Private ruling: Capital losses
Published: November 2012
Date scheme commenced: 1 July 2011

Ruling: Questions and answers: | Are you entitled to a deduction for the interest expense incurred in taking out a loan for the purpose of investing in a development company? | Yes. | Are you entitled to a deduction for the expenses incurred in taking legal action to recover investment losses? | No. | Has a capital gains tax event occurred to enable you to claim a capital loss that resulted from a loan to a development company? | No.


Relevant legislative provisions: Income Tax Assessment Act 1936 Section 8-(1) | Income Tax Assessment Act 1936 Section 104-10 | Income Tax Assessment Act 1936 Section 104-25

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except to the extent that they are of a capital, private or domestic nature or relate to the earning of exempt income. Taxation Ruling TR 2004/4 Income tax: deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities, provides the Commissioners view on the deductibility of interest where the income-producing asset has been disposed of and the taxpayer is still liable on the balance of the loan. Taxation Ruling TR 2004/4 states as follows: 10. Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and income earning activities (whether business or non business) have ceased, it is apparent that the interest is not incurred in gaining or producing the assessable income of that period or any future period. However, the outgoing will still have been incurred in gaining or producing the assessable income if the occasion of the outgoing is to be found in whatever was productive of assessable income of an earlier period… 12. An outgoing of interest in such circumstances will not fail to be deductible merely because; · the loan is not for a fixed term; · the taxpayer has a legal entitlement to repay the principal before maturity, with or without penalty; or · the original loan is refinanced, whether once or more that once. 13. However, if the taxpayer; · keeps the loan on foot for reasons unassociated with the former income earning activities, or · makes a conscious decision to extend the loan in such a way that there is an ongoing commercial advantage to be derived from the extension which is unrelated to the attempts to earn assessable income in connection with which the debt was originally incurred, · the nexus between the outgoings of interest and the relevant income earning activities will be broken. In your circumstances, you borrowed funds in order to generate assessable income by means of non-business activities. Further, after the borrower became insolvent you did not have the capacity to repay the loan. The cessation of the investment activity will not sever the nexus of the original purpose of the loan, which was to generate assessable income. Also we consider that you have not kept the loan in such a way that there is an ongoing commercial advantage. Therefore you are entitled to a deduction for the interest on the loan. Accordingly, you are entitled to a deduction for the interest expenses incurred in servicing the loan under section 8-1 of the ITAA 1997. | Detailed Reasoning - Deductibility of legal expenses: As previously stated section 8-1 of the ITAA 1997 allows a deduction for all losses or 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 that purpose. However, where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income they will not be deductible. The fundamental requirement is that there must be a sufficient nexus between a particular expense and the assessable income such that the expense is incidental and relevant to the gaining of assessable income. This was recognised in Case U134 87 ATC 780; 18 ATR 3646 when a director of a company, who received no payment for his work, was denied a deduction under section 8-1 of the ITAA 1997 because it was held that the expenses he incurred in the course of his directorship were not incurred in gaining or producing assessable income. The nature of the expenditure must also be considered. The nature or character of the legal expenses follows the advantage that is sought to be gained by incurring the expenses. If the advantage to be gained is of a capital nature, then the expenses incurred in gaining the advantage will also be of a capital nature. In Case V140 88 ATC 874; AAT Case 4596 (1988) 19 ATR 3859, a solicitor was denied a deduction for legal expenses incurred in defending certain allegations before the Statutory Committee of the Law Society, concerning the solicitor's trust account. The Committee ordered the taxpayer be suspended from practice for a period, and to pay costs. The Administrative Appeals Tribunal (AAT) held that the payments made by the taxpayer were not deductible as the payments were characterised as capital expenditure. Further, in Case X84 90 ATC 609; AAT Case 6528 (1990) 21 ATR 3721 , the AAT held that legal expenses incurred by a medical practitioner in defending charges brought against him at a Medical Disciplinary Tribunal inquiry, were not deductible because the expenditure was incurred to protect a structural asset, that is, their registration as a medical practitioner, and was of a capital nature. In your case the advantage sought from taking legal action was to recover the initial capital investment. Therefore, it follows that the nature of the legal expenses incurred to recover said capital will also be capital in nature. Accordingly, you are not entitled to a deduction for the legal expenses incurred to recover the initial capital investment under section 8-1 of the ITAA 1997. Capital losses Section 102-20 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that a capital gain or loss arises if a capital gains tax event (CGT event) happens to a capital gains tax asset (CGT asset). A CGT asset is any kind of property, or a legal or equitable right that is not property, real estate is a CGT asset under section 108-5 of the ITAA 1997. Section 108-5 of the ITAA 1997 gives examples of CGT assets which includes debts owed to you. An unpaid loan would be considered to be a debt that is owing to you. In your case your right to receive the balance of the loan from the borrower is properly characterised as an asset, and the disposal of that asset would constitute a CGT event. Section 104-25 of the ITAA 1997 provides that CGT event C2 happens if 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. For an asset such as a debt or a loan, this means that you would no longer be entitled to seek payment of any outstanding amount or sue for its repayment. In your case, although you have pursued the borrower for the capital that you loaned with little success, you ceased any further action based on the advice of your lawyer. Further you are yet to pursue the other guarantors contained within the loan agreement. Therefore, as you do not meet any of the criteria contained within section 104-25 of the ITAA 1997, CGT event C2 has not occurred. However, this CGT event may occur in the future if the company and guarantors are wound up and de-registered or enter bankruptcy. In addition, there are no other CGT events listed under section 104-10 of the ITAA 1997 that are appropriate to your particular circumstances. Accordingly, as there is yet to be a CGT event under section 104-10 of the ITAA 1997, you are not entitled to claim a capital loss.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. If you have any concerns about this ruling you wish to discuss, you will find our contact details in the fact sheet. | Relevant facts: You and you spouse became involved with a company acting as trustee for a Trust (the borrower). | At the time that you became involved with the borrower, they were in the process of a property developing project. | You signed an agreement with the borrower whereby you would loan the company a sum of money. In return the borrower will; | · pay interest on the funds borrowed; and | · pay a percentage of the net profit from the project. | You borrowed a sum to service the loan to the borrower from a bank. | After the project was completed, you discovered that the borrower had problems with the bank due to outstanding debt. | Due to the outstanding loans, the bank seized ownership of the property development project. | As a result of the bank's action you have not received any proceeds including your initial investment. | You took legal action against the borrower to recover the amount loaned to the borrower. | You were advised by your lawyer that it was futile to continue to pursue the borrower, as there was little chance of recovering the amount loaned to the borrower. | You have not pursued any legal action against the remaining guarantors as you were advised by you lawyer that to do so would be futile. | You have not received, nor do you expect to receive, any income from the failed investment. | You have incurred interest expense in relation to the initial amount borrowed from the bank and loaned to the borrower. | You have incurred legal expenses trying to recover your original investment. | The original loan from the bank has not been restructured or refinanced and is currently being paid off. | You have provided copies of the legal expense invoices and a copy of the loan agreement.