Edited version of private advice

Authorisation Number: 1052032319561

Date of advice: 14 September 2022

Ruling

Subject: Am I in business - money lending

Question

Can the relevant loans be deducted as a bad debt under paragraph 25-35(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No. It is not considered that you are in the business of money lending. Paragraph 25-35(1)(b) of the ITAA 1997 is not satisfied and therefore you cannot deduct the relevant loans under this provision.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

K is director and shareholder of K Pty Ltd as trustee for K Trust (the trust/you). You undertake business principally in providing building consultancy and management services.

In the financial year ending 30 June 20XX, you made X separate loans (the relevant loans) to Borrower Pty Ltd (Borrower) and its directors, A and B. These loans were still in existence and present on your balance sheet at 30 June 20XX.

The relevant loans were made to assist in financing a construction venture to build homes, and to make a return on investment by way of interest income.

A and B were acquaintances of K via general networking in the industry, however K had no prior dealings with A and B. A and B approached K for the lending of money. A and B told K about their venture, and initially wanted to bring K on as an investor and issue shares to K in exchange for their funds. K only wished to have a debt interest due to the risk factor.

All loans were secured against real property.

The agreement between you and Borrower provided that, should Borrower default on its loan, the build contracts under the venture would be assigned to a related entity of K's. Borrower defaulted on its loan and the assignments did occur, however many of the homes were undervalued by Borrower, resulting in losses being made on many of the contracts. Shortly after the assignments occurred, legal costs were incurred in addition to staff redundancies and payouts, which reduced much of the remaining profit from the assignments.

Borrower went into liquidation in the 20XX financial year. You incurred legal costs in dealing with the liquidator, and a settlement was reached whereby you were required to pay an amount to Borrower (in liquidation). B was bankrupted in the 20XX financial year; A was bankrupted in the 20XX financial year.

You made demands for repayment to A and B in order to recover the debts. Legal actions were taken at various points against Borrower, A and B, their spouses and Borrower's accountant. Legal work commenced to take action against A and B, however given they were already bankrupted, this action was eventually dropped so as to not incur further legal costs on an unlikely outcome. Legal work commenced to take action against Borrower's accountant, however this was not pursued further so as to not incur further legal costs on a likely unsuccessful outcome; or, if successful, the amount of money would have been negligible.

Legal actions were taken against the spouses of A and B to recover net proceeds from the sale of X secured properties in the 20XX financial year. Amounts were recovered from the net proceeds of these sales, however legal fees for these actions absorbed most of the recovered amounts. You have supplied various pieces of documentation substantiating these actions taken to recover the amounts, along with other pieces of relevant documentation such as financial statements.

You wrote off the relevant loans as bad in the 20XX financial year. No amounts of principal or interest were ever repaid to you in respect of the relevant loans. No dividend was received by you from the liquidation of Borrower.

You have previously made loans to unrelated parties, sometimes through other entities; for example, your related entity made a loan to an unrelated party in 20XX. You advised us that there was no formal documentation for this loan.

You have not previously charged interest on loans made in the course of your money lending activities. Apart from interest charged on Division 7A loans, no amount of interest income reported in your financial statements or tax returns relate to loans made by you.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 25-35

Income Tax Assessment Act 1997 paragraph 25-35(1)(b)

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Section 25-35 of the ITAA 1997 provides that you can deduct a debt (or part of a debt) that you write off as bad in the income year if:

(a)  it was included in your assessable income for the income year or for an earlier income year; or

(b)  it is in respect of money that you lent in the ordinary course of your business of lending money.

Section 995-1 of the ITAA 1997 defines 'business' as including any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

Bad debts

Paragraph 3 of Taxation Ruling TR 92/18 Income tax: bad debts provides that the question of whether a debt is bad is a matter of judgment having regard to all the relevant facts. Generally, provided a bona fide commercial decision is taken by a taxpayer as to the likelihood of non-recovery of a debt, it will be accepted that the debt is bad. The debt, however, must not be merely doubtful.

Paragraphs 31 to 33 of TR 92/18 provide circumstances in which a debt may be considered to have become bad. These include circumstances where the debtor has become bankrupt; where, if the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the debt; and where a taxpayer has taken the appropriate steps to attempt to recover the debt.

In your case, records show that the borrowers, being individual and corporate entities, were bankrupted and liquidated respectively after taking on the debts. You provided documentation that shows that appropriate steps were taken to attempt to recover the debts, including various legal actions, and some amounts were recovered through the sales of secured real property. It is accepted that in your case, the relevant loans went bad.

Carrying on a business

Whether an entity is carrying on a business is a question of fact, depending on the circumstances of the particular case. As noted in the Federal Court decision in Evans v. Federal Commissioner of Taxation 89 ATC 4540; (1989) 20 ATR 922, no single indicator is decisive. Whether a business is being carried on is based on the overall impression gained after looking at the activity as a whole and the intention of the taxpayer undertaking it.

Common law has identified a number of indicators that are relevant in determining whether a taxpayer's activities constitute the carrying on of a business. These indicators are discussed in Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production?

Although TR 97/11 discusses primary production businesses, the principles and indicators can be applied to non-primary production activity.

Paragraph 12 of TR 97/11 provides that, whilst each case might turn on its own particular facts, the determination of the question is generally the result of a process of weighing all the relevant indicators. Therefore, although it is not possible to lay down any conclusive test of whether a business ... is or is not being carried on, the indicators outlined ... provide general guidance.

Per paragraphs 13 and 18 of TR 97/11, the courts have held that the following indicators are relevant in determining if a business is being carried on:

•         whether the activity has a significant commercial purpose or character;

•         whether the taxpayer has more than just an intention to engage in business;

•         whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity;

•         whether there is repetition and regularity of the activity;

•         whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business;

•         whether the activity is planned, organised and carried on in a businesslike manner, such that it is directed at making a profit;

•         the size, scale and permanency of the activity;

•         whether the activity is better described as a hobby, a form of recreation or a sporting activity.

Carrying on a business as a moneylender

It is accepted that your main business activities are building consultancy and management services; however, the relevant question is whether or not you carried on a money lending business as well.

Per paragraph 43 of TR 92/18, the question of whether a taxpayer is carrying on the business of lending money is necessarily a question of fact. However, the following passage of Bowen CJ in F.C. of T. v. Marshall and Brougham Pty Ltd 17 FCR 541, 87 ATC 4522, 18 ATR 859 at ATC p. 4528, ATR p. 866 provides some useful general guidelines on determining whether a taxpayer is a moneylender:

'It is generally accepted that in order to be regarded as carrying on a business one must demonstrate continuity and system in one's dealings. In the case of money lending it has been said that a person must hold himself out as willing to lend money generally to all and sundry (subject to credit-worthiness): see Litchfield v. Dreyfus [1906] 1 KB 584. It is not decisive whether the lender is a registered money-lender or not, although this will be a factor to take into account. It should be mentioned that it need not be the only business or the principal business of the taxpayer. It will be insufficient, however, if it is merely ancillary or incidental to the primary business. In the end, it will be a question of fact for the court to decide by looking at all the circumstances involved: see Newton v. Pyke (1908) 25 TLR 127.'

Additionally, paragraph 46 of TR 92/18 provides that a money lender need not necessarily be ready and willing to lend moneys to the public at large or to a wide class of borrowers. It would be sufficient if the taxpayer lends moneys to certain classes of borrowers provided the taxpayer does so in a businesslike manner with a view to yielding a profit from it.

Application to your circumstances

In this case it must be considered whether your activity of money lending is of the same kind and carried on in a similar way to that of the ordinary trade, amongst consideration of other indicators discussed in TR 97/11.

Paragraph 63 of TR 97/11 provides that an activity is more likely to be a business when it is carried on in a manner similar to that in which other participants in the same industry carry on their activities. Lord Clyde in IR Commissioners v. Livingston at TC 542 said that:

'... the test, which must be used to determine whether a venture... is, or is not, "in the nature of trade", is whether the operations involved in it are of the same kind, and carried on in the same way, as those which are characteristic of ordinary trading in the line of business in which the venture was made.'

Paragraph 29 of TR 97/11 states that a way of establishing that there is a significant commercial purpose or character is to compare the activities with those of a taxpayer who is carrying on a similar activity that is a business.

Per paragraph 47 of TR 97/11, prospect of profit is considered a very important factor in determining whether a business is being carried on. In Hope at CLR 8-9; ATC 4390; ATR 236, Mason J indicated that the carrying on of a business is usually such that the activities are:

'... engaged in for the purpose of profit on a continuous and repetitive basis.'

Per paragraph 68 of TR 97/11, in Newton v. Pyke the court suggested that business should be conducted systematically. A business is characteristically carried on in a systematic and organised manner rather than on an ad hoc basis. An activity should generally conform with ordinary commercial principles to amount to the carrying on of a business.

You advised that, apart from the relevant loans, you have never charged interest on loans you have previously made in the course of your money lending activities. This is inconsistent with how activity of the same kind is carried on by other participants in the same industry. It is not considered that your money lending activity is carried on in a similar way to that of the ordinary trade.

It is not enough that you had intention to make a profit with respect to the relevant loans, as you have been unable to demonstrate that your money lending activity historically has been carried out in a businesslike manner with prospect of profit, or in a similar manner to that of the ordinary trade, given that no interest has ever been charged on any loan made prior to the relevant loans.

You provided balance sheets disclosing other loans have been made previously, however you have not demonstrated a degree of system, continuity and repetition. You may have demonstrated significant size and scale in terms of the amounts of some of the loans you have made; however, to have not charged interest on such other loans (notwithstanding that the relevant loans referred to in your ruling application would have had interest charged, had the loans not gone bad) does not demonstrate that your money lending activity is carried on in a similar way to that of the ordinary trade, whether presently or historically.

Although money was lent in the course of your business and there was a perceived benefit that was likely to flow from the relevant loans in the form of interest income before the relevant loans went bad, you were not carrying on a moneylending business. We consider that you did not carry on a business of money lending, and therefore the requirement in paragraph 25-35(1)(b) of the ITAA 1997 is not satisfied. Accordingly, you cannot claim a deduction under section 25-35 of the ITAA 1997 for the relevant loans.