Edited version of your written advice

Authorisation Number: 1012797552164

Ruling

Subject: Unpaid loan money

Question 1

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for moneys loaned to two companies that were never repaid?

Answer

No.

Question 2

Will the non-repayment of moneys loaned to the two companies give rise to a capital loss at the time when the companies are completely wound up?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 200X

Year ended 30 June 200X

Year ended 30 June 200X

The scheme commenced on:

1 July 200X

Relevant facts

You were a director of two companies.

You provided funding to the company with the company agreeing to pay you back. The other directors voted to fold the company and you received nothing back.

You formed company two and you were sole director. You later resigned as director. This company no longer operates.

You funded the companies from your private funds and savings.

Under the written agreement with the companies you were to be repaid the loan money and interest within six months.

Both companies were closed and you were never repaid any of the money that you had put in.

You did not receive any director's fees, salary or dividends from the companies.

You are not in the business of lending money.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1.

Income Tax Assessment Act 1997 Section 25-35.

Income Tax Assessment Act 1997 Section 102-20.

Income Tax Assessment Act 1997 Section 108-5.

Reasons for decision

Allowable deductions

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for all losses and outgoings to the extent to which 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 except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income, or a provision of the ITAA 1997 prevents it.

A number of significant court decisions have determined that for an expense to be an allowable deduction:

• it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478) (Lunney's case), 

• there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income (Ronpibon Tin NL v. FC of T, (1949) 78 CLR 47), and

• it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Directors of a company would not ordinarily be expected to incur expenses relating to the business's operations. Such expenses are normally incurred by a business in relation to their operations and, thus, the earning of the business's assessable income. As highlighted in FCT v. Munro (1926) 38 CLR 153, a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of an entity other than the one who incurs it.

The issue of failing to derive interest income was considered in 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.

Although you did not borrow to lend the money to the company and incur interest expenses, the principles remain relevant.

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.

It is a long standing principle that a taxpayer does not satisfy section 8-1 of the ITAA 1997 merely by demonstrating some casual connection between the expenditure and the derivation of income. What must be shown is a closer and more immediate connection. The expenditure must be incurred in gaining or producing your assessable income (Lunney's case). These principles have been affirmed by the High Court in Commissioner of Taxation v Payne [2001] HCA 3.

In your case, you did not earn assessable income as a director.

Although the successful operation of the business would have enabled you to derive assessable income in the form of director's fees or other remuneration, the expense of loaning money to the companies does not have the necessary connection with your assessable income.

Also, the money loaned is regarded as a capital amount. That is, the unpaid amount under the loan agreement is a capital sum and therefore no deduction is allowed under section 8-1 of the ITAA 1997.

Bad debts

Section 25-35 of the ITAA 1997 allows a deduction for bad debts in certain circumstances. To qualify for a bad debt deduction under section 25-35, the written off bad debt must be:

• included in your assessable income for the income year or for an earlier income year, or

• in respect of money that you lent in the ordinary course of your business of lending money.

As you have not satisfied the requirements under section 25-35 of the ITAA 1997, a deduction for a bad debt cannot be allowed.

Capital gains tax provisions

A debt owed is a capital gains tax (CGT) asset (section 108-5 of the ITAA 1997).

Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens. The gain or loss is made at the time of the CGT event.

When a debt owed to you ends, CGT event C2 happens. The time of a CGT event C2 in relation to a debt owed to you will occur when you enter into the contract that results in the asset ending (for example, a settlement deed) or, if there is no contract, when the asset ends (for example, when it becomes irrecoverable at law).

In your case, you had loan agreements with a company that is no longer operating. As the debt is irrecoverable, CGT event C2 event has occurred. You are therefore entitled to a capital loss in relation to the debt.

Please note that a capital loss can only be used to offset a capital gain either in the same year as the loss or in a future year.