-20(1) of the ITAA 1997 states that in working out a taxpayer's net capital gain or loss for an income year, any capital loss made from a personal use asset is disregarded.

Personal use assets

Definition of 'personal use asset' in paragraph 108-20(2)(d) of the ITAA 1997 includes a debt as follows:

(d) a debt arising other than:

(i) in the course of gaining or producing your assessable income; or

(ii) from carrying on a business

Can the loan to the company be said to have been made in the course of gaining or producing your assessable income? If the loan was made on ordinary commercial terms, it would be expected to generate interest income and would therefore not be a personal-use asset.

The loan you made to the company being charged an interest of X% per annum subject to the company making a profit is not considered standard practice in commercial lending. Further, the primary purpose of the loan was to provide funds for the purchase of the business and ensure the company had funds for ongoing expenses in running the business. During the period from when you made your loan to the company to the date the business ceased its operations, you received no income in the form of salary, interest, director's fees or dividends from the company.

In your case, you are not in the business of lending money for profit therefore the loan you made to the company as a director is not considered to have been made in the course of gaining or producing your assessable income nor does it arise from you carrying on a business.

The issue of failing to derive any interest income was first considered in The Federal Commissioner of Taxation v Munro (1926) 38 CLR 153 (Munro's Case). The principles established here were that neither the lending to the company in which Mr Munro was a shareholder, nor the financing of an acquisition of shares by his sons were regarded as sufficient to characterise the incurring of the interest as being directed to the gaining of the taxpayer's income.

Since Munro's Case there have been a significant number of cases in which directors and shareholders of companies have provided benefits at their own expense to the companies with which they were associated which have not satisfied the characterisation test.

The exception is the decision of the Full Federal Court in FC of T v. Total Holdings (Australia) Pty Ltd 79 ATC 4279; (1979) 9 ATR 885 (Total Holdings). This case recognised the earning of dividends as a sufficient purpose to characterise interest on money borrowed to on-lend to another entity for the purpose of its business as falling within section 8-1 of the ITAA 1997.

You advised the Tax Office that there was a loan agreement in place between the company and the directors, and that the company will be charged X% interest per annum subject to the company making a profit. The company has not distributed income to you in your capacity as a director and no income or dividends were received during the whole of the period that you were involved with the company.

There was no expectation of a profit being made by you by way of standard interest rate charged on the loan to the company applied to the borrowed funds as would occur in a commercial loan. Your purpose in incurring the interest expense cannot be seen as characterising the expenditure as incurred in gaining or producing assessable income.

We consider the loan to the company was not made as part of carrying on a business by you but for the company to meet its ongoing expenses in running a business. You did not derive dividends from the company. You are not in the business of lending money rather you simply extended funds to the company.

The debt is considered to be a personal-use asset under paragraph 108-20(2)(d) of the ITAA 1997 and so under subsection 108-20(1) of the ITAA 1997, any capital loss arising from the loan is disregarded in working out your net capital gain or loss.

Therefore, the taxpayer will not be able to claim a capital loss in their personal tax return under section 102-5 of the ITAA 1997.