Private ruling: Capital loss for payments made under guarantee
Date of advice: 22 August 2017
Published: December 2017
Ruling period: Year ended 30 June 2016 | Year ended 30 June 2017
Date scheme commenced: 1 July 2015

Ruling: Q1: Are you entitled to a deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for satisfying your company’s expenses as a guarantor? | A1: No | Q2: Is the amount paid under the personal guarantee considered a capital expense and subject to the Capital Gains Tax provisions? | A2: Yes | Q3: Are you entitled to claim a capital loss before the amount owed under the guarantee has been paid in full? | A3: No

Relevant facts and circumstances: You were the director of a company (in Liquidation). The company incurred legal expenses defending a claim against work it performed. The company was liquidated and did not pay the legal expenses owed to the law firm who represented it. The Law firm pursued you, the director, for the legal costs owed by your company (in Liquidation) based on the personal guarantee you provided to them in the deed of guarantee. You are not in the business of entering into contracts of guarantee. You are now repaying the amount owed to the law firm in monthly amounts paid from the wage you now receive from an unrelated entity.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 8-1 | Income Tax Assessment Act 1997 Subsection 104-25 | Income Tax Assessment Act 1997 Subsection 108-5 | Income Tax Assessment Act 1997 Subsection 108-20(2) | Income Tax Assessment Act 1997 Subsection 110-25(2) | Income Tax Assessment Act 1997 Subsection 112-25(4)

Reasons for decision: Summary: Section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) allows a deduction for a loss or an outgoing to the extent to which it is incurred in gaining or producing assessable income, except where the loss or outgoing is of a capital, private or domestic nature. A number of significant court decisions have determined that for an expense to be an allowable deduction: ● it must have the essential character of an outgoing incurred in gaining assessable income or, in other words, of an income-producing expense ( Lunney v. FC of T ; (1958) 100 CLR 478), ● there must be a nexus between the outgoing and the assessable income so that the outgoing is incidental and relevant to the gaining of assessable income ( Ronpibon Tin NL v. FC of T , (1949) 78 CLR 47), and ● it is necessary to determine the connection between the particular outgoing and the operations or activities by which the taxpayer most directly gains or produces his or her assessable income ( Charles Moore Co (WA) Pty Ltd v. FC of T , (1956) 95 CLR 344; FC of T v. Hatchett , 71 ATC 4184). Legal expenses are generally deductible if the expenses arise out of the day to day activities of the taxpayer's business ( Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169), and the legal action has more than a peripheral connection to the taxpayer's income producing activities ( Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542). Taxation Ruling TR 96/23 discusses the deductibility of payments made under guarantee. The ruling states that liabilities arising under contracts of guarantee will not be deductible under section 8-1 of the ITAA 1997 if the provision of guarantees and the losses or outgoings under the guarantees are not regular and normal incidents of the taxpayer’s income earning activities. The ruling further states that if the provision of guarantees is not a regular and normal incident of the taxpayer’s income earning activities, any payments made under those guarantees will be capital in nature. Directors of a company would not ordinarily be expected to guarantee a business’s debts. Debts are normally incurred by a business in relation to their operations and, thus, the earning of the business’s assessable income. You have incurred expenses in settling legal costs owed by your company as a personal guarantor. The purpose of your action was not to directly produce any assessable income for yourself, but to fulfil your commitment as guarantor. You were not in the business of entering into contracts of guarantee therefore it is not considered that the provision of guarantees was undertaken by you as a regular and normal incident of your income earning activities. As a result of this a deduction for paying the company’s legal expenses and fees are not allowable under section 8-1 of the ITAA 1997 as it relates to the company’s affairs and not your assessable income. The Commissioner's view on the Capital Gains Tax (CGT) implications of a guarantee to pay a debt is set out in Taxation Ruling TR 96/23. A capital loss is not incurred by a guarantor if a debt arising to the guarantor under a right of indemnity or a right of subrogation, on payment, is a 'personal-use asset'. Subsection 108-20(2) of the ITAA 1997 defines a ‘personal-use asset’; included in this definition at paragraph 108-20(2)(d) of the ITAA 1997 is a debt arising other than in the course of gaining or producing your assessable income or from your carrying on a business. 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. 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, 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. You were a director of your company at the time you provided the guarantee to the law firm. In your circumstances it is accepted that paragraph 108-20(2)(d) of the ITAA 1997 would not apply as it can be objectively determined that the primary purpose in entering into the guarantee was to assist the company to continue in business and enhance its income earning activity. Therefore, the capital loss will not be disregarded by subsection 108-20(1) of the ITAA 1997. On entering a contract of guarantee, a guarantor acquires an asset which is a right to be indemnified by the principal debtor. 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. The guarantor acquires the right of indemnity at the time of making the contract. 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. When the guarantor makes payment in full 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 principal debtor and the guarantor has the general rights of a creditor. The amount paid under the guarantee remains the relevant cost base of the merged asset. It is our view that the part payment of the debt (either by the debtor or the guarantor) does not bring about a part disposal of the debt and that the debt is only disposed of when it is discharged by payment in full (or by release). It follows, that a part payment by the guarantor of the amount payable under the guarantee does not bring about a part disposal of the creditor's rights under the guarantee. Also, a part payment of the debt by the debtor does not bring about a part disposal of the creditor's rights under the guarantee. The guarantee will be disposed of when either the debt is extinguished by payment (discharged) or by release or partly by one means and partly by the other; or the guarantor has paid the full amount due under the guarantee (taking into account any payments made by the debtor). In your case, when payment in full is made under the guarantee to the law firm, your right of indemnity will become an enforceable debt against your company. This enforceable debt is a CGT asset within section 108-5 of the ITAA 1997 and the amount you pay under the guarantee is the first element of the cost base of this asset for the purposes of subsections 110-25(2) or 112-25(4) of the ITAA 1997. As outlined in TR 96/23 at paragraph 119, a debt which arises under the right of indemnity, once payment has been made under the guarantee, can be disposed of in the following ways in terms of subsection 104-25(1) of the ITAA 1997 and a capital loss may arise: ● There may be no likelihood of payment by the principal debtor – the guarantor must take some action in terms of subsection 104-25(1) in order to dispose of the debt. ● The debt is forgiven at law (or in equity) by the guarantor; a formal deed of forgiveness is required in this situation. ● The principal debtor could be discharged from bankruptcy (in the case of an individual); similarly the liquidation of a company will also constitute a release and disposal. Liquidation of the company is not enough to end your rights in one of the ways contemplated by subsection 104-25(1) of the ITAA 1997. When the company is deregistered in accordance with the Corporations Law it will cease to exist, the company's debt to you will be 'abandoned, surrendered or forfeited' for the purposes of paragraph 104-25(1)(d) of the ITAA 1997and CGT event C2 in section 104-25 of the ITAA 1997 will happen. If no capital proceeds are received for the purposes of subsection 104-25(3) of the ITAA 1997 before the company is deregistered you will make a capital loss when the company is deregistered. As such when the full amount owed to the law firm has been paid by you in satisfaction of your obligations as guarantor, your rights of subrogation and indemnity against your company can be enforced. As your company has been deregistered in accordance with the Corporations Law you will not receive any capital proceeds from them, and thus you will be eligible to claim a capital loss for the amount you have paid in full satisfaction of the guarantee to the law firm at the time of final payment.