Private ruling: Capital gains tax
Published: April 2014
Ruling period: Year ended 30 June 2011 | Year ended 30 June 2012 | Year ended 30 June 2013 | Year ending 30 June 2014 | Year ending 30 June 2015 | Year ending 30 June 2016
Date scheme commenced: 1 July 2010

Ruling: Q1: Will a capital gains tax (CGT) event occur, in relation to the payment made under a personal guarantee, in the relevant financial year? | A1: No, the CGT event will occur in the subsequent financial year. | Q2: Will a CGT event occur, in relation to the funds on lent to the company, in the relevant financial year? | A2: No, the CGT event will occur in the subsequent financial year. | Q3: Are you entitled to a deduction for interest paid on funds borrowed and on lent to the company? | A3: Yes.

Relevant facts and circumstances: Individuals A and B were both ordinary shareholders in the company. The company purchased a business, as a going concern. The purchase price was $X million. In total the company borrowed $Y million to cover the purchase plus stamp duty, solicitor fees, accounting fees, borrowing and facility fees. The purchase was financed by a bank. The facilities were secured by • a charge over the company assets • a mortgage over land owned by the individuals • a mortgage over a commercial property owned by individual A • a mortgaged over a property owned by individual A's parents • guarantees from the individuals and their parents When the business was purchased it had been operating for approximately Z years. Although financing costs put pressure on the business, it operated with relative success initially. The turnover dropped due to the company's inability to purchase new season stock on a timely basis. To facilitate the timelier landing of new stock, the individuals borrowed additional funds from family members which were then put into the business. At the time, the individuals believed the loans would be repaid quickly once the stock was received as the company already had orders for the items. The individuals expected to receive dividend income in the future. The turnover of the business fell considerably and as a result, the money could not be repaid. The bank withdrew support from the business and asked for repayment of the company's borrowings. A liquidator was appointed by the bank. When the company could not refinance, the bank acted upon the guarantees and mortgages. The bank also sold the company's equipment, furniture and fittings and applied the funds to the outstanding loans. The bank was not repaid in full. During the relevant financial year, all trading activity had ceased and all the company's assets had been sold. The liquidators did not make a declaration or similar that the company would not be able to pay out any remaining debts. The company was deregistered in the subsequent financial years. The individuals continue to incur interest repayments in relation to the funds borrowed from family members.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 8-1 | Income Tax Assessment Act 1997 section 102-20 | Income Tax Assessment Act 1997 Section 104-25 | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1997 subsection 108-20(1) | Income Tax Assessment Act 1997 paragraph 108-20(2)(d)

Reasons for decision: Summary: Capital gains tax Section 102-20 of the ITAA 1997 provides that a capital gain or loss arises if a CGT event happens to a CGT asset. A CGT asset is any kind of property, or a legal or equitable right that is not property, for example, a debt that is owed to you. An unpaid loan would be considered to be a debt that is owing to you. Payments made under guarantee The Commissioner's view on the CGT implications of a guarantee by a shareholder for a private company debt is set out in Taxation Ruling TR 96/23. On entering a contract of guarantee, a guarantor (director/shareholder) acquires an asset which is a right to be indemnified by the principal debtor (the private company). The guarantor is taken to have acquired this right for a cost base equal to the amount the guarantor pays, or is required to pay, under the contract of guarantee. Until the default of the principal and payment by the guarantor, a guarantor is not entitled to sue on the right of indemnity (paragraphs 30, 31 and 109 of TR 96/23). When a creditor's debt is paid in full, the guarantor'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. The guarantor is taken to have acquired the right of subrogation for (the first element of) a cost base equal to the amount the guarantor paid under the contract or guarantee. The asset is deemed to have been acquired by the guarantor under section 109-10 of the ITAA 1997 and the time of acquisition is governed by Division 104 and 109 of the ITAA 1997. It is taken to be acquired on payment (paragraphs 32 to 34 and 112 of TR 96/23). When the guarantor makes a payment to the creditor under a guarantee, the guarantor's right of indemnity and right of subrogation become co-extensive. That is, they are merged into one asset being an 'enforceable debt' against the principle debtor and the guarantor has the general rights of a creditor. On payment by the guarantor under the guarantee, the right on indemnity (or the merged asset if there is a right of subrogation) is enforceable as a debt against the principal debtor. The amount paid under the guarantee remains the (first element of the) relevant cost base of the merged asset and there are no CGT consequences from the merging of the indemnity and subrogation rights (paragraphs 35 to 37 and 84 to 85 of TR 96/23). Application to your circumstances In this case, the individuals were shareholders of the company (the principal debtor). The execution of a guarantee in favour of the creditor created the right to be indemnified by the business. The cost base of this right was the amount the individuals were required to pay under the guarantee. The properties held by the individuals were sold and the proceeds used to pay out the company's debt with the bank. We considered that when the payment under the guarantee was made, the individuals' right of indemnity became an enforceable debt against the company. The enforceable debt is a CGT asset within section 108-5 of the ITAA 1997. Subsection 108-20(1) of the ITAA 1997 disregards any capital loss made by you on a personal use asset. Paragraph 108-20(2)(d) defines a debt arising other than in the course of gaining or producing assessable income or from carrying on a business as a personal use asset. We accept that in this case, the debt is not a personal use asset. Therefore, the capital loss will not be disregarded under subsection 108-20(1) of the ITAA 1997. Timing of the event Section 104-25 of the ITAA 1997 provides that CGT event C2 happens if the ownership of an intangible CGT asset ends by the asset: (a) being redeemed or cancelled (b) being released, discharged or satisfied (c) expiring; or (d) being abandoned, surrendered or forfeited The time of the event is when you enter into the contract, that results in the asset ending or if there is no contract, when the asset ends. The mere writing off of a debt (by a taxpayer) is insufficient to constitute a cancellation, release, discharge, satisfaction, surrender, forfeiture, expiry or abandonment at law or in equity. Accordingly, CGT event C2 will not happen to the debt owed to you and you cannot claim a capital loss until the rights under the agreement are legally and irrevocably surrendered, released or abandoned and, as a result, all provable debts are released. Application to your circumstances In this case, the debt did not come to end and during the relevant financial year when the company was placed into liquidation. This act is not enough to end the individuals' rights in one of the ways contemplated by subsection 104-25(1) of the ITAA 1997. We consider that CGT event C2 occurred when the company was deregistered in the subsequent financial year. In this case, the individuals borrowed funds from relatives and on lent these funds to the company with a view to earn assessable dividend income. The right to be repaid by the company is properly characterised as an asset, and the disposal of that asset would constitute a CGT event. As discussed above, CGT event C2 happens if the ownership of an intangible CGT assets comes to an end. We consider that CGT event C2 occurred when the company was deregistered in the subsequent financial year. In this case, we accept that the debt is not a personal use asset. Therefore, the capital loss will not be disregarded under subsection 108-20(1) of the ITAA 1997. Interest expenses Section 8-1 of the ITAA 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income. Generally, interest expenses incurred for income producing purposes are deductible under section 8-1 of the ITAA 1997, to the extent that it is not capital, private or domestic in nature. The essential character of the expense is a question of fact to be determined by reference to all the circumstances. Taxation Ruling TR 95/25 provides the Commissioner's view regarding the deductibility of interest expenses. As outlined in TR 95/25, there must be a sufficient connection between the interest expense and the activities which produce assessable income. TR 95/25 specifies that to determine whether the associated interest expenses are deductible, regard must be given to all the circumstances including the purpose of the borrowing and the use to which the borrowed funds are put. Taxation Ruling TR 2004/4 provides guidance on the deductibility of interest incurred after the production of assessable income. Paragraph 10 states the following: Where interest has been incurred over a period after the relevant borrowings (or assets representing those borrowings) have been lost to the taxpayer and relevant 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. In this case, the individuals borrowed funds from relatives and on lent this money to the company. The company then used these funds to pay out creditors. Although the company is no longer in existence, the individuals continue to incur interest. We accept that the interest was initially incurred in the course of producing assessable dividend income. Therefore a deduction for interest incurred on the borrowings is allowable under section 8-1 of the ITAA 1997.