Edited version of your written advice

Authorisation Number: 1013054129844

Date of advice: 19 July 2016

Ruling

Subject: Deductions - guarantor and other payments

Question 1

Are you entitled to a deduction for break fees associated with finalising your residential rental property loan?

Answer

Yes.

Question 2

Are you, in your capacity as a guarantor, entitled to a deduction for the settlement payment/break costs associated with the finalising the business loan and commercial lease?

Answer

No.

Question 3

Are you entitled to a capital loss in relation to the settlement payment/break costs associated with finalising the business loan and commercial lease?

Answer

Yes.

Question 4

Are the pre-insolvency consultant fees claimable as an allowable deduction or a capital loss?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2016

The scheme commences on

1 July 2015

Relevant facts and circumstances

You and your spouse operated a business through Entity X.

Your spouse was the sole director and you were both employees of Entity X.

Entity X ceased business and was liquidated.

At the time of liquidation, Entity X had a business loan and a commercial lease for the business premises.

You and your spouse were guarantors for both the loan and the commercial lease.

You were required to make payments under the guarantees as settlement/break costs for the loan and the lease.

You owned a property which was used to earn rental income. A mortgage was secured against the property. The mortgage funds had been used solely to purchase the property.

The bank repossessed applied the sale proceeds against the loan. As the sale price was less than the outstanding loan, the bank passed the matter to the mortgage insurers.

You made a break fees payment to the mortgage insurers to cease further action against you and to break the loan.

You engaged a pre-insolvency firm a fee to negotiate the above settlements with the bank, mortgage insurer and landlord.

You are not in the business of providing guarantees.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 8-5

Income Tax Assessment Act 1997 Section 12-5

Income Tax Assessment Act 1997 Section 25-30

Income Tax Assessment Act 1997 Section 102-20

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 108-5

Reasons for decision

Summary

The payment to the mortgage insurer is a deductible expense as it relates to a property which was used to earn assessable income.

The payments you have made as a guarantor are not deductible expenses as they are considered to be capital losses. You can use these capital losses to reduce a capital gain in the same year or if there are no capital gains in that year, in a future year.

The fee paid to the consultant to negotiate the settlements is not deductible nor is it considered to be a capital loss for income tax purposes.

Detailed reasoning

Mortgage insurers break costs

Section 8-5 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a taxpayer to deduct from their assessable income amounts that another provision of the ITAA allows them to deduction, that is, specific deductions.

Section 12-5 of the ITAA 1997 lists those provisions which allow specific deductions. Included in this list is section 25-30 of the ITAA 1997 which deals with the expenses of discharging a mortgage.

Section 25-30 of the ITAA 1997 allows a deduction for expenditure incurred to discharge a mortgage in the following circumstances:

• where the mortgage is given by the taxpayer as security for the repayment of money borrowed by the taxpayer and used by the taxpayer for the purpose of producing assessable income

• where the mortgage is given by the taxpayer as security for the payment of the whole or part of the purchase price of property bought by the taxpayer for the purpose of producing assessable income.

If the borrowed money or purchased property is used by the taxpayer solely for the purpose of producing assessable income, all expenditure incurred in discharging the mortgage is deductible. However, if the borrowed money or purchased property is used by the taxpayer only partly for the purpose of producing assessable income, the expenditure incurred in discharging the mortgage is only deductible to the extent the money or property is used for that purpose, that is, only a proportion of the expenditure is deductible.

In your case, you borrowed funds to purchase a property which was used to earn rental income. As the expenses incurred in discharging the mortgage, that is the payment to the mortgage insurer, relate to a property used to produce assessable income, they are deductible expenses under section 25-30 of ITAA 1997.

Deductibility of payments as guarantor

Section 8-1 of the ITAA 1997 allows a deduction for a loss or outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature.

Taxation Ruling TR 96/23 discusses the deductibility of payments made under guarantee. The ruling states that liabilities arising under contracts of guarantee will not be deductible under section 8-1 of the ITAA 1997 if the provision of guarantees is not a regular and normal incident of the taxpayer's income earning activities. The ruling further states that if payments under the guarantee are not deductible under section 8-1 of the ITAA 1997, any payments made under the guarantee are capital in nature.

In your case, you provided a guarantee for Entity X's business loan and commercial lease. When Entity X went into liquidation, you were required to make payments to the bank and landlord under the guarantees. The purpose of the payments was not to directly produce your assessable income but to fulfil your commitment as a guarantor.

As you are not in the business of providing guarantees and the purpose of the action was not to produce any assessable income for yourself, you are not entitled to claim a deduction for these expenses under section 8-1 of the ITAA 1997.

Guarantor payments - capital gains tax provisions

Under section 102-20 of ITAA 1997 you make a capital gain or loss as a result of a capital gains tax (CGT) event.

CGT events are the different types of transactions or events involving a CGT asset.

A CGT asset is:

• any kind of property; or

• a legal or equitable right that is not property.

A debt owed to you is a CGT asset as it is a legal or equitable right that is not property.

When a guarantor repays a debt under guarantee to a primary creditor (such as a financial institution), the guarantor acquires a CGT asset, namely, the debt owed to the guarantor by the debtor (such as a company). If the debtor (company) cannot repay the debt, the guarantor will make a capital loss under section 104-25 of the ITAA 1997 (CGT event C2) due to the cancellation of the debt in the event of the company being wound up.

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).

As Entity X has been wound up, it cannot be said that the company will pay the outstanding debt to you. As the debt is irrecoverable, it is considered that a CGT C2 event has occurred for you. Therefore you are entitled to a capital loss.

Please note that a capital loss can only be used to reduce a capital gain in the same year or if there are no capital gains in that year, they may be used in a future year.

Pre-insolvency consultant fees

You engaged a consultant to negotiate settlements with the bank and landlord regarding Entity X's debts and lease obligations as part of your efforts to avoid personal bankruptcy.

As stated above, a deduction is allowable where it relates to the gaining or producing of assessable income. However, bankruptcy related expenses are not considered to be incurred in earning assessable income. Although the non-payment of a liability arising from an income earning activity may eventually lead to bankruptcy, the bankruptcy expenses are being incurred in relation to a matter that is one step removed from the income earning process. Bankruptcy expenses are considered to be too remote to be incurred in the course of earning assessable income.

Bankruptcy is a matter related to an individual's personal financial position and is subsequently considered to be inherently private in nature. Expenses incurred to avoid bankruptcy are expenses of a capital nature as they are incurred in order to gain an enduring benefit, that being, the avoidance of bankruptcy.

For the reasons discussed above, it is considered that the fees you incurred in engaging a consultant to negotiate settlements in an effort to avoid personal bankruptcy are not deductible under section 8-1 of the ITAA 1997.

As stated above, you make a capital gain or loss in respect of a CGT event involving a CGT asset.

The consultant fee you incurred is not a CGT asset as it is not a kind of property or a legal or equitable right.

Therefore, by incurring the fees you have not made a capital loss for the purposes of the income tax legislation.

You cannot claim the consultant fees as a deduction or a capital loss for the reasons discussed above.