Private ruling: Bad debt deduction
Published: September 2013
Ruling period: Year ended 30 June 2012
Date scheme commenced: 1 July 2011

Ruling: Q1: Are you entitled to a 'bad debt' deduction under section 25-35 of the Income Tax Assessment Act 1997 (ITAA 1997) in the financial year ended 30 June 20XX? | A1: No | Q2: Are you entitled to a 'bad debt' deduction under section 8-1 of the ITAA 1997 in the financial year ended 30 June 20XX? | A2: No

Relevant facts and circumstances: You are a company whose profit-making strategy consists of a number of diverse activities which includes loaning funds to unrelated parties (which you state started in 200X) Your strategy in relation to the loan activities is to provide a boutique service i.e. to provide funds to start-up ventures and other "high risk" ventures at rates of interest that reflect the risk profile of the venture. You provided this service as traditional lenders were unwilling to provide any credit. The loans provided to third parties had the following characteristics: · The loans related to a high risk enterprise · The interest rate or return on the funds lent were significantly higher than current market rates · Each loan agreement was individually tailored to suit both the client's needs and the level of risk as determined by the company i.e. the initial funds advanced to the borrower in loan 2 required significant provision of security, loaned over a short term with interest calculated on a monthly basis. The subsequent loan to the same borrower (loan 3) required no provision of security, there was no fixed term for the loan (although the development was expected to be completed in a relatively short space of time) but a significant payment for the use of the funds was expected (X% of the total profit of the development) to offset the generous security terms and the risk taken by the company. · The loans were provided for a relatively short period of time, (Loan 3 was for an indefinite period but it was understood that the development would be completed in a relatively short space of time). The system, which included the above characteristics, has proven profitable and produced significant assessable income in the past. You had considered other applicants for loans but after examination they were rejected as they did not fit into the established criteria. Since 200X you have made Y loans as follows: Loan 1 A loan agreement was entered into between two parties. You were not a party to the original loan agreement, however, the lender of that agreement assigned guarantees to you and another company and later assigned the loan agreement and share mortgages to you and another company. Due to the assignment you were entitled to X% of the interest of the original loan. The loan was repaid in full and the company received interest income over the life of the loan. Loan 2 In 200Y a loan was made to Company A (an unrelated party) to invest in a development opportunity. The full amount was repaid in 200X. Interest of income was received. Loan 3 The third loan, which is the subject of this private ruling, was loaned by the you to Company A in 200Y. The money was loaned at different times. An initial amount was provided and further funds of were also loaned at a later date. No formal loan agreement was drafted however hand written diary notes were written. You stated that it was agreed between the parties that: · Any interest would be deferred until the completion of the development · The interest would be calculated at Y% per annum · The profit from the development would be split 50/50; and · No security would be taken over the loan. Company A received sales income from the sale of the development but failed to realise a profit. Company A did not pay any interest or capital on the loan amount to you as there were no funds remaining to do so. Company A also had another loan with a financial institution. The proceeds from the sale of the development were firstly applied against the bank loan. When this was repaid no funds remained to pay you any interest or capital repayments. Consideration was given to allowing Company A to pay off the debt over a longer period. However, it was apparent from discussions with Company A that there were no potential future earnings or plans for such and it would be forced in insolvency should the debt be pursued. You made a commercial decision not to pursue the unsecured debt on this basis along with not wishing to incur further recovery expenses for a debt that was deemed to be uncollectable. In the 20YY financial year, you and Company A entered into a deed of agreement releasing Company A from any further payment or obligations in relation to the loan. You state that once the deed was executed, you lost any legal avenue by which you could recover the debt and at this point the debt was bad. You state that after signing the deed of release the debt was written off in the books of account for the year ended 30 June 20ZZ. A bad debt expense was recorded in your accounts. You state that you are actively looking for further lending opportunities.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 25-35 | Income Tax Assessment Act 1997 Section 8-1

Reasons for decision: Detailed Reasoning - Bad debt under section 25-35 of the ITAA 1997: Section 25-35 of the Income Tax Assessment Act 1997 (ITAA 1997) deals with bad debts. Subsection 25-35(1) of the ITAA 1997 states 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. Paragraph (a) is not relevant to you as you agreed to the deferral of interest income from the borrower until the completion of the development. You therefore did not receive any income in relation to the loan and consequently did not include any amount in your assessable income in any year. Therefore, the only avenue in which you may be able to claim a deduction for a bad debt under section 25-35 of the ITAA 1997, is if it can be determined that the money was lent in the ordinary course of a business of lending money. | Detailed Reasoning - Are you in the business of lending money?: The question whether a taxpayer is carrying on the business of lending money is a question of fact ( Newton v. Pyke (1908) 25 TLR 127). It is only necessary that the business of money lending be carried on; it need not be the only business or the principal business. It does not appear to be sufficient, however, if the lending of money is merely ancillary to or an adjunct of the business carried on by the taxpayer ( 11 CTBR Case 29 ). Also, it is not enough merely to show that a person has on several occasions lent money at remunerative rates of interest; there must be a certain degree of continuity and system about the transactions. The activity should be capable of being described as 'business operations intended to yield a profit' ( Richard Walter Pty Ltd v. FC of T 31 ATR 95; 95 ATC 4440 per Tamberlin J at p 4457) (Taxation Ruling TR 92/18, paragraphs 42-45). Ordinarily, a money lender is one who is ready and willing to lend to all and sundry. However, as stated in paragraph 46 of TR 92/18: …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. The above comments explain that to be considered to be in the business of lending money a taxpayer must be able to satisfy the following factors; · there is continuity and system about their money lending transactions · there is a willingness to lend money to the public, or at least a particular class of borrowers · the transactions are undertaken in a businesslike manner, and · the transactions are undertaken with a view to a profit Failure to satisfy a majority (or even merely one) of the factors listed above may lead to the conclusion that a taxpayer is not the business of lending money as occurred in Case M74 80 ATC 521. In that case, the taxpayer made between one and 12 loans each year from money originally derived from share sales. Some were to clients of the taxpayer's solicitor and some were "on demand" loans to companies associated with the taxpayer. The taxpayer had no standard loan application form and did not advertise. Borrowers were selected on the quality of the security and the rate of return. Unsecured loans were made if considered safe and if the interest rate was attractive. It was held that the taxpayer was merely investing its funds and was not carrying on business as a money lender. This was so despite the fact that at the time the loans were provided the taxpayer had insisted that its main function had been lending money. | Detailed Reasoning - Application to your circumstances: In your case, you have stated that you satisfy the factors deemed necessary to be considered to be in the business of lending money. You state that you have identified a niche market and have been willing to lend (or not) to particular clients based on their risk profile. You state that you have rejected a number of other lending proposals based on businesslike considerations and that it has always been your intention for the money lending activities to yield a profit. However, based on the information provided, we consider that you are not in the business of lending money. In the (approximately) X years since you have been lending money, you have made only X loans to a number of different entities. The first loan was actually an assignment of another entity's loan to you and therefore you have merely 'taken over' the loan with its current agreements and guarantees already in place. The second and third loans were made to the same entity within approximately Y months of each other. The second loan was granted under a formal loan agreement with security in the form of mortgages over certain land and a guarantee provided by the borrower. The third loan, however, had no formal loan agreement in place, nor was any security taken for the monies loaned to the entity. While it may be argued that the money lending transactions were undertaken with a view to a profit and that you at least lent monies to a particular class of borrowers (that is, high risk ventures that could not raise funds through traditional lenders), the fact remains that there does not appear to be any continuity and system about the money lending transactions, nor does it appear that the transactions were undertaken in a businesslike manner, specifically in regards to the circumstances surrounding the provision of the third loan which is the subject of this ruling. There does not appear to be any standard loan documentation that is common between the three transactions which would be expected if an entity was in the business of lending money. There also appears to be no set protocol on what, if any, security should be taken when providing loans to entities. Further, apart from the activity relating to the assignment of a loan in 200Y, you have only ever loaned money to one entity. This lack of a pattern and continuity in your activities regarding the provision of loans indicates that the transactions were undertaken in an ad-hoc rather than businesslike manner. These activities appear more like a capital investment than any sort of business activity. Accordingly, we consider that the activity is merely an investment of your funds and does not constitute money lent in the ordinary course of your business of lending money. As the written off debt is not in respect of money that you lent in the ordinary course of your business of lending money a deduction for a bad debt is not allowable under section 25-35 of the ITAA 1997. | Detailed Reasoning - Does the debt exist?: Even if we consider that you are in the business of lending money for the purposes of this section, which we do not, a bad debt deduction under section 25-35 of the ITAA 1997 would still not be allowable. Taxation Ruling TR 92/18 clarifies the circumstances in which a deduction for a bad debt will be allowable. While the ruling refers to sections of the Income Tax Assessment Act 1936 (ITAA 1936) , specifically section 63(1) and section 51(1). It is accepted that the ruling still has application to the corresponding sections in the ITAA 1997, that being section 25-35 (formerly section 63(1)) and section 8-1 (formerly section 51(1). Taxation Ruling TR 92/18, at paragraph 24, explains; Four conditions must be satisfied in order to qualify for a bad debt deduction. First , a debt must exist. Second , the debt must be bad. Third , the debt must be written off as a bad debt during the year of income in which the deduction is claimed. Fourth , the debt must have been brought to account as assessable income in any year or, in the case of a money lender, the debt must be in respect of money lent in the ordinary course of the business of lending of money by a taxpayer who carries on that business. In relation to the first condition, to be deductible the debt must be in existence at the time it is treated as a bad debt and claimed as such. A deduction will not be allowed if the taxpayer's right to the debt was in fact extinguished before the time of writing off. Thus, once a debt is settled, compromised, released or otherwise extinguished, any purported writing off will be ineffectual and a deduction will not be allowed under section 25-35 of the ITAA 1997. In Point v FC of T 70 ATC 4021, as part of a scheme of arrangement, the taxpayer released a company from a debt. The deed of release was executed in May 1964 but did not become effective until late July 1964. Some time between September 1964 and April 1965, an employee of the accountants who kept the taxpayer's books made an entry showing that the debt had been written off at 30 June 1964. The taxpayer's claim to deduct the bad debt in the year ended 30 June 1964 was rejected. Owen J held that the debt was not purportedly written off as bad until the following year, when the entry in the books was made. However, his Honour also held that the deed of release extinguished the debt and therefore the debt did not exist, and thus could not be written off, when the entry was made in the books. | Detailed Reasoning - Application to your circumstances: In your case, you determined that the debt owed from Company A was bad once the deed of release (releasing Company A from any further obligations under the loan) was executed. You then wrote off the debt as bad. Therefore, as the debt was extinguished prior to the debt being written off on the books of account, the write-off was ineffective. No debt existed to write off after the debt had been extinguished under the deed of release. As the debt no longer existed you fail to satisfy the first required condition. Accordingly, a deduction for a bad debt for monies lent to Company A, will not be an allowable deduction under section 25-35 of the ITAA 1997. | Detailed Reasoning - Bad debt under section 8-1: Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which; a) they are incurred in gaining or producing assessable income; or b) they are necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income However, you cannot deduct a loss or outgoing to the extent that the loss or outgoing is of a capital, private or domestic nature, or is incurred in relation to gaining or producing exempt income. TR 92/18, at paragraphs 10 and 11, states: Certain taxpayers who fail to satisfy the requirements under section 63 (now 25-35) may be entitled to a bad debt deduction under subsection 51(1) (now 8-1). Any business losses or outgoings of a revenue nature are an allowable deduction under subsection 51(1) when incurred. Whether or not a loss occasioned by a bad debt is of a revenue or capital nature depends upon a consideration of the facts and circumstances in each case. A loss occasioned by a bad debt is clearly incurred when the loan is disposed of, settled, compromised or otherwise extinguished. Where a debt is not disposed of, settled, compromised or otherwise extinguished, it is accepted that the loss of the debt is incurred under subsection 51(1) when it is written off as bad in the same way as in section 63. And at paragraph 67; the question of whether or not such a loss is of a revenue or capital nature depends upon a consideration of the facts and circumstances in each case. It is necessary to ascertain the circumstances which occasioned the loss and the relation that these circumstances bear to the taxpayer's income earning activities. If the loss is an ordinary incident of the taxpayer's income earning activities then the loss will be on revenue account. For example, a bad debt loss incurred by a financial institution would generally be expected to be a revenue loss. Ordinarily, a taxpayer who is carrying on a business as a banker, or moneylender or in the limited categories of other cases where loans represent the trading stock of the lender, could account for losses on loans on revenue account. 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. The issue of whether a loss is on capital or revenue account has been considered by the courts in various cases, most notably in Sun Newspapers Ltd. and Associated Newspapers Ltd. v. F.C. of T. (1938) 61 CLR 337 at p. 363, where Dixon J made the following statement: "There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment." | Detailed Reasoning - Character of the advantage sought and manner in which it is to be enjoyed: These matters are concerned with whether the expenditure may result in an enduring benefit for the taxpayer. When the words "permanent" or "enduring" are used in this connection it is not meant that the advantage which will be obtained will last forever. The distinction which is drawn is that between more or less recurrent expenses involved in running a business and an expenditure for the benefit of the business as a whole. In your case, the loan made to Company A resulted in you obtaining a new capital asset, that being a debt owed to you (section 108-5 of the ITAA 1997). While you entered into the arrangement to earn assessable income, being interest income and a share of the profit on the venture being undertaken by Company A, this does not necessarily mean that the expenditure (being the payment made to Company A) will be on revenue account. Indeed, as the arrangement in question is one of only X money lending transactions entered into over a period of years, we do not consider that the loans represent your trading stock and therefore the loans cannot represent money that was lent in the ordinary course of earning assessable income of the company. Instead, we consider that the amount you loaned constitutes a capital sum which you have employed to earn assessable income. On this basis, it can be argued then that the advantage sought was the generation of income from the utilisation of a capital asset for your benefit and the benefit of the business as a whole as excess profit made from the arrangement can be used in other areas of the business. Further, the manner in which the advantage is to be enjoyed was as income for your business. This situation is similar to that in Case U26 87 ATC 204, where Member Roach concluded that a loss on monies loaned to fund a real estate venture by an investor was a capital loss for the purposes of 51(1). The principal sum was the "profit yielding subject" which was to generate interest income in the short term and profit from sale of the developed land in the long term and as such was capital in nature. In that case, it was found that the taxpayer was not carrying on a money lending business, nor was the money lent in the ordinary course of earning their assessable income, it was merely an ad-hoc investment on the part of the taxpayer. Further, a similarity can also be drawn with that of a taxpayer, who is not in the business of share trading, but acquires capital assets such as shares. In this situation, the taxpayer has utilised the capital asset to earn assessable income through dividends. If the shares become worthless in the future and are disposed of at a loss, the taxpayer is not entitled to a deduction under section 8-1 of the ITAA 1997 as the loss is of a capital nature, and not a loss of a revenue nature, despite the fact the assets were used to earn assessable income. | Detailed Reasoning - Means adopted to obtain it: You state that you have entered into an undocumented loan agreement with Company A where you initially lent a sum of money and provided further funds under the same facility. You state that as you made a series of payments to Company A, and not just one lump sum, you consider that the payments are recurrent, indicating that the funds lent are not capital in nature. However, we do not consider that these payments provided to Company A show that regular outlays were incurred in order to obtain regular returns in the form of assessable income. The payments appear to be of a nature entirely different from the continual flow of working expenses (ie. expenditure on revenue account). Instead, the process in which you provided funds to Company A was simply a matter of agreement between yourself and Company A and merely shows that you are increasing your investment in the company, in other words, you are enlarging the 'profit-yielding subject' of your company which is a capital outlay. As it has already been established that you are not in the business of lending money, the loss cannot be incurred in carrying on a business for the purpose of gaining or producing assessable income. Further, as we do not consider that the loan to Company A represents your 'trading stock' it cannot represent money that was lent in the ordinary course of earning assessable income of the company. Therefore, the loss incurred by the extinguishment of the debt owed to you by Company A, was a loss concerning the 'profit yielding subject' of the company, a capital asset. Therefore, while there clearly is a loss (being the total amount of debt owed to you by Company A) the fact remains that the loss is of a capital nature. Accordingly, the capital investment you made to Company A is a capital outlay and therefore the loss incurred by the extinguishment of the debt is considering a capital loss. As such, no deduction for the loss occasioned by the bad debt will be allowable under section 8-1 of the ITAA 1997.