Edited version of your written advice

Authorisation Number: 1051352948730

Date of advice: 22 March 2018

Ruling

Subject: Amount paid following court ruling – deduction or capital loss

Question 1

Am I eligible to claim an income tax deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for an amount I paid the lender following the court judgment and subsequent settlement and Deed of Release?

Answer

Yes.

Question 2

Will I incur a capital loss for any part of the money I settled to pay the lender as per the Deed of Release?

Answer

No.

This ruling applies for the following period:

Year ending 30 June 2017

Relevant facts and circumstances

The following documents should be read in conjunction with and form part of the scheme of this ruling:

● Affidavits

● Judgment/Order

● Bankruptcy Notice

● Direction to Pay

● Deed of Release

As detailed in the court judgment, an acquaintance (the lender) loaned you a total sum of money to use in a development project (the project).

On receipt of the loan, you credited the funds to a bank account of your company (the company).

The lender paid the loan establishment costs and made some initial payments towards the loan.

There was no written agreement between you and the lender but the agreement was that your company would make the interest repayments on the loan and pay the lender a percentage of the profit once the project was finalised. It was estimated that the lender would have all their money paid back to them with their profit no later than a year from the date they loaned you the money.

You, a relative and the company are in a partnership (the partnership). The partnership paid the company a fee to carry out the project.

The whole amount borrowed from the lender was used in the project.

The project asset was sold. The partnership’s income for that income year was solely the proceeds of the sale of the asset.

You received a partnership distribution of the proceeds of the sale of the project asset proportionate to your ownership and included the distribution in your individual tax return for that income year.

The company continued to service the loan for a number of years and made some repayment of principal.

Some years after the company stopped servicing the loan, the lender commenced proceedings against you to recover the amounts unpaid. It was your opinion that the debt and the profit was a liability to the company which was in liquidation at the time.

The court ruled in favour of the lender who obtained judgment by default. The court did not accept that the loan was made to the company and not to you personally.

The default judgment amount is the sum of:

● the remaining principal on the loan

● pre-judgment interest

● fees relating to the default judgment

● the agreed share of profit; and

● other interest.

You were served with a bankruptcy notice requiring you to pay the lender the claimed debt amount or make arrangements to the lender’s satisfaction for settlement of the debt.

The bankruptcy notice shows that the pre-judgment interest was calculated on the amount of outstanding loan principal and the agreed share of profit.

After numerous meetings with the lender and their solicitor it was agreed that the debt would be settled with a lesser amount than the default judgment, to be paid in full by 30 June of the specified income year.

A Direction to Pay signed by the lender advised that the agreed amount was to be reduced if certain conditions were met.

You and the lender entered into a Deed of Release (the deed) agreeing to resolve your dispute concerning the payment of the judgment debt by you to the lender on the terms and conditions of the deed. The amount stated in the Deed of Release was the lesser amount referred to in the Direction to Pay (reduced only if certain conditions were met). Not all of the conditions were met.

You made a number of payments in satisfaction of the terms of the deed.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 100-45

Income Tax Assessment Act 1997 Section 108-5.

Reasons for decision

Question 1

Summary

You are eligible to claim an income tax deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) in the income year for the ruling for the amount you paid the lender following the court judgment and subsequent settlement and Deed of Release.

Detailed reasoning

The loan

As there is some inconsistency in the details of the money loaned we must accept the findings of the court; in particular that the loan was made to you personally; and that there was unpaid balance of the loan.

We acknowledge that you and the lender verbally agreed on settling this matter with a lesser amount than that set down by the court and both signed a Deed of Release regarding the agreement.

You told us that the amount that you and the lender agreed on is made up of only the profit amount and interest. However, you are unable to provide supporting evidence of how and why you settled on the reduced amount. For example, if the lender accepted that you had paid them all principal on the loan or, if they agreed to write off that part of the debt.

We therefore cannot be certain that no part of the agreed amount is unpaid loan principal. If no part of the agreed amount is unpaid loan principal then we consider your allocation of the amount owing to interest is far too high.

We have given weight to the calculations of additional pre-judgment interest and post-judgment interest in the bankruptcy notice, calculated using the unpaid balance of the loan accepted by the court.

The Deed of Release signed by you and the lender provides the strongest evidence of the amount agreed on to settle the matter. Accordingly, we are going to follow the Deed of Release.

Income tax deduction

Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income, except where the loss or outgoing is of a capital, private or domestic nature, or incurred in relation to earning exempt income.

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 (Ronpibon's case).

Taxation Ruling TR 2004/4 provides the Commissioner’s view of an outgoing incurred after the income earning activity has finished but can be traced back to that income earning activity.

Paragraph 10 and 11 of TR 2004/4 says as follows:

Interest incurred after assessable income

10. Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and relevant income earning activities (whether business or non-business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing 'the assessable income' if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period.

11. Whether or not the occasion of the outgoing of interest is to be found in what was productive of assessable income of an earlier period requires a judgment about the nexus between the outgoing and the income earning activities.

The explanation part of TR 2004/4 goes on to say that the same approach applies in testing deductibility of other outgoings (that is, that this view is not limited to interest).

Application to your circumstances

It is our assessment that the funds were contributed by you to the partnership. We accept this contribution was made for the purposes of the project and therefore that the borrowed funds were put to an income producing purpose (being the expected profit share).

The interest incurred while the project was in progress was deductible as there was a clear nexus with the gaining or production of your assessable income (being your share in the profits).

For the same reasons as explained in TR 2004/4, the occasion of the interest outgoings are to be found in the purpose to which those original borrowings were put.

That purpose was to enable the partnership to derive profits from the project and for you to share in those profits via your partnership interest. The occasion of the interest outgoings is therefore found in the gaining or producing of your assessable income from the project.

The completion of the project and sale of the project asset does not sever connection between the interest expenses and your previous income earning activity (the project).

We consider the characterisation of the share in the profit paid to the lender is the same as it is an additional amount promised in consideration for the making of the original loan (contingent upon the project being profitable). The occasion of the outgoing can again be found in the production of assessable income from the project.

Your income tax deduction

We will allow you to deduct payments you made to the lender towards the amounts attributed to the following components of the default judgment and interest calculation:

● profit on the project

● statutory interest

● pre-judgment interest

● fees relating to the default judgment; and

● post judgment interest.

In the income year for the ruling, you paid the lender in excess of the amount agreed to in the Deed of Release.

However, as you are paying a lesser amount as per the Deed of Release, this is the maximum income tax deduction we will allow you.

We accept that you made the above payments towards the profit share and interest components as set out in the default judgment.

Conclusion

You can claim an income tax deduction of up to the amount stated in the Deed of Release in your personal income tax return for the income year of the ruling.

This is the maximum amount we will accept that you had to pay the lender.

If the total deduction exceeds your assessable and net exempt income for the income year of the ruling, you can carry forward the excess but you must claim it at the first opportunity.

Other comments

Note that if we did accept it was the company that the lender loaned the money to, you would not be eligible to claim any tax deduction against your personal income in relation to the payments under the Deed of Release. In other words, no deduction would be available to you if it was the company’s debt and not your personal debt.

Question 2

Summary

You will not incur a capital loss for any part of the money you settled to pay the lender as per the Deed of Release.

Detailed reasoning

The money that the court ordered you to pay the lender (under the Deed of Release settling the amount) comprises the profit it was agreed the lender would be paid from the project, and interest.

This is a tax loss for you that you can deduct from your income as explained in the ‘Detailed reasoning’ for Question 1.

A tax loss is different from a capital loss. A capital loss occurs when you dispose of a capital gains tax asset for less than its cost base or reduced cost base.

Section 108-5 of the ITAA 1997 defines a capital gains tax asset as 'any kind of property' or 'a legal or equitable right that is not property'. This may include debts owed to you but it does not include debts you owe to another entity.

Accordingly, there is no capital deduction available to you in respect of the money you settled to pay the lender as per the Deed of Release.