Private ruling: Loss as indemnifier
Date of advice: 15 April 2021
Published: June 2021
Ruling period: Year ending 30 June 2021 | Year ending 30 June 2022
Date scheme commenced: 1 July 2020

Ruling: Q1: Are you entitled to a deduction for the loss incurred as indemnifier? | A1: No. | Q2: Does a CGT event and capital loss occur in the relation to the amount incurred as indemnifier? | A2: Yes. | Q3: Does the CGT event and capital loss occur in the 2021-22 income year after the final payment is made? | A3: Yes.


Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Section 103-15. | Income Tax Assessment Act 1997 Section 104-25. | Income Tax Assessment Act 1997 Section 108-5.

Reasons for decision: Detailed Reasoning - Allowable deductions: Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing 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. Directors of 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. Although TR 96/23 discusses guarantees, the principles are relevant in your situation. In your case, you were party to a deed of indemnity for a warranty insurance that was issued to the company. Pursuant to the Deed, you agreed to unconditionally and irrevocably indemnify the insurance company against any losses and liabilities incurred by the insurance company in relation to works covered by policies of warranty insurance issued to the company. The company was placed under external administration. You have subsequently paid money as an indemnifier. The purpose of your action was not to directly produce any assessable income for yourself, but to fulfil your commitment as indemnifier. You were not in the business of entering into contracts of indemnity. It is not considered that the provision of indemnities was undertaken by you as a regular and normal incident of your income earning activities. It is acknowledged that you paid the expenses of the company. However, such expenses do not sufficiently relate to your income earning activities. Furthermore, the expense is capital in nature. The expenses more directly belong to the company. That is the expenses belong to the company and you paid the expenditure on behalf of the company. Therefore, a deduction for paying the company's debt will not be allowable under section 8-1 of the ITAA 1997 as it relates to the company's affairs and not your assessable income. | Detailed Reasoning - 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 ITAA 1997 (CGT event C2). That is, on entering into a contract or deed of indemnity, an indemnifier acquires a CGT asset which is a right to be indemnified by the principal debtor. The indemnifier is taken to have acquired this right for a cost base equal to the amount the indemnifier pays, or is required to pay, under the contract of indemnity. The indemnifier acquires the right of indemnity at the time of making the contract. When a creditor's debt is paid in full, the indemnifier's right of subrogation is created that is, the right to stand in place of the creditor and be subrogated to the creditor's remedies against the principal debtor. The right of subrogation does not arise in all cases for example, when the creditor's debt is not paid out in full. When the indemnifier makes payment in full to the creditor under a contract, the indemnifier's right of subrogation exists. That is, the indemnifier has an enforceable debt against the principal debtor. The amount paid under the deed or contract remains the relevant cost base of the asset. It is considered that the part payment of the debt does not bring about a part disposal of the debt and that the debt is only disposed of when it is discharged by payment in full (or by release). The asset will be disposed of when either the debt is extinguished by payment (discharged) or by release or partly by one means and partly by the other. In your case, when payment in full is made under the deed of indemnity with the insurance company, your right of indemnity will become an enforceable debt against the company. This enforceable debt is a CGT asset within section 108-5 of the ITAA 1997 and the amount you pay under the deed is the first element of the cost base of this asset for the purposes of subsection 110-25(2) of the ITAA 1997. 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 of a company will also constitute a release and disposal. Liquidation of the company 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, the company's debt to you will be 'abandoned, surrendered or forfeited' for the purposes of paragraph 104-25(1)(d) of the ITAA 1997and CGT event C2 in section 104-25 of the ITAA 1997 will happen. If no capital proceeds are received for the purposes of subsection 104-25(3) of the ITAA 1997 before the company is deregistered you will make a capital loss when the company is deregistered. As such when the full amount owed to the insurance company has been paid by you in satisfaction of your obligations as indemnifier, your rights of subrogation against the company can be enforced. As the company is deregistered in accordance with the Corporations Law you will not receive any capital proceeds from them, and thus you will be eligible to claim a capital loss for the amount you have paid in full satisfaction of the indemnity to the insurance company at the time of final payment. Please note that a capital loss can only be used to reduce a capital gain in the same year or if there are no capital gains in that year, they may be used in a future year.

Relevant facts: You were one of two directors of the company that is now deregistered. | On or around xxxx you became party to a deed of indemnity, where you agreed, amongst other things, to unconditionally and irrevocably indemnify the insurance company against any losses and liabilities incurred by the Insurance Company in relation to works covered by policies of warranty insurance issued to the company. | In or around xxxx, the company was placed under external administration. Subsequently, a number of claimants sought indemnity under the relevant warranty insurance policies for losses arising, due to the insolvency of the company. | The insurance company incurred losses of $xxxx as a result of assessing the claims and indemnifying the relevant claimants. | Without any admission as to liability, the insurance company and you have agreed to compromise your liability as indemnifier for $xxxx, paid in instalments over xx months. | Under the terms of settlement made in xxxx, the initial payment of $xxxx was made by xxxx, then the xx consecutive monthly instalments of $xxxx was first payable by xxxx and the last by xxxx. You have stuck to the schedule to this point. | As a result of the deed and settlement, the insurance company agrees to not pursue you in respect of the existing claims and any other potential and/or future claims it may have under the original deed of indemnity. | The other director was also a party and signatory to the indemnity deed. | Entity A was the managing director for the company and managed the projects and the day to day operations of the company. You only had input predominately in relation to the company's growth. | You expected to receive income, profits or capital gains from the company. You received $xxxx salary and wages from the company in the xxxx income year. | You were not related to the Insurance Company at all. A decision was made internally by the directors at conception of the company to use the Insurance Company | You have not been party to any other indemnity deeds.