Private ruling: Deductibility of Losses, Goodwill and Black-hole Expenditure
Published: March 2015
Ruling period: From 1 July 2014 to 30 June 2018
Date scheme commenced: 1 July 2013

Ruling: Q1: 1) Will the Commissioner recognize the 'Financier's loss of $X as a loss on an isolated transaction and be deductible under subsection 8-1, or any other specific provision of the Income Tax Assessment Act 1997 (ITAA 1997)? Answer: No 2) Will the Commissioner recognize that a capital loss of $X was incurred by the Financier as a result of a CGT event C2 happening? Answer: No 3) If the amount of $X is considered to be a loan, will the Commissioner recognise a loss under CGT event G3, given the voluntary liquidation of the Company? Answer: No 4) If the transaction is not deductible on revenue account, a CGT event C2 or CGT event G3, is the loss then deductible under section 40-880 of the ITAA 1997 as Black-hole expenditure? Answer: Yes

Relevant facts and circumstances: The Financier had entered into a Seed Funding agreement with an unrelated entity (the Company) in 200X, and has assisted the borrower financially by lending a total sum of $X. The amount has been paid progressively between 200X - 200Y for the purpose of establishing a manufacturing facility with the business aim of gaining sole supplier rights to provide raw material to the proposed business and thereby expanding their infrastructure and prospects of revenue growth. In 20XX the Financier learned that the Company has not commenced the project for which the funds were provided, and has been unable to make any re-payments on the sum borrowed and was subsequently de-registered on dd/mm/yyyy. The Financier has applied to the Commissioner to have its loss of $X recognised as a capital loss in the financial year ended 30 June 20XX. The relevant facts are as follows: • The Financier applicant is a private Australian company and a wholly owned subsidiary of a overseas based parent company ZZ. • The Financier has assisted the Company (an unrelated entity) with funds to further mutual business aims. • The funds were advanced based on the draft of a seed funding agreement arranged between the Financier and the Company in respect of the proposed project. • The Financier has advanced a total of $X in instalments to the Company over the 200X - 200Y period. • The Financier has made provision for the amount as a doubtful debt in the 200X - 200Z years. • The Financier has not treated the amount advanced as a bad debt or written it off. • The Financier has not executed a deed of release to discharge the Company (the borrower) from repayment. • The Financier has not given a promise under seal to forgive the Company from the obligation to repay the amount owed by the Company. • The Company's director - X had applied for voluntary deregistration of his company on dd/mm/yyyy. • The Australian Securities and Investment Commission (ASIC) published the notice of proposed deregistration (voluntary) dated dd/mm/yyyy. • The Company was deregistered by ASIC on dd/mm/yyyy. • The Financier was not informed of the Company's deregistration. • The Company's then director has advised that it did not have a 'loan or debt' to the Financier as the contingent condition of the 'Seed funding agreement ' between the two companies had not reached 'financial close' in the project, which was an essential requirement to fulfil the conditions of the loan. • The Company's director has advised that if the contingent conditions of the agreement were not fulfilled, the borrower was not required to make repayments on the borrowings. • Neither the Financier, nor the Company had shareholdings in each other • The Financier has not received any re-payment in respect of the amount of $X advanced to the Company. • The Financier was not in the business of money lending. • The Financier has made submissions in support of its application for a Private Binding Ruling. • The Company's director has confirmed that the Company did not have the capacity to repay the amount advanced by the Financier.

Relevant legislative provisions: Income Tax Assessment Act 1997: Section 8-1 | Section 40-880 | Subsection 104-25(1) | Subsection 108-5(2) | Subsection 108-20(1) | Subsection 104-25(2) | Subsection 110-25(5A) | Tax Laws Amendment (2006 Measures No.1) Act 2006

Reasons for decision: Summary: The Financier had entered into a Seed Funding agreement as 'Financier' with an unrelated entity called the 'Company' in the agreement, and has assisted the borrower by lending a total sum of $X. The amount has been advanced progressively by the Financier between 200X - 200Y for the purpose of establishing a manufacturing facility with the business aim of gaining sole supplier rights to raw material. In 20XX, the Financier learned that the borrower had voluntarily been de-registered, leaving the Financier with no prospect of recovering the sum advanced. 1) Will the Commissioner recognize the Financier's loss of $X as a loss on an isolated transaction and be deductible under subsection 8-1, or any other specific provision of the Income Tax Assessment Act 1997 (ITAA 1997)? | Detailed Reasoning - Detailed reasoning: Section 8-1 of the ITAA 1997 (corresponding section to section 51(1) of the Income Tax Assessment Act 1936) allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. However, no deduction is allowed under subsection 8-1(2) of the ITAA 1997 for expenses to the extent that they are of capital or of a capital nature, or is of a private or domestic nature. The courts have differentiated between two types of expenses when determining deductibility. The first being deductible revenue or income related expenses and secondly expenses referrable to capital account that will not qualify for deductions under section 8-1 of the ITAA 1997. The Financier has advanced funds to the Company to assist with the construction of a manufacturing facility with the ultimate aim of gaining sole supplier rights to raw material, which if successful, had the scope of considerably expanding its future business operation. The critical factor in determining the essential character of an outgoing ' is the character of the advantage sought by the making of the expenditure ' (Sun Newpapers Ltd v. FCof T (1938) 61 CLR 337 at 363 per Dixon J). At 355 per Latham J, stated that: an enduring benefit does not require that the taxpayer obtain an actual asset, it may be a benefit which endures, .….. If expenditure produces some asset or advantage of a lasting character for the benefit of the business it will be considered to be capital expenditure. This view was previously enunciated by Viscount Cave L.C. in British Insulated and Helsby Cables v. Atherton (1926) 10 T.C. 155 at 192: " … when expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such expenditure as properly attributable not to revenue but to capital." As the Financier's outgoing has been incurred with the aim of ' bringing into existence an advantage for the enduring benefit of trade ' by expanding/enhancing the profit-yielding structure of the business, the expenditure is considered to be of a capital nature and therefore no deduction is allowable in terms of section 8-1 of the ITAA 1997. Theoretically, a specific deduction provision which could have application is section 25-40 of the ITAA 1997. Section 25-40 of the ITAA 1997 provides that a loss arising from the carrying on or carrying out of a profit-making undertaking or plan is deductible, if any profit from that plan would have been included in your assessable income by section 15-15 of the ITAA 1997 (which is about profit -making undertakings and plans). However, no such profit would be included in assessable income by section 15-15 of the ITAA 1997 by virtue of subsection 15-15(2) of the ITAA 1997 which states: this section does not apply to a profit that: a) is assessable as ordinary income under section 6-5; or b) arises in respect of the sale of property……….. Taxation Ruling TR 92/4 on ' whether losses on isolated transactions are deductible' further confirms that section 25-40 of the ITAA 1997 is not applicable in the Financier's context as explained at paragraph 11 of TR 92/4: If an isolated transaction was expected to produce a capital profit, a loss incurred in that transaction is not deductible under subsection 51(1). Such a loss is expressly excluded from deduction as being a loss of capital or of a capital nature, regardless of whether the transaction also produced, or was expected to produce, income. As explained above, the amount advanced to the Company is determined to be a loss of Capital or of a Capital nature and is therefore not deductible under section 25-40 of the ITAA 1997. A further specific deduction provision which could apply would be section 25-35 of the ITAA 1997. Section 25-35(1) provides: 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. As the Financier's unrecovered sum of $X has resulted from the default in repayment of the funds advanced to the Company for business purposes, and has not been written off, the amount cannot be claimed as a 'Bad debt' under section 25-35 of the ITAA 1997, as the Financier was not in the business of money lending. Taxation Ruling 92/18 (TR 92/18) explains at paragraph 5: the bad debt has to be written off in the year of income before a bad debt deduction is allowable under section 63. and at paragraph 6, TR 92/18 states: If a taxpayer is not carrying on a business of money lending, a bad debt deduction is not allowable [………] unless the debt has been previously included in assessable income. Consequently the amount of $X is not deductible to the Financier under any specific provisions of the ITAA 1997, most specifically section 25-40 or section 25-35. | Detailed Reasoning - Capital Losses: Section 100-20 of the Income Tax Assessment Act 1997 (ITAA 1997) states that you can make a capital gain or loss only if a CGT event happens. Section 108-5 of the ITAA 1997 specifies different types of CGT assets (which includes debts owed to you and rights to enforce contractual obligations). Sub section 108-20(1) of the ITAA 1997 provides that losses from personal use assets must be disregarded in working out the net capital loss. However, as the amount owed to you resulted from a commercial transaction (an advance made for business purposes), we do not consider the amount of $X resulted from a personal use asset. Taxation Ruling TR 92/18 explains at paragraphs 31 and 32 that a debt may be considered to have become bad and thus come to an end (by being written off) in any of the following circumstances: a) the debtor has died leaving no, or insufficient, assets…… b) the debtor cannot be traced …… c) where the debt has become statute barred …… d) if the debtor is a company, it is in liquidation or ……insufficient funds to pay…..the whole debt…. e) where, on an objective view of all the facts…. there is no likelihood of the debt being recovered… However, in the financier's case, the unrecovered amount is not recognised as a 'debt' by the borrower due to a condition of the Seed funding agreement not having been fulfilled - specifically that the project had not reached 'financial close' the resultant effect of which was that, no legal obligation arose for the borrower to make repayment. The Seed funding agreement specified as follows at clause 7 (Repayment of Advances): a) Subject to clause 7(b), the company must repay the 'Outstanding Principal' and must pay all amounts payable in respect of ZZ's Project Expenses in accordance with clause 5 to the Financier on the date that Financial Close occurs. b) The Company shall not repay or return Seed Capital to any provider of Seed Capital (or engage in any transaction with a similar effect), other than the Financier, prior to the repayment of the outstanding Principal and payment of all amounts payable in respect of ZZ's Project Expenses in accordance with clause 5 to the Financier, unless the Financier receives an amount in respect of its Seed Capital that is proportionate to the amounts received by the other providers of Seed Capital. 'Outstanding Principal' is defined to mean the aggregate of the unrepaid Advances. A contingent condition of the agreement was that the monies advanced were not required to be repaid to the financier if the project did not reach 'financial close'. As the project was not initiated and no 'financial close' was reached, the conditions of repayment were not met for the obligations of the borrower to arise. What was 'Financial close': In Schedule 1 of the Seed funding Agreement between you and the Company, "Financial Close" is defined to mean the first time the aggregate of: a) the equity capital of the Company; plus b) the aggregate amount of the Debt of the Company (including drawn and undrawn amounts), exceeds $10 million; provided that the Seed Capital shall not be included in calculating such amount; Given that the Financier was not recognised as a creditor, and that the Company has voluntarily de-registered, it follows that in the absence of a debt (CGT asset), CGT event C2 could not have happened. Section 104-25 of ITAA 1997 provides that a CGT event C2 happens when the ownership of an intangible CGT asset ends by the asset: a) being redeemed or cancelled; or b) being released, discharged or satisfied; or c) expiring; or d) being abandoned, surrendered or forfeited…. e) if the asset is an option - being exercised; or f) if the asset is a convertible interest - being converted. The Taxation Determination TD 2000/7 upon which you have relied, is applicable in respect of shares of the company which is deregistered. It takes the view that a CGT event C2 in section 104-25 of the ITAA 1997 happens in respect of the members shares when a company is deregistered voluntarily under subsection 601AA(4) of the Corporations Law. As no CGT asset is identified in the relevant transactions of the Financier with the Company, no CGT event C2 has happened and therefore no Capital loss is recognized. 3) If the amount of $X is considered to be a loan, will the Commissioner recognise a loss under CGT event G3 given the voluntary liquidation of the Company? CGT event G3 in section 104-145 of the ITAA 1997 provides a mechanism for a shareholder to make a capital loss on worthless shares or financial instruments in a company before the time of the deregistration of the company if an administrator or liquidator declares in writing that they had reasonable grounds to believe that there was no likelihood that the shareholders would receive any further distributions. Despite the amount advanced to the Company ($X) being recorded/listed as a 'loan' in the Financier's books, the borrower maintains there was no 'loan' as the funds had been advanced on a 'draft' Seed funding agreement where the Financier had agreed to finance the project and where the agreement carried a contingent condition that no repayment was required from the borrower until the project reached 'financial close', which did not eventuate. Further CGT event G3 did not happen in respect of shares as the Financier did not own shares in the borrower. It is therefore determined that no reduced cost base is available in the absence of a CGT asset and that no CGT event C3 has happened (as no 'debt', 'loan' or financial instrument has in fact been established between the lender and the borrower, as the relevant contingency has not been fulfilled in accordance/as required by the agreement). 4) If the transaction is not deductible on revenue account, a CGT event C2 or CGT event G3, is the loss then deductible under section 40-880 of the ITAA 1997 as Black-hole expenditure? It is explained above that the amount of $X advanced by the Financier to the Company is not deductible under section 8-1 of the ITAA 1997 because it was of a capital nature. The amount was not deductible under CGT provisions as the amount is not recognised as part of the reduced cost base of a CGT asset. | Detailed Reasoning - Section 40-880:: As a result of the above conclusions, we have examined the provision of last resort: section 40-880 of ITAA 1997 Black-hole expenditure as amended by Tax Laws Amendment (2006 Measures No.1) Act 2006 which applies to business related capital expenditure incurred after 1 July 2005, in relation to a business being carried on for a taxable purpose. The Financier's outgoing of $X qualifies under the requirements of section 40-880, as section 40-880(2) provides that the capital expenditure must be incurred in respect of: • a business that is carried on for a taxable purpose • is not deductible under any other provision • has been 'incurred' after 1 July 2005 • does not fall under the limitations or exceptions of this provision It should be noted that paragraph 40-880 (5)(f) prevents a deduction where expenditure could get taken into account in working out the capital gain or capital loss from a CGT event. Although it could be argued that the expenditure was incurred in preserving the CGT asset's goodwill and as such could be included in the 4 th element of the cost base under paragraph 110-25(5)(a); given that the purpose or effect of the expenditure was to increase or preserve the value of goodwill , this subsection (5) does not apply in relation to goodwill (section 110-25(5A)). Taxation Ruling 2011/6 (TR 2011/6) sets out the Commissioner's views on the scope and operation of section 40-880 of the ITAA 1997. TR 2011/6 discusses how the amount of expenditure seeking deductibility must qualify in the above mentioned categories and also: • be capital in nature (see explantion in answer to question 1) • be business related • must relate to the taxpayer's current, former or proposed business • be in connection with the business from which the taxpayer is deriving assessable income TR 2011/6 also explains at paragraph 12 that the meaning of the word 'incurred' is the time the taxpayer incurs expenditure 'at the time they owe a present money debt that they cannot avoid paying' and is similar to the requirement for the term incurred in section 8-1 of the ITAA 1997. Paragraph 63 of TR 2011/6 states that the principles developed by case law as set out in Taxation Ruling TR 97/7 would assist in determining when the expenditure was incurred. | Detailed Reasoning - When was the Financier's expenditure incurred?: We recognise that your loss was incurred as a result of a transfer of funds of $X advanced to the Company for business purposes, was in fact business related expenditure. As there is no statutory definition of the term 'incurred' and to determine the exact time when the expenditure was incurred, we take guidance from Taxation Ruling TR 97/7 - ' meaning of 'incurred'- timing of deductions' which states at para 19 and 20 that a taxpayer has incurred the outgoing when he can be 'completely subjected to a liability' and is 'definitively committed to the outgoing' and the lender is irrevocably unable to recover the amount advanced. In the Financier's case, it was when the Company became deregistered on dd/mm/yyyy, that the Financier's 'advance' became completely unrecoverable and therefore 'fully' incurred. Consequently we consider that the Financier's loss was in fact incurred on dd/mm/yyyy and was occasioned as a result of the borrower becoming deregistered, which made the amount unrecoverable to the financier. As the loss was incurred post 1 July 2005, the timing of the loss falls within the requirements of section 40-880 of the ITAA 1997. In view of the above, we consider that the Financier satisfies the requirements of section 40-880 of ITAA 1997 in respect of the unrecovered sum of $X advanced to the now deregistered Company. As the amount is not deductible under any of the other provisions of the ITAA 1997, the Financier can avail itself of the deduction under section 40-880 of the ITAA 1997, which can be claimed as a straight-line write-off over five years, and the expenditure is not required to be apportioned if it is incurred part way through the year. A deduction of more than 20% of the total expenditure of $X cannot be claimed in any particular income year. This amount is deductible in equal amounts over a period of five (5) years, commencing with the year in which it was incurred. ie: 20% of the total sum of $X may be deducted each financial year from 30 June 2014 to 30 June 2018. | Detailed Reasoning - ATO view documents:: Taxation Rulings and Determinations: TR 92/18 - Income tax : bad debts TR 97/7 - Meaning of 'incurred'- timing of deductions TR 92/4 - whether losses on isolated transactions are deductible TD 2000/7 - Capital gains-when does a CGT event happen to shares in a company TR 2011/6 - Business related capital expenditure - section 40-880 core issues | Detailed Reasoning - Relevant Legislative Provisions:: Income Tax Assessment Act 1997: Section 8-1 Section 25-40 Section 40-880 Subsection 104-25(1) Subsection 108-5(2) Subsection 108-20(1) Subsection 104-25(2) Subsection 110-25(5A) Tax Laws Amendment (2006 Measures No.1) Act 2006 | Detailed Reasoning - Cases: British Insulated and Helsby Cables v. Atherton (1926) 10T.C. 155 at 192 Sun Newpapers Ltd v. FCof T (1938) 61 CLR 337 at 363 per Dixon J). at 355 | Detailed Reasoning - Other references (non ATO view): ATO ID 2003/215 ATO ID 2004/656 | Detailed Reasoning - Other relevant sources: Corporations Act 2001: Subsection 601AA(4)

Subject: Deductibility of Losses, Goodwill and Black-hole Expenditure: ' Financier' is the lender and 'the Company' is the receiver/borrower in the following Ruling: