Edited version of private advice

Authorisation Number: 1051887490970

Date of advice: 5 October 2021

Ruling

Subject: Deductions

Question 1

Can you claim a tax deduction for the interest paid on the investment?

Answer

Yes.

Question 2

Can you claim a deduction for legal costs and other outgoings associated with establishing the loan?

Answer

Yes.

Question 3

Can you claim a deduction for legal costs and other outgoings associated with maintenance of the loan?

Answer

Yes.

Question 4

Can you claim a deduction for legal costs associated with recovery of the loan to ABC Pty Ltd?

Answer

No, however they will form part of the cost base in relation to the unrecoverable loan made to the borrower.

Question 5

Can you claim a deduction for legal costs and other outgoings associated with being released from the loan from DEF Pty Ltd?

Answer

Yes

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 March 20XX

Relevant facts and circumstances

In XXX 20XX, you (the lender/ investor) entered into a loan agreement with a property developer ABC Pty Ltd (the borrower).

The loan agreement stated that, you will lend the borrower $XXX,XXX on the terms that loan interest is payable at X.X% per annum, plus a fixed amount of $XX,XXX.

The purpose of the loan was to allow the borrower to secure funding to purchase XXX properties marked for urban expansion. The borrower intended to purchase the XXX existing properties to hold, until there was a demand for land and the price increased.

Pending the success of the project, the borrower was to pay the lender back initial loan in full, including interest, borrowing costs and legal costs with an additional X% share capital of the borrower, which would lead to pay a dividend once the properties were sold in future years.

To finance the investment, you entered into a separate borrowing agreement with a financial product provider, DEF Pty Ltd, to provide a short-term mortgage loan at an interest rate of XX%, rising to XX% per annum should the loan remain unpaid past the initial agreed lending period of XX months.

The initial total mortgaged amount with DEF Pty Ltd was $XXX,XXX, compromised of:

•         Initial loan: $XXX,XXX

•         Up front set up costs: $XX,XXX

•         Pre-paid interest: $XX,XXX

The upfront set-up costs included legal fees, accountant fee, mortgage management fee, broker fee, research fee and loan processing fees.

DEF Pty Ltd charged costs related to the maintenance of the loan on a monthly basis until the loan was fully paid off comprised of interest, mortgage management fee, rollover fee and mortgage extension fees.

The borrower failed in securing its ongoing finance and the development project ended.

In late XXX 20XX, you engaged a lawyer to pursue financial recovery due to the borrower failing to make the first repayment on time. This left an unpaid default of $XX,XXX. In XXX 20XX, the borrower repaid an amount of $XXX,XXX to you.

With the payment received from the borrower, you repaid DEF Pty Ltd, leaving an outstanding amount of $XXX,XXX.

You did not receive any further amount or a share certificate. Furthermore, the borrower is currently in liquidation and it is unlikely you will receive any distribution.

In XXX 20XX, the borrower was notified that they were in default of the agreement from not adhering to the original terms of the loan agreement.

You have since incurred interest changes of $XX,XXX in relation to the investment.

In relation to the release of the loan, you incurred costs including security release, loan expiry notice and legal fees.

You incurred legal fees of $XX,XXX in relation to recovering the debt from the borrower.

You have been unable to fund the remaining balance owed to DEF Pty Ltd and your sole Director, XXX XXX, guarantor of the DEF Pty Ltd mortgage paid the interest and principal from his own funds and finalised the DEF Pty Ltd mortgage loan in XXX 20XX.

Relevant legislative provisions

Income tax Assessment Act 1997 section 8-1

Income tax Assessment Act 1997 section 25-25

Income tax Assessment Act 1997 section 25-30

Income tax Assessment Act 1997 section 102-20

Income tax Assessment Act 1997 section 104-25

Reasons for decision

Section 8-1 of the Income Taxation Assessment Act 1997 (ITAA 1997), allows a deduction for all losses and outgoings to the extent that they are incurred or necessarily incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature.

A loss or outgoing need not actually produce assessable income to give rise to a deduction, so long as it would be expected to produce assessable income.

Interest

Tax Ruling 95/25: Income tax: deductions for interest under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith provides the Commissioner's view regarding the deductibility of interest expenses and outlines:

•         there must be a sufficient nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income,

•         it must have the essential character of an outgoing incurred in gaining assessable income or of an income producing expense, and

•         it is necessary to determine the connection between outgoing and the operational activities by which the taxpayer most directly gains or produces assessable income.

You can claim a deduction for interest charged on money borrowed to buy shares and other investments that you derive, or intend to derive, assessable income from.

In your case you incurred interest expenses in relation to your investment in the borrower where you intended to derive assessable income in the form of interest from on lending the borrower funds and from dividends from shares you were to receive in the borrower.

Therefore, you can claim a deduction under section 8-1 of the ITAA 1997 in relation to the interest as it was incurred with the intention to derive assessable income in the form of interest and dividends. You claim the interest expenses in the income years in which they were incurred.

Legal expenses

In determining whether a deduction for legal expenses is allowed under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. FC of Taxation (1946) 72 CLR 634; (1946) 3 AITR 436; (1946) 8 ATD 190). The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

The courts, on a number of occasions, have determined legal expenses to be an allowable deduction if the expenses arise out of the day to day income producing activities of the taxpayer (The Herald and Weekly Times Ltd v. FC of T (1932) 48 CLR 113). In this case, the taxpayer, the proprietor and publisher of an evening newspaper, claimed outgoings (for legal advice, defence costs and damages awarded) in connection with libels the newspaper had published. The Full High Court allowed the deduction since, firstly, publishing the newspaper was both the source of income and the cause of liability and, secondly, the risk of libel was a regular and almost unavoidable incident or inherent risk of publishing.

In John Fairfax & Sons Pty Ltd v. FC of T (1958-9) 101 CLR 30 Menzies J stated at page 49:

...there must, if an outgoing is going to fall within its terms, be found (i) that it was necessarily incurred in carrying on a business; and (ii) that the carrying on of the business was for the purpose of gaining assessable income. The element that I think is necessary to emphasise here is that the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations.

Loan establishment costs

Expenses incurred in establishing a loan are capital in nature as they are incurred for the purpose of securing an enduring benefit (the loan) and are therefore not deductible under section 8-1 of the ITAA 1997.

However, section 25-25 of the ITAA 1997 allows a deduction for expenditure you incur for borrowing money where the borrowed money is used by you for the purpose of producing, or intending to produce, assessable income. Where the total borrowing costs exceed $100, the claim must be apportioned over the period of the loan or five years, whichever is the lesser.

In your case you incurred legal expenses and other costs establishing the loan with the intention of deriving assessable income in the form of interest from on lending the borrower funds and from dividends from shares in the borrower. Since the term of the loan was less than one year, you can claim a deduction for these loan establishment costs under section 25-25 of the ITAA 1997 in the income year ended 30 June 20XX.

Loan maintenance costs

Expenses are an allowable deduction under section 8-1 of the ITAA 1997 if they are incurred in producing assessable income, except where they are of a capital, private or domestic nature, as explained above.

Expenses incurred in maintaining a loan, where the loan was used to invest with the intention of deriving interest and dividend income, were incurred to derive, or intending to derive, assessable income.

You have incurred expenses such as mortgage management fees, rollover fees and mortgage extension fees in relation to maintaining a loan which you on lent with the intention to earn assessable income in the form of interest from the on lending and dividends from shares you were to receive in the borrower,

Therefore, you are allowed a deduction for these expenses under section 8-1 of the ITAA 1997.

Loan recovery costs

Legal expenses incurred in recovering the debt are capital in nature as they are incurred for the purpose of securing an enduring benefit and are therefore not deductible under section 8-1 of the ITAA 1997.

As explained above, the nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature.

Given that you were attempting to recover a capital amount, being the principal remaining on loan given to the borrower, the legal expenses incurred in relation to that debt recovery are also capital and not deductible under section 8-1 of the ITAA 1997.

Section 102-20 of the ITAA 1997 explains the ways you can make a capital gain or loss. The costs that are not tax deductible under either sections 8-1, 25-25 or 25-30 of the ITAA 1997, can be capitalised to be recorded as a capital loss.

You have chosen to invest in the borrower. The investment itself is capital in nature.

CGT event C2 happens if your ownership of a capital gains tax asset (CGT) asset ends by the asset expiring or by it being released, discharged, redeemed, cancelled, abandoned, surrendered, or forfeited (subsection 104-25(1) of ITAA 1997). When the borrower is deregistered its debts are abandoned, surrendered or forfeited for the purposes of section 104-25 of the ITAA 1997. As such, CGT event C2 will occur in relation to the debt owed to you by the borrower when it is deregistered. The money you lent to the company and any capital costs not otherwise deductible, including the recovery legal fees of $XX,XXX, will form part of the cost base in calculating the capital loss from the C2 event.

Loan release costs

Expenses incurred in being released from a loan are capital in nature as they are incurred for the purpose of securing an enduring benefit and are therefore not deductible under section 8-1 of the ITAA 1997.

However, section 25-30 of the ITAA 1997 states you can deduct expenditure you incur to discharge a mortgage that you gave as security for the repayment of money that you borrowed if you used the money solely for the purpose of producing assessable income.

In your case, you undertook the opportunity to invest in the borrower with intentions to earn assessable income in the form of interest from on lending and dividends from shares in the borrower. To invest, you obtained a loan from DEF Pty Ltd to on lend to the borrower. You expected the initial loan in full, including interest, borrowing costs and legal costs repaid and to receive X% of the share capital in the borrower which would pay a dividend once the properties were sold in future years.

Therefore, you are entitled to a deduction for the costs related to being released from the debt you owed to DEF Pty Ltd under section 25-30 of the ITAA 1997.