Edited version of private advice

Authorisation Number: 1052228046019

Date of advice: 21 June 2024

Ruling

Subject: CGT losses - personal guarantee

Question 1

Can you claim a capital loss for an amount you paid under a personal guarantee on a business loan for a company that went into liquidation and has since been deregistered?

Answer

Yes.

Question 2

Do the annual interest payments on the loan you took out to honour the personal guarantee and repay the company debt from part of the capital loss against which you can offset future capital profits, or is the interest deductible against your assessable income in each year it is incurred?

Answer

No.

Question 3

Can the amounts paid to the company to ensure the business remained solvent be treated as part of the capital loss?

Answer

Yes.

Question 4

Can amounts paid directly to the company's directors/shareholders loan accounts be treated as a capital loss when the company was deregistered?

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The company

The company was a primary production business.

The farm was growing approximately X ton of produce a week.

You purchased the business as an ongoing entity and took out loans to finance the purchase in the company name.

As part of the financing arrangement, you were required to give a personal guarantee to the bank to honour the

debt in the event of the company defaulting.

Your connection to the company

From the commencement of operations, you were an employee of the company in the role of general manager.

You are also a shareholder of the company.

You received wages from the company and were eligible for the payment of dividends.

Company history

During the operation of the business after approximately X years of trading, a disease was identified in the growing rooms. The disease decreased productivity and the business was operating at a loss. This necessitated the injection of funds by yourself and other shareholders to pay the operational expenses while you endeavoured to

eradicate the disease and get production back to profitable levels. Despite the best endeavours and seeking the advice of world experts, production levels did not increase.

You and others were again asked to inject further funds into the company while you continued attempts to rid the farm of the disease.

After a number of years, the efforts to eradicate the disease were not successful and it was decided to have the company placed into liquidation and a liquidator was appointed.

The liquidator operated the business for a period of time, but it was decided they could not turn the business around or sell it as a going concern. Consequently, it was decided to cease business operations.

At this point all the assets of the business were sold and proceeds used to partly pay down the loan with the bank. After the liquidator disposed of all the company assets there was still a sizeable loan outstanding. It is this loan that you were called upon to pay, under the personal guarantee.

You took out a personal loan to extinguish the company loan.

The company was subsequently deregistered.

Details of the loan

You provided loan documents which detailed the following:

Finance details are as follows:

o   Business Options Overdraft.

o   A Bank Bill Business Loan with Options Redraw.

o   A second Bank Bill Business Loan with Options Redraw for another amount.

Security for the loan:

o   A Limited Guarantee from Person A.

o   A Limited Guarantee from You - supported by mortgage over a residential property.

o   A Limited Guarantee from Person B - supported by mortgage over a residential property.

o   Mortgage from the Company over real property.

o   Fixed and floating Mortgage Charge from the Company over all assets and uncalled capital.

The purpose of the loan

The purpose of the loan was to purchase an existing operating business, a commercial farm trading as the Company.

Funding and period of the loan

The funding took the form of two Bank Bill Business loans. The loan did not have a fixed term.

Parties to the loan

The loan was taken out in the name of the Company. The Bank held a charge over the assets of the company with the three shareholders providing personal guarantees for the loan in the event of default. The Bank also held mortgages over the residential properties of two of the shareholders.

Guarantee amount

The guarantee was for the balance of the loan together with any interest accruing. The shareholders were jointly and severally liable.

Who provided guarantee

The persons providing the guarantee were the shareholders, namely Person A, Person B and Yourself.

Details around the finalisation of loan obligations upon the activation of the guarantee

Repayment of the outstanding loan amount was made jointly by the guarantors. You paid half of the amount.

The loan obligations were extinguished after the Bank exercised their rights under the guarantee and alternate funding was obtained by the shareholders to pay out the company debt.

In a letter the Bank stated the Guarantee given by yourself in respect of money owed to the bank by the customer, the Company, was now released.

These payments of $XXX,000 were made against the business loan with the Bank in the company name.

The total of the amounts paid to the business loans and overdraft in the name of the company plus the $XXX,000 under the personal guarantee bring the total amount contributed by you to $XXX,XXX.

Funds contributed by you were credited to the shareholders loan account held in your name on the books of the Company and funds contributed by the other director were credited to the shareholders loan account in their name held in the books of the company.

These funds were paid into the trading chequing account in the name of the Company held with the Bank.

Evidence of these loan accounts showing contributions of $XX,000 has also been provided. These amounts were contributed prior to X 20XX when you injured yourself and stepped out of your role as farm manager. You were no longer involved in the daily operation of the business.

The other director also contributed an additional $XX,000 and this is reflected in the loan account general Ledger detail provided.

No monies were paid directly to the Company after the company was deregistered as the company had ceased to exist as an entity on XX X 20XX.

Funds were contributed to the company in amounts of $XX,000 by each of the shareholders over a period of time and these amounts were credited to the loan account of each shareholder/director. These amounts represent part of the balance shown in the loan account for which information has previously been provided in the form of General Ledger (detail) from the company accounting records.

After the company was deregistered the obligations under the guarantee came into operation so the former directors commenced discussions with the Bank about organising a refinance proposal to pay out the loans taken out when we purchased the business.

Discussions took place with the Bank about refinancing the existing debt of the Company as they held security over both of the director's residences. You had, as part of the borrowings signed personal guarantees for the borrowings taken out to finance the business. The Bank were reluctant to provide any refinancing options to the other director or yourself, but they were never prepared to explain why. This process was very drawn out.

As the debt was continuing to mount, we commenced making contributions towards reducing the debt or at least stop it from growing any further and it is these amounts which commenced on XX X 20XX, after the company was deregistered. The repayments we made to the Bank under the Guarantee obligations prior to refinancing totalled $XXX,XXX each.

The loans were eventually refinanced with a Bank in X 20XX and these funds were used to extinguish the existing loan to the previous bank.

The critical date for treatment of the flow of funds, and their appropriate treatment, is XX X 20XX, the date of deregistration of the Company.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 section 103-15

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 110-25

Income Tax Assessment Act 1997 section 110-55

Income Tax Assessment Act 1997 section 116-20

Corporations Act 2001 subsection 601AD(1)

Reasons for decision

Question 1

Capital gains tax provisions

When an indemnifier repays a debt under a deed of indemnity to a primary creditor (such as a financial institution or insurance company), the indemnifier acquires a CGT asset, namely, the debt owed to the indemnifier by the debtor (such as a company). If the debtor (company) cannot repay the debt, the indemnifier will make a capital loss under section 104-25 of the Income Tax Assessment Act 1997 (ITAA 1997) (CGT event C2).

Once payment has been made under the deed, the asset can be disposed of in the following ways in terms of subsection 104-25(1) of the ITAA 1997 and a capital loss may arise:

•         There may be no likelihood of payment by the principal debtor - some action must be taken in terms of subsection 104-25(1) in order to dispose of the debt.

•         The debt is forgiven at law (or in equity); a formal deed of forgiveness is required in this situation.

•         The principal debtor could be discharged from bankruptcy (in the case of an individual); similarly the liquidation and deregistration of a company will also constitute a release and disposal.

Liquidation of the company alone is not enough to end your rights in one of the ways contemplated by subsection 104-25(1) of the ITAA 1997. When the company is deregistered in accordance with the Corporations Law it will cease to exist and the company's debt to you will be "released, discharged, or satisfied" for the purposes of paragraph 104-25(1)(d) of the ITAA 1997. At this time CGT event C2 in section 104-25 of the ITAA 1997 will happen.

As such when the full amount owed to the Bank was paid by you in satisfaction of your obligations as indemnifier, your rights of subrogation against the Company could be enforced. At this time, you acquired a CGT asset. Its cost base is the amount you paid to satisfy the obligations of the Company.

Please note that capital losses can only be used to reduce a capital gain in the same year. If there are no capital gains in that year, the losses may be carried forward to reduce capital gains in future years.

Question 2

Allowable deductions for interest

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

A number of significant court decisions have determined that for an expense to be an allowable deduction:

•         it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense (Lunney v. FC of T; (1958) 100 CLR 478),

•         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), and

•         it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income (Charles Moore Co (WA) Pty Ltd v. FC of T, (1956) 95 CLR 344; FC of T v. Hatchett, 71 ATC 4184).

Taxation Ruling TR 96/23 Income tax: capital gains: implications of a guarantee to pay a debt 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 and the losses or outgoings under the guarantees are not regular and normal incidents of the taxpayer's income earning activities. The ruling further states that if the provision of guarantees is not a regular and normal incident of the taxpayer's income earning activities, any payments made under those guarantees will be capital in nature.

Directorsof a company would not ordinarily be expected to guarantee a business's debts. Debts are normally incurred by a business in relation to their operations and, thus, the earning of the business's assessable income. As highlighted in FCT v. Munro (1926) 38 CLR 153, a loss or outgoing will not be deductible if it is incurred in gaining or producing the assessable income of an entity other than the one who incurs it. That is, where expenses are incurred by the company and paid for by a director or someone else, a deduction is not allowable to the director or that other person.

In your case

A business finance agreement was loaned to the Company. As part of the agreement you agreed unconditionally to offer a personal guarantee to the Bank in the event the loan could not be repaid by the Company.

The Company was placed under external administration. You have subsequently paid money to the Bank as a guarantor in satisfaction of the loan owed by the Company.

The purpose of your action was not to directly produce any assessable income for yourself, but to fulfil your commitment under the guarantee. You were not in the business of entering into contracts of guarantor. It is not considered that the provision of the guarantee was undertaken by you as a regular and normal incident of your income earning activities.

It is acknowledged that the interest you incurred arose from paying the expenses of the company. However, such expenses do not sufficiently relate to your income earning activities. The interest was incurred paying expenses which belong to the company and you paid the expenditure on behalf of the company. Therefore, a deduction for interest incurred on loans to pay the company's debt will not be allowable under section 8-1 of the ITAA 1997 as it is incurred in the course of earning the assessable income of the company, rather than your assessable income. Furthermore, the expense is capital in nature.

Capital gains tax - Interest

The general capital gains tax (CGT) provisions are set out in Parts 3-1 and 3-3 of the ITAA 1997.

Under the CGT provisions a taxpayer will make a capital gain or loss only if a CGT event happens to a CGT asset.

Section 108-5 of the ITAA 1997 provides that a CGT asset is any kind of property, or a legal or equitable right that is not property. The notes to section 108-5 of the ITAA 1997 state that a debt owed to a taxpayer and a right to enforce a contractual obligation are both viewed as being CGT assets.

Section 102-20 of the ITAA 1997 states that a capital gain or capital loss is made only if a CGT event happens to a CGT asset. The gain or loss is made at the time of the CGT event.

Section 104-25 of the ITAA 1997 provides that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset being redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered, forfeited or expiring.

The time of the CGT event C2 is when you enter into the contract that results in the asset ending; or if there is no contract - when the asset ends. You make a capital loss when a CGT event C2 occurs if the capital proceeds are less than the CGT asset's reduced cost base. In your case this will be taken to be the date of deregistration of the Company as there was no prospect of recovering the money under the guarantee at this time.

Subsection 110-55(2) of the ITAA 1997 states that all of the elements of a reduced cost base will be the same as those for a cost base, with the exception of the third element.

Elements of the reduced cost base

The reduced cost base of a CGT asset has the same five elements as the cost base, except for the third element:

•         money or property given for the asset

•         incidental costs of acquiring the CGT asset or that relate to the CGT event

•         balancing adjustment amount (any amount that is assessable because of a balancing adjustment for the asset or that would be assessable if certain balancing adjustment relief were not available)

•         capital costs to increase or preserve the value of your asset or to install or move it

•         capital costs of preserving or defending your title or rights to your asset.

Third element: costs of ownership

Under subsection 110-25(4) of the ITAA 1997, costs of ownership of a CGT asset include, but are not limited to;

•         interest on money borrowed to acquire the asset or to refinance such a borrowing,

•         interest on money borrowed to finance capital improvements to the asset,

•         repairs and maintenance,

•         insurance premiums, and rates and land tax.

Application to your circumstances

Interest on the loan taken out to fulfill your obligations under the personal guarantee would be included under the third element of the cost base if you had made a capital gain. As the reduced cost base of a CGT asset does not include the third element, this interest expense is not included in your reduced cost base to increase your overall capital loss. Any loss claimed under the C2 event is limited to the amount you have paid in full satisfaction of the indemnity to the Bank at the time of final payment.

Question 3

A capital gains tax (CGT) asset is defined as any kind of property, or a legal or equitable right that is not property - subsection 108-5(1). Examples of CGT assets include land and buildings; shares in a company and units in a unit trust; options; debts owed to you; a right to enforce a contractual obligation; and foreign currency.

Taxation Ruling TR 96/23 considers the CGT implications of a guarantee to pay a debt.

On payment by the guarantor, the right of indemnity becomes an enforceable debt against the principal debtor. Because the right of indemnity on payment by the guarantor is a CGT asset, it may give rise to a capital loss if it is disposed of for no consideration, or it may be a 'personal-use asset' as defined in subsection 108-20(2) of the ITAA 1997 so that a capital loss does not arise on its disposal.

Paragraph 47 of Taxation Ruling TR 96/23 states 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 that of gaining or producing income or in the carrying on of a business. Therefore, if the debt which came to be owed, as a consequence of entering the contract of guarantee, was expected to promote and enhance the income earning activity of the guarantor, or came to be owed in the carrying on of a business, the debt would not be a personal-use asset and a capital loss would be allowed.

The deregistration of a company has the effect that the company ceases to exist on deregistration (subsection 601AD(1) of the Corporations Act 2001). At that time, its debts, if any, are abandoned, surrendered or forfeited for the purposes of section 104-25 of the ITAA 1997, and CGT event C2 will happen.

Subsection 116-30(2) of the ITAA 1997 provides that the capital proceeds from a CGT event are replaced with the market value of the asset for CGT event C2, if those proceeds are more or less than the market value. In your case you did not receive any capital proceeds, however the market value of the debt at the time of the event was also nil, as the company was in liquidation and about to be deregistered.

Conclusion

The purpose of the debt was not personal but came to be owed, as a consequence of you entering the contract of guarantee, supporting the capacity of the Company in carrying on a business. Consequently, the $XXX,XXX paid directly towards the servicing the company's debts incurred up until deregistration on XX X 20XX would be taken as the additional capital loss to the $XXX,XXX highlighted under the personal guarantee as they were paid part of your overall obligation to the Bank.

As such when the full amount owed to the Bank was paid on XX X 20XX by you and other director in satisfaction of the obligations as indemnifier, your rights of subrogation against the Company could be enforced. At this time, you acquired a CGT asset. Its cost base is the amount you paid to satisfy the obligations the Company including the $XXX,XXX debt and servicing costs.

Question 4

Amounts previously paid to the Share/Directors Loan Account.

The amount of $XX,000 you contributed to the shareholders/director's loan account will be seen as a separate CGT asset to the amounts contributed under the loan agreement/guarantee with the Bank. It is separate paid-up capital which, is seen as not the same CGT asset as the payments made under the loan agreement, but a CGT asset in its own asset.

CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset expiring or by it being released, discharged, redeemed, cancelled, abandoned, surrendered, or forfeited, subsection 104-25(1) of the Income Tax Administration Act 1997 (ITAA 1997). The time of the event is when you enter into the contract that results in the asset ending; or if there is no contract, when the asset ends.

When a company is deregistered, it ceases to exist. At that time, its debts, if any, are abandoned, surrendered or forfeited for the purposes of section 104-25 of the ITAA 1997, and CGT event C2 will happen.

Subsection 116-30(2) of the ITAA 1997 provides that the capital proceeds from a CGT event are replaced with the market value of the asset for CGT event C2, if those proceeds are more or less than the market value. In your case you did not receive any capital proceeds, however the market value of the debt at the time of the event was also nil, as the company was in liquidation and about to be deregistered.

Your capital loss was realised on the date the company was deregistered with ASIC.