Edited version of private ruling

Authorisation Number: 1011600940100

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Ruling

Subject: Investment loss

1. Are you entitled to a deduction for the loss of on-lent funds?

No.

2. Are you entitled to a deduction for your share of legal expenses incurred while attempting to recover funds on-lent to a borrower?

No.

3. Are you entitled to a deduction for your share of the interest expense incurred on funds on-lent to a borrower?

Yes.

4. Are accounting fees relating to the preparation of a private ruling considered a cost of managing tax affairs?

Yes.

This ruling applies for the following periods:

Year ended 30 June 2010

Year ended 30 June 2009

Year ended 30 June 2008

Year ended 30 June 2007

The scheme commences on:

1 July 2006

Relevant facts and circumstances

During the 2006-07 financial year you and your spouse withdrew finds from a line of credit in both you and your spouses' names, and on-lent the funds to the Company. The director of the Company was your friend.

The Company purchased two properties and planned to subdivide and develop the land into two blocks.

The estimated completion date for the project was in the 2007-08 financial year.

You and your spouse organised a feasibility study for the investment, which concluded that it was a sound investment with an expectation of profit.

The plan was to sell the properties 12 months after the initial investment, as the developer was optimistic about how the property market was performing.

The terms of the loan were outlined in a loan agreement created by your solicitor.

The funds were on-lent interest free, and the repayment of the loan was to occur when the properties were sold, or at the latest, five years after the date of the agreement. The repayment amount was to be no less than the money invested, with a potential profit calculated using a specific formula.

There were substantial planning approval delays and the project began to take longer than you had envisaged. Therefore, you approached the Company and requested that they sell the properties as they were, in order to recover your investment funds. Whilst it would have meant that you would not make a profit, you thought at least you would recover the funds you on-lent. However, you were not aware that the Company had already remortgaged the properties and had got themselves into irretrievable financial difficulties.

Within 12 months of on-lending the funds the Company went bankrupt.

The land was in the Company's name, and you and your spouse had no title to the land. You also had no access to bank accounts relating to the investment.

You and your spouse were not shareholders of the Company.

A clause in the loan agreement with the Company stated that the borrower was required to sign any mortgage requested by the lender over the property referred to in the agreement. You did not invoke this clause as you were good friends with the director of the Company and you didn't become aware of the dire circumstances they were in until the liquidators were called in.

The properties were sold at auction under the instructions of the appointed liquidators. You did not attend auction due to work commitments.

You and your spouse sought legal advice to ascertain if you would be able to recover the on-lent funds. You incurred legal fees from your solicitor.

The fees related to the solicitors performing relevant searches into the business dealings of the Company. They also determined who the liquidators were and they represented you in attempting to recover the on-lent funds. A proof of debt form was completed and sent to the liquidators. However as you were unsecured creditors you were advised that you had little chance of recovering your money.

You have incurred interest on the line of credit relating solely to the on-lent funds. You have no capacity to repay the loan in full but you are making regular periodic repayments towards the loan.

You also advised that you incurred accounting fees in relation to this private ruling.

You are not in the business of lending money.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 25-35

Income Tax Assessment Act 1997 Section 108-20

Income Tax Assessment Act 1997 Section 118-10

Reasons for decision

Summary

Deduction for the loss of on-lent funds

Deduction as a bad debt

As you are an individual taxpayer, you would be reporting on a cash basis and would not have included the bad debt in your assessable income. As such you are not entitled to a deduction as a bad debt.

Deductibility as a general deduction

The debt is not considered to be been incurred in the gaining or producing of your assessable income, or the carrying on of a business to gain or produce assessable income. Therefore, you are not entitled to a deduction under the general deduction rules.

Capital gains tax (CGT) consequences

The contractual arrangement with the Company is considered a CGT asset.

After the bankruptcy of the Company, a CGT event C2 has happened as your ownership of the CGT asset ends due to the asset being abandoned, surrendered or forfeited.

As such, the cost base for the debt is the amount of the debt. In your case, the cost base is the capital amount on-lent.

Legal expenses

You incurred legal expenses in seeking advice to establish your rights in relation to the funds on-lent to the Company. The advantage sought to be obtained by seeking legal advice was to establish your right to the capital invested. Therefore, the legal expenses are capital in nature as they relate to the asset rather than the derivation of income from that asset. Accordingly, the legal expenses are not deductible.

CGT consequences

The second element of the cost base comprises of incidental costs an entity incurs to acquire a CGT asset, such as costs incurred for the services of a legal adviser. Therefore, these costs should be included in the second element of your cost base.

Interest on Loan

In your circumstances, you drew down on a line of credit in order to generate assessable income by means of non-business activities. The cessation of the investment activity will not sever the nexus of the original purpose of the loan, which was to generate assessable income. Further, after the borrower became bankrupt you have not had the capacity to repay the loan. Therefore, you are entitled to a deduction for the interest on the loan.

Accounting fees

Expenses incurred for the preparation of a private ruling is considered expenditure for managing your tax affairs. Therefore, it is a deductible expense.

Detailed reasoning

A deduction for a bad debt may be claimed under either section 25-35 of the Income Tax Assessment Act 1997 (ITAA 1997) or section 8-1 of the ITAA 1997.

Deduction for the loss of on-lent funds

Deduction as a bad debt

Taxation Ruling TR 92/18 discusses that generally, a debt is bad in the following circumstances:

· the debtor has died without leaving assets or is insolvent

· the debt is statute-barred and the debtor relies on this as a defence for non-payment

· the debtor and the debtors assets cannot be traced

· in the case of a corporate debtor, the company is in liquidation and there are insufficient funds to pay the debt, or

· on an objective view, there is little or no likelihood of the debt being recovered.

In your circumstances, the Company has been declared bankrupt and you have provided proof that you provided a proof of debt form to the liquidators involved in the bankruptcy. As you were unsecured creditors you were advised by the liquidators that you had little chance of recovering your money. The debt of funds lent to the debtor is therefore considered to be bad.

For a bad debt to qualify for deduction under section 25-35 of the ITAA 1997, two conditions must be met:

· the debt must be written off as bad during the year of income in which the deduction is claimed, and

· the debt must have been brought to account by the taxpayer as assessable income. This requirement will not be satisfied by a taxpayer who lodges returns on a cash basis because those debts will not have been brought to account as assessable income.

As you are an individual taxpayer, you would be reporting on a cash basis and would not have included the debt in your assessable income. You are therefore not able to meet the second condition and are denied a deduction for a bad debt under section 25-35 of the ITAA 1997.

When a bad debt is not deductible under section 25-35 of the ITAA 1997, that debt may be deductible as a general deduction under section 8-1 of the ITAA 1997.

Deductibility as a general deduction

In order for a deduction to be allowed under section 8-1 of the ITAA 1997, the debt must have been incurred and must be a loss relating to the production of the taxpayers assessable income, or from the carrying on of a business to gain or produce assessable income. The loss must not be private, domestic or capital in nature.

You did not charge interest on the loan that was made to the Company. You did not receive any repayments of the loan principle. You did not make the loss as a result of carrying on a business activity. The debt has not been incurred in the gaining or producing of your assessable income, or the carrying on of a business to gain or produce assessable income. Therefore you are not entitled to a deduction under section 8-1 of the ITAA 1997.

CGT implications

Whist a deduction for the loss of on-lent funds is not allowable under section 8-1 of the ITAA 1997, the legal expenses may be included in the capital loss calculations.

Section 102-20 of the ITAA 1997 provides that a capital gain or loss can only arise when a capital event occurs in respect of a capital asset.

As a result of you entering into the contractual arrangement with the Company, it is considered that you acquired contractual rights. These contractual rights are CGT assets for the purposes of paragraph 108-5(1)(b) of the ITAA 1997.

Section 104-25 of the ITAA 1997 provides that a CGT event C2 happens if your ownership of a CGT asset ends by the asset being abandoned, surrendered or forfeited.

In your case you on-lent funds to the Company for the purpose of earning assessable income. However, 12 months after on-lending the funds the Company went bankrupt.

Based on the above facts, it is considered that you have abandoned the contract with the Company with the effect that your rights under the contract have been discharged. Accordingly, it is considered that CGT event C2 in section 104-25 of the ITAA 1997 happened.

The cost base or reduced cost base for the debt is the amount of the debt (section 110-25 ITAA 1997). In your case the cost base of the debt owing to you is the amount of funds you on-lent to the company.

Legal expenses

In determining whether a deduction for legal expenses is allowable under section 8-1 of the ITAA 1997, the nature of the expenditure must be considered (Hallstroms Pty Ltd v. Federal Commissioner of Taxation (1946) 72 CLR 634; (1946) 8 ATD 190; (1946) 3 AITR 436). 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.

Legal expenses may be of a revenue nature and therefore deductible if they arise out of the day to day activities of the taxpayer's business or income producing activity (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 2 ATD 169). Where however, expenditure is devoted towards a structural rather than an operational purpose, the expenditure is of a capital nature and the expenses are not deductible (Sun Newspapers Limited v. Federal Commissioner of Taxation (1938) 61 CLR 337; (1938) 5 ATD 23; (1938) 1 AITR 403).

Outgoings incurred in the preservation of an existing capital asset have been held to be capital in nature (John Fairfax and Sons Pty Ltd v. Federal Commissioner of Taxation (1959) 101 CLR 30; (1959) 11 ATD 510; (1959) 7 AITR 346).

In your case, you incurred legal expenses in seeking advice to establish your rights in relation to the funds on-lent to the Company. The advantage sought to be obtained by seeking legal advice was to establish your right to the capital invested. Therefore, the legal expenses are capital in nature as they relate to the asset rather than the derivation of income from that asset. Accordingly, the legal expenses are not deductible under section 8-1 of the ITAA 1997.

CGT consequences

Whist the legal expenses are not an allowable deduction under section 8-1 of the ITAA 1997, the legal expenses may be included in the capital loss calculations.

The cost base and reduced cost base of a CGT asset each consist of five elements. The second element of the cost base and reduced cost base each comprise of incidental costs an entity incurs to acquire a CGT asset or that relate to a CGT event. The term 'incidental costs' is defined in subsection 110-35(2) of the ITAA 1997 to include remuneration for the services of a legal adviser.

In your case, you incurred legal costs in seeking advice to establish your rights in relation to the funds on-lent to the Company, while attempting to recover your initial investment (a capital amount). Therefore, these costs should be included in the second element of your cost base. There is no requirement that the calculation of the cost base be limited to expenditure incurred before the time of disposal (CGT Determination Number 23 TD 23).

Interest on Loan

Section 8-1 of the 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.

Taxation Ruling TR 2004/4 states as follow:

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.

In Placer Pacific Management Pty v. FC of T 95 ATC 4459; (1995) 31 ATR 253, the Full Federal Court considered the deductibility of an expense incurred in honouring a warranty claim after the business had ceased. At p4464 the Court said:

In our view AGC should be taken as establishing the proposition that provided the occasion of a business outgoing is to be found in the business operations towards the gaining or producing of assessable income generally, the fact that the outgoing was incurred in a year later that the year in which the income was incurred and the fact in the meantime business in the ordinary sense may have ceased will not determine the issue of deductibility.

Subsequent decisions in Federal Commissioner of Taxation v Brown (1999) FCA 721; (1999) 43 ATR 1; 99 ATC 4600 and Federal Commissioner of Taxation v Jones (2002) FCA 204; 2002 ATC 4135; (2002) 49 ATR 188, indicate that this principle applies equally to recurring expenses such as interest.

Taxation Ruling TR 2004/4 also states:

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 drew down on a line of credit in order to generate assessable income by means of non-business activities. Further, after the borrower became bankrupt you have not had 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.

Accounting fees

Paragraph 25-5(1)(a) of the ITAA 1997 provides that a taxpayer can deduct expenditure they incur to the extent that the expenditure is for managing tax affairs.

Expenses incurred for the preparation of a private ruling is considered expenditure for managing your tax affairs. Therefore, it is a deductible expense under section 25-5 of the ITAA 1997.

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