Edited version of private advice

Authorisation Number: 1051720686429

Date of advice: 19 August 2020

Ruling

Subject: Deduction for loan

Question 1

Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for the loss on the loan to Company X?

Answer

No

Question 2

Are you entitled to a deduction under section 25-40 of the ITAA 1997 for the loss on the loan to Company X?

Answer

No

Question 3

Will you make a capital loss when the loan to Company X you provided is forgiven?

Answer

No

This ruling applies for the following period:

Year ended 30 June 2020

The scheme commences on:

1 July 2019

Relevant facts and circumstances

You are the sole director and sole shareholder of Company X.

In 20XX you engaged with an individual to lend money. The borrowing was arranged through your respective companies.

On February 20XX a short-term loan agreement was executed between Company X (Lender) and Company Y (Borrower) showing:

·         Loan amount $XXX

·         Purpose of loan for Borrower to purchase the Land or meet repayment obligations under this agreement

·         Borrower must repay loan amount by maturity date being 120 days

·         Borrower will pay to the Lender the 'Availability Fee' of X% of the loan amount by the maturity date

·         Secured by mortgage over land and personal guarantee

·         Clauses for late payments

·         Lender to register caveat over the nominated property

·         Interest will accrue at X% p.a

Minutes of Company X (resolution of sole director) dated February 20XX show that Company X will borrow from you to on lend to Company Y ("Company X Loan").

On March 20XX you transferred $XX from your Home Loan to Company Y.

On March 20XX you transferred $XX from your bank account to Company X and then to Company Y.

You provided the source of the funds on Company X's behalf because Company X did not have financial capacity. Company X had no capacity to repay you other than with repayments from Company Y.

There is no loan agreement between you and Company X. You provided that the Company X Loan had no interest payable for the three-month term, however, a X% availability fee was payable at maturity. These terms were to match the loan agreement with Company Y.

The Balance sheets as at 30 June 20XX and as at 30 June 20XX of Company X show the Company X Loan:

Company X has been in a loss position since the 20XX income year.

On June 20XX Company X commenced legal proceedings for recovery of the loan to Company Y. On June 20XX a default judgment was obtained. Following legal advice, no further action was taken, and it is not expected that the loan will be recovered.

You have not received any repayments from Company X. You have not attempted to recover the Company X Loan. You will enter a deed of release, to release Company X of the obligation to repay the Company X Loan, in the 20XX income year.

Relevant legislative provisions

Section 8-1of the Income Tax Assessment Act 1997

Section 25-40of the Income Tax Assessment Act 1997

Section 104-25 of the Income Tax Assessment Act 1997

Section 108-20 of the Income Tax Assessment Act 1997

Reasons for Decision

You have requested a ruling on whether the loss from the 'Company X Loan' is tax deductible. As well we will address whether a capital loss arises when a deed of release is executed.

Deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)

Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature.

In your case, you have lent funds to Company X, and have decided to enter a deed of release with Company X to forgive debt owing to you. The principle amount lent represents the amount of loss you seek to claim as a deduction.

Losses of loan principal are generally capital in nature

The relevant exclusion in section 8-1 of the ITAA 1997 is that the loss on the Company X Loan should not be capital or of a capital nature.

Ordinarily, a taxpayer may account for losses on loan principal on revenue account if the taxpayer is carrying on a business as a banker, financier or moneylender or in the limited categories of other cases where the loans represent trading stock of the lender. Those taxpayers who do not fall within the above categories would ordinarily account for the corpus of a loan as capital and any loss in relation to that capital asset is a loss on capital account.

In Avco Financial v. FC of T 82 ATC 4246 the court stated that:

...a loan and the repayment of a loan are generally an affair of capital. And so they are. The money lent, judged from the viewpoint of both borrower and lender, is in general capital; on the other hand, the interest payable on the money lent is generally income in the hands of the lender and a revenue outgoing in the hands of the borrower.

In the Full Federal Court decision in Sanctuary Lakes Pty Ltd v FC of T 2013 ATC 20-395, Edmonds J considered the deductibility to Sanctuary Lakes Pty Ltd of a loss on a loan to Sanctuary Lakes Residents Association Limited (SLRA) under 8-1 of the ITAA 1997 and came to the following conclusions:

Accepting for present purposes that the forgiveness of the SLRA debt occurred in the course of Lakes carrying on its business, it is, nevertheless, difficult to identify, on the evidence and the findings thereon, any relevant nexus between that business, irrespective of its scope, and the incurring of a loss by foregoing a debt to an unrelated company (SLRA was a company limited by guarantee).

But even if a relevant nexus can be identified, clearly it is a loss of capital or of a capital nature and not deductible under s 8-1.

You have not provided that you are a banker, money-lender or financier.

Isolated transaction

You have provided that the loss you made on the Company X Loan is deductible as a loss arising from carrying out a profit-making undertaking. You are providing that you had a profit-making undertaking when you lent money to Company X because at some point you could be paid a dividend if Company X returned profits.

The Commissioner's view on profits and losses from an isolated transaction are outlined in Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income and Taxation Ruling TR 92/4 Income tax: whether losses on isolated transactions are deductible respectively.

The relevant principle for whether there is a profit or loss from an isolated transaction, including as part of a 'business operation or commercial transaction' is Federal Commissioner of Taxation v Myer Emporium [1987] HCA 18. The recent ATO Decision Impact Statement following the decision in Greig v Commissioner of Taxation [2020] FCAFC 25 affirms this position.

In Greig's case, the Full Court considered whether the taxpayer, who was employed as a full-time senior executive and not otherwise carrying on a business during the relevant period, acquired the Nexus shares in a 'business operation or commercial transaction'. This is the second limb of the principle in Myer Emporium that a profit or loss from an isolated transaction will generally be on revenue account where the:

• intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain, and

• transaction was entered into, and the profit or loss was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction

Paragraph 49 of TR 92/3 provides a transaction or operation has the character of a business operation or commercial transaction if the transaction or operation would constitute the carrying on of a business except that it does not occur as part of repetitious or recurring transactions or operations. Some factors which may be relevant in considering whether an isolated transaction amounts to a business operation or commercial transaction are the following:

• the nature of the entity undertaking the operation or transaction;

• the nature and scale of other activities undertaken by the taxpayer;

• the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;

• the nature, scale and complexity of the operation or transaction;

• the manner in which the operation or transaction was entered into or carried out. This factor would include whether professional agents and advisers were used and whether the operation or transaction took place in a public market;

• the nature of any connection between the relevant taxpayer and any other party to the operation or transaction. For example, the relationship between the parties may suggest that the operation or transaction was essentially a family dealing and not business or commercial in nature;

• if the transaction involves the acquisition and disposal of property, the nature of that property;

• the timing of the transaction or the various steps in the transaction.

We do not accept that the arrangement between you and Company X would reveal a profit for you. The primary purpose for the Company X loan was not for you to earn assessable income, rather to put Company X in a position to earn assessable income. Whether or not a dividend is paid out of Company profits is not definitive and profits can be retained or if paid out as a dividend sourced out of various other profits. Even where we accept you had an intention to make a profit - the transaction was not entered into, and the loss not made, in the course of carrying out a commercial transaction.

You have provided a meeting minute that provides you will lend to Company X for Company Y. There is a lack of formal source documentation to support a commercial arrangement. No loan agreement depicting terms for the loan including obtaining security, repayment. The meeting minute does not include the terms for the Company X loan. There is no evidence of the commercial assessment made by you in lending to Company X. You were aware Company X could not finance the loan advance to Company Y, so you chose to provide the funds in your personal capacity.

There is no evidence of professional advice being sought. You are not in the business of lending money, nor have you provided evidence you possess necessary knowledge or expertise in lending money.

The reason you have incurred a loss is because you made the decision to forgive the debt. There is no evidence to support you made an assessment based on sound commercial considerations to forgive the debt. You have made no reasonable attempts to recover. Other liabilities in Company X are also notated as loans from you, with an increase in Company X's assets. You have continued to transact with Company X, despite providing it cannot repay you.

It is not considered that you are entitled to a deduction under section 8-1 of the ITAA 1997 for a loss from an isolated transaction. In any case, it is considered your loss from the Company X Loan is capital or capital in nature (Avco Financial and Sanctuary Lakes) and is therefore excluded from deductibility under paragraph 8-1(2)(a) of the ITAA 1997.

Deduction under section 25-40 of the ITAA 1997

Losses from transactions are deductible under section 25-40 of the ITAA 1997 where the gain would have been assessable under section 15-15 (which is about profit-making undertakings and plans). Section 15-15 does not apply to a profit that is assessable as ordinary income under section 6-5 or arises out of respect of the sale of property acquired on or after 20 September 1985. We note that profits from isolated transactions can be included as ordinary income under section 6-5.

The case of Antlers Pty Ltd (in liq) v. FC of T 97 ATC 4201; 35 ATR 64, although a decision about the first limb of the former section 25A of the Income Tax Assessment Act 1936, contains helpful obiter dicta as to the role of intention and purpose in section 15-15 as a successor to the second limb of section 25A. Lockhart J said in this case: FCT v. Myer Emporium Ltd (1987) 163 CLR 199 is authority for the proposition that the profit arising from an isolated commercial or business transaction will constitute income if the taxpayer's purpose or intention in entering into the transaction was to make a profit, notwithstanding that the transaction was not part of the taxpayer's daily business activities....

The taxpayer's purpose or intention is usually ascertained from an objective consideration of the circumstances of the case but his subjective purpose or intention is also of course relevant and may sometimes be the determining factor.

It is the intention of the taxpayer that is relevant for section 25A purposes; it may be gleaned not by mere declarations of intention, but also by examining all the relevant circumstances, especially the conduct of the taxpayer in order to discern or ascertain his intention or purpose.

The purpose in the case of a company is the purpose of those who direct its affairs: Whitfords Beach.

The determination of the taxpayer's purpose in acquiring the relevant property involves an analysis of his state of mind at the time of purchase and his declarations of intention. However, it is important to examine carefully, not only the taxpayer's declarations of intention, but also the objective facts, especially as they existed at the time of the purchase, in order to glean the taxpayer's purpose.

We are not considering the purpose of Company X or you as the director/shareholder of Company X in the transaction. What is important is your actual purpose for lending to Company X and whether your undertaking with Company X demonstrated a commercial nature and was carried out with the purpose of making a profit. The principal objective of your loan with Company X was to put Company X in a position to lend to Company Y. You chose not to lend to Company Y in your personal capacity rather using Company X instead. You chose to provide personal funds instead of obtaining finance or transacting with Company Y. As described above we do not consider you carried out a commercial transaction when you lent to Company X.

We cannot accept that the proposed 'availability fee' or any of the other terms as depicted in the loan agreement for the Company Y Loan automatically applied as the terms for the Company X Loan. You have not documented terms for the Company X Loan, nor attempted recovery after the maturity date nor charged interest failing repayment. You have chosen to forgive the debt to Company X because Company X is not going to recover the funds from Company Y.

The lending of money to Company X is not a profit-making undertaking or plan.

In Clowes v FC of T (1954) 10 ATD 316, Dixon J said that to enter into a contract to provide a specified sum on such terms, to pay it and then to await results cannot be described as carrying out an undertaking or plan. Similarly, the lending of money with a view to generating interest or the outlay of a sum of money to purchase an asset to be applied to income-producing purposes is not a profit-making undertaking or plan (Case W47, 89 ATC 453).

The arrangement between you and Company X does not demonstrate you were to derive a profit. A profit arising from a transaction in most cases will be a net receipt. If you had of made a 'profit' from the Company X Loan, this would have been in the form of interest income, which would form part of your assessable income as ordinary income under section 6-5 (noting exclusion under section 15-15) and not an increase in the principal loan amount. If you received a dividend from Company X it would be assessable income to you as a shareholder regardless of whether a profit-making undertaking took place.

The arrangement between you and Company X reveals no profit. Therefore, as there is no profit-making undertaking, no deduction for a loss under section 25-40 is allowable.

Capital gains tax - personal use asset

As determined above, the loss on the Company X loan is capital or capital in nature.

You can only make a capital gain or capital loss if a capital gains tax (CGT) event happens to a CGT asset (Subsection 102-20 of the Income Tax Assessment Act 1997 (ITAA 1997)).

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 provided in the notes to section 108-5 of the ITAA 1997 is a debt owed to the taxpayer. Thus, an unpaid loan would be considered to be a debt that is owing to a taxpayer.

CGT event C2 in section 104-25 of the ITAA 1997 happens if a taxpayer's ownership of an intangible CGT asset ends in certain ways, including because the asset expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited.

The time of the event is when a taxpayer enters into the contract that results in the asset ending. If there is no contract, the event happens when the asset ends (subsection 104-25(2) of the ITAA 1997).

Subsection 108-20(1) of the ITAA 1997 states that a capital loss that is made from a personal use asset, including a personal use asset that is a debt, is disregarded.

A 'personal use asset' is defined in subsection 108-20(2) of the ITAA 1997.

Paragraph 108-20(2)(d) of the ITAA 1997 provides that a 'debt' is a personal use asset unless the debt has arisen:

a)    in the course of gaining or producing the taxpayer's assessable income; or

b)    from carrying on the taxpayer's business.

Paragraph 47 of Taxation Ruling TR 96/23 provides that the test of what is a personal use asset requires a finding that the debt came to be owed for a primary purpose other than of gaining or producing income or in the carrying on of a business of the lender.

Therefore, if the debt was expected to promote and enhance the income-earning activity of the lender or came to be owed in the carrying on of the lender's business, the debt would not be a personal use asset and a capital loss would be allowed.

You did not earn any interest income from the loan and as described in above sections, you do not carry on a business of lending money and there is not a profit-making undertaking or plan. The primary purpose of the Company X Loan was to enable Company X to transact with Company Y and Company X earn assessable income. No dividends have been paid to you from Company X.

You will make a capital loss on the Company X loan when you enter the deed of release to forgive the debt. As the Company X loan was not made in earning your assessable income or carrying on a business, it is determined to be a personal use asset under paragraph 108-20(2)(d) of the ITAA 1997 and any capital loss must be disregarded by you.