Private ruling: Capital loss - guarantor
Published: September 2014
Ruling period: Year ended 30 June 2011 | Year ended 30 June 2012 | Year ended 30 June 2013
Date scheme commenced: 1 July 2010

Ruling: Q1: Are you entitled to a capital loss in respect of the payment made to the bank as guarantor for the company? | A1: No | Q2: Are you entitled to a deduction under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997) for the whole or any part of the payment made to the bank as guarantor? | A2: No

Relevant facts and circumstances: The trust held approximately x% of the issued share capital in the company. The trust is a discretionary trust with you and your spouse as primary beneficiaries. The company carried on the business activity. Your spouse was a director and employee of the company. As part of the financing arrangements of the company, you and your spouse provided the company's financier with a personal guarantee. That guarantee was secured by way of mortgage over your family home. You and your spouse were one of several co-guarantors in respect of the bank loan. The other guarantors were individuals related to the majority shareholder of the company. The company was placed into liquidation in the relevant financial year. The bank demanded payment of the outstanding amount under the guarantee. As a result of defaults by the company in relation to the loan, the bank commenced proceedings against, inter-alia, you and your spouse for payment under the guarantee. By Deed of Settlement, the bank agreed to accept from you and your spouse, $x to be paid on a certain date. The payment was 'in full and final settlement' of proceedings against you and your spouse. You and your spouse paid the settlement amount at or prior to that date. You and your spouse have never filed a proof of debt with the liquidator of the company because there was no prospect of recovery. Even if you could prove as debtors, the company was never in any position to pay any dividends to you as unsecured creditors. To date, the liquidation of the company is still ongoing and the company has not yet been deregistered.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 108-20 | Income Tax Assessment Act 1997 Subsection 108-20(2) | Income Tax Assessment Act 1997 Section 40-880 | Income Tax Assessment Act 1997 Paragraph 40-880(5)(f) | Income Tax Assessment Act 1997 Subsection 40-880(6)

Reasons for decision: Summary: As a beneficiary of a discretionary trust, there is insufficient nexus between the guaranteeing of the loan and the earning of trust income. The debt owed to you by the company is a personal-use asset and any capital loss made on disposal is disregarded. As the payment under the guarantee could be taken into account in working out the amount of a capital gain or capital loss, a deduction is not allowable under section 40-880 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Capital loss A capital gains tax (CGT) asset can be any kind of property, or a legal or equitable right that is not property. A debt or a right to repayment is a CGT asset. Taxation Ruling TR 96/23 considers the CGT implications of a guarantee to pay a debt. On entering into a contract of guarantee, the guarantor acquires an asset which is a right to be indemnified by the principal debtor. The guarantor acquires the right of indemnity at the time of making the contract and the cost base is equal to the amount the guarantor pays, or required to pay, under the contract of guarantee. 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. Section 108-20 of the ITAA 1997 provides that a capital loss that is made from a personal-use asset is disregarded. A personal-use asset includes a debt arising other than: (i) in the course of gaining or producing your assessable income; or (ii) from your carrying on a business. 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 test is an objective purpose test, by examining the surrounding circumstances at the time of entering into the guarantee. If the purpose of a shareholder in a company in making a loan to the company, for instance, was to assist the company to continue in business, and thus to earn profits and to distribute dividends to the shareholder, the debt would not be a personal-use asset. In your case, you were a beneficiary of a discretionary trust, which was a shareholder of the insolvent company. The debt owed to you by the company is a personal-use asset because your entering the contract of guarantee was not expected to promote and enhance your income earning activity. There is an insufficient nexus between your guaranteeing the loan and the earning of trust income because, as a beneficiary of a discretionary trust, you did not have an absolute interest in either the company or trust income. Taxation Ruling IT 2385, which is about expenses incurred by beneficiaries of discretionary trusts, states that beneficiaries of discretionary trusts are unable to show a sufficient nexus between their activities and the receipt of assessable income from a discretionary trust because, at its highest, the beneficiary of a discretionary trust has the mere expectancy of receiving income from the trust. This is distinguishable from a shareholder of a company or a beneficiary of a fixed trust, who has an absolute interest in the company or trust income. This tax treatment is affirmed by Taxation Board of Review No.3 Case M36 80 ATC 280; Case 11 24 CTBR (NS) and again by Administrative Appeals Tribunal Case U44 87 ATC 318. Therefore because the debt owed to you by the company is a personal-use asset, a capital loss does not arise in any income year. Section 40-880 The object of section 40-880 of the ITAA 1997 is to provide a deduction over five income years for certain business capital expenditure incurred after 30 June 2005 which is not otherwise taken into account or denied a deduction by some other provision. Subsections 40-880(3) to (9) of the ITAA 1997 set out the limitations and exclusions to deductibility under section 40-880. Paragraph 40-880(5)(f) of the ITAA 1997 provides that an entity cannot deduct anything under section 40-880 of the ITAA 1997 for an amount of expenditure they incur to the extent that it could, apart from section 40-880, be taken into account in working out the amount of a capital gain or capital loss from a CGT event. Paragraph 2.73 of the Explanatory Memorandum to the Tax Laws Amendment (2006 Measures No. 1) Bill 2006 makes it clear that where a capital gain or capital loss worked out is to be disregarded or reduced an amount is still 'taken into account in working out the amount of a capital gain or capital loss'. The payment made under the guarantee will be the first element of the cost base and reduced cost base of the CGT asset that is your enforceable debt against the company. As the amount could be taken into account in working out the amount of a capital gain or capital loss from a CGT event, the exclusion under paragraph 40-880(5)(f) of the ITAA 1997 applies. (Also refer Taxation Ruling TR 2011/6 paragraphs 253 - 258) Subsection 40-880(6) of the ITAA 1997 does not apply to prevent paragraph 40-880(5)(f) of the ITAA 1997 applying because the expenditure was not incurred to preserve the value of goodwill. As such, none of the expenses incurred in relation to the guarantee are deductible under section 40-880 of the ITAA 1997.