Edited version of private ruling

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Ruling

Subject: Claiming a capital loss upon the forgiveness of debts to related entities

Question 1

Do you make a capital loss under subsection 104-25(3) of the Income Tax Assessment Act 1997 (ITAA 1997) when loans you have provided to certain related entities are forgiven?

Advice/Answers

No.

Question 2

If you do make a capital loss under subsection 104-25(3) of the ITAA 1997, can that loss be applied to reduce a capital gain you made in the same income year in accordance with subsection 102-5(1) of the ITAA 1997?

Advice/Answers

Not applicable.

Question 3

Is your calculation of a capital loss under subsection 104-25(3) of the ITAA 1997 affected by the related debtor entities disregarding an amount in accordance with subsection 245-195(1) of Schedule 2C to the Income Tax Assessment Act 1936 (ITAA 1936) after the application of the commercial debt forgiveness rules in Schedule 2C to the ITAA 1936?

Advice/Answers

No.

This ruling applies for the following period

Income Year ended 30 June 2009.

The scheme commenced on

1 July 2008.

Relevant facts

You are a family trust. You provided loans to some of your related entities which you later forgave.

It became apparent to you that the Commercial Debts to your related entities were never going to be recovered for the following reasons:

Two of the entities have never traded therefore they don't earn any income nor do they own any assets. The funds you loaned to these entities have been used up by annual expenses such as ASIC fees and Accounting fees and pay out bank loans over the last 6-7 years.

A third related entity traded but never made a profit. In order to pay its expenses and wages, it borrowed money from you. Due to decreasing sales, the business was closed.

A fourth related entity borrowed money from you to purchase assets. Unfortunately due to increasing costs, this entity was forced to sell its assets for a loss. As the sale proceeds didn't cover the bank loans, you settled the outstanding bank loan balance on behalf of the entity.

On several occasions, the related entities have attempted to repay their loans, however as their financial situations have only worsened they've ended up borrowing further funds from the creditor as the years go on.

Upon application of the commercial debt forgiveness provisions, some of your related entities have disregarded an amount in accordance with subsection 245-195(1) of Schedule 2C to the ITAA 1936.

You have stated that the amounts of the loan that were provided are also the market value of the loans when they were forgiven.

You sold your principal place of business and made a capital gain on this sale during the 2008-09 financial year. The commercial property was 100% owned by you and has no relation to the above named entities to whom the debts were forgiven.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 104-25.

Income Tax Assessment Act 1997 Subsection 102-5(1).

Income Tax Assessment Act 1997 Section 102-20.

Income Tax Assessment Act 1997 Section 104-5.

Income Tax Assessment Act 1997 Section 104-25.

Income Tax Assessment Act 1997 Subsection 104-25(1).

Income Tax Assessment Act 1997 Section 108-5.

Income Tax Assessment Act 1997 Section 110-55.

Income Tax Assessment Act 1997 Section 110-25.

Income Tax Assessment Act 1997 Section 112-15.

Income Tax Assessment Act 1997 Section 112-20.

Income Tax Assessment Act 1997 Subsection 112-20(1).

Income Tax Assessment Act 1997 Section 116-30.

Income Tax Assessment Act 1997 Subsection 116-30(1).

Income Tax Assessment Act 1997 Subsection 116-30(3).

Income Tax Assessment Act 1997 Subsection 116-30(3A).

Income Tax Assessment Act 1936 Subsection 245-195(1) of Schedule 2C.

Reasons for decision

Issue 1 - Debt forgiveness

Question 1

Summary

When you provide loans to related entities, the debt owed to you will be a CGT asset of yours. When you forgive those loans, CGT event C2 applies in relation to that event. You will make a capital loss from CGT event C2 if the capital proceeds received are less than the reduced cost base of the debts owed to you.

However, as you have not been dealing with the related entities at arm's length when you provided and forgave those loans, the market value substitution rule will apply. This rule will deem the first element of your cost base or reduced cost base to be the market value at the time the loans were provided, and the capital proceeds to be the market value of the loans at the time they forgiven.

Hence, whether or not you make a capital loss upon the forgiveness of loans provided to your related entities will depend on the market value of the loans at the time they were provided and forgiven.

Based on the facts provided, the market value substitution rule will reduce any potential capital loss to nil.

Detailed reasoning

CGT event C2

Section 102-20 of the ITAA 1997 states that you can make a capital gain or capital loss if and only if a CGT event happens. A summary of the CGT events is listed in section 104-5 of the ITAA 1997.

CGT event C2 occurs if your ownership of an intangible CGT asset ends by the asset being redeemed, cancelled, released, discharged, satisfied, expiring, abandoned, surrendered or forfeited.

A CGT asset is defined in section 108-5 of the ITAA 1997 as any kind of property or a legal or equitable right that is not property. Note 1 to section 108-5 of the ITAA 1997 specifically lists debts owed to you as a CGT asset. Capital Gains Tax Determination TD 2 also specifically states that a debt is an asset of the lender.

A debt owed to you is considered to be an intangible asset to which CGT event C2 applies. The forgiveness of the debt is a release, discharge or satisfaction of the debt which ends your ownership of the intangible CGT asset of the debt owed to you. Consequently, CGT event C2 applies upon the forgiveness of loans provided to your related entities.

The timing of CGT event C2 is when a contract is entered into that results in the asset ending or otherwise when the contract ends. This is the time of when the debt is forgiven.

If CGT event C2 applies, you make a capital gain if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base.

Cost base, reduced cost base and capital proceeds

The cost base of a CGT asset is generally the cost of the asset when you bought it. However, it also includes certain other costs associated with acquiring, holding and disposing of the asset, specifically:

1. money or property given for the asset

2. incidental costs of acquiring the CGT asset or that relate to the CGT event

3. costs of owning the asset

4. capital costs to increase or preserve the value of your asset or to install or move it

5. capital costs of preserving or defending your ownership of or rights to your asset.

The reduced cost base of a CGT asset has the same five elements listed above, except the third element is substituted for the following:

3. balancing adjustment amount, that is, any amount that is assessable because of a balancing adjustment for the asset or that would be assessable if certain balancing adjustment relief were not available

The reduced cost base does not include any costs you have incurred for which you have claimed a tax deduction or have omitted to claim, but can still claim, a deduction because the period for amending the relevant income tax assessment has not expired, for example, capital works deductions for capital expenditure.

Section 116-20 of the ITAA 1997 provides that the capital proceeds from most CGT events are the total amount of money or the value of any property you receive, or are entitled to receive in respect of the event happening.

Modifications to the general rules

There are modifications that apply in certain situations to the general rules outlined above in respect of the cost base, reduced cost base and capital proceeds.

The market substitution rule outlined in section 112-20 of the ITAA 1997 applies to substitute the first element of the cost base and the reduced cost base of a CGT asset you acquire from another entity with the market value of that asset. This modification applies if you did not deal at arm's length with the other entity in connection with the acquisition of the asset.

There are some exemptions to the market substitution rule in subsections 112-20(2) and 112-20(3) of the ITAA 1997, however these exemptions are not applicable to your situation.

Similarly, a market value substitution rule also exists in section 116-30 of the ITAA 1997 in respect of capital proceeds. Where no capital proceeds are received from a CGT event, you are taken to have received the market value of the CGT asset that is the subject of the event. The market value is worked out as at the time of the event.

Specifically in relation to CGT event C2, the capital proceeds from a CGT event are also replaced by the market value of the CGT asset where you did not receive the market value of the capital proceeds, or the capital proceeds cannot be valued. The market value of a CGT asset in respect of CGT event C2 is worked out as if the event had not occurred and was never proposed to occur.

There are some exemptions to the market value substitution rule outlined in subsections 116-30(2A), 116-30(2B) and 116-30(3) of the ITAA 1997, however these are not applicable to your situation.

Capital Gains Tax Determination TD 2 confirms the application of the market substitution rule in the situation of a lender waiving a debt. It states that generally, the cost base of the debt to the lender is the amount of the loan.

TD 2 also states that if the lender receives no consideration for the disposal of the debt, the lender is taken to have received an amount equal to the market value of the debt at the time of the disposal. The lender is also taken to receive market value on the disposal of the debt when the consideration is less than the market value of the debt. The market value of the debt at the time of its disposal is worked out as though the debt was not waived and was never intended to be waived.

Arm's length

The Guide to Capital Gains Tax 2009 states that you are said to be dealing at arm's length with someone if each party acts independently and neither party exercises influence or control over the other in connection with the transaction. The law looks not only at the relationship between the parties but also at the quality of the bargaining between them.

It is evident from the facts you have provided that you did not deal at arm's length when providing and subsequently forgiving the loans to your related entities. As the related entities are all under common ownership, it cannot be said that each party has acted independently, or has not exercised influence or control over the other in connection with the transaction. It is unlikely that a non-arm's length party would have provided a loan to other entities that have no or limited means of generating a profit, no or negligible assets and without a loan agreement. It is also unlikely that an entity would forgive a loan for no consideration without the presence of formal winding up or deregistration procedures in progress.

As you have not been dealing at arm's length when providing and forgiving the loans to related entities, the market value substitution rule will apply in respect of the cost base and the reduced cost base, as well as the capital proceeds.

Consequently, whether or not you have made a capital loss upon the forgiveness of loans made to your related entities will depend on the market value of the loans both at the times they were provided and when they were forgiven.

Market value

Part C4 of the Consolidation reference manual provides guidelines for determining the market value for the purposes of the application of the consolidation rules. Part C4 of the Consolidation reference manual extends to market valuations generally, subject to certain exemptions, and the ATO fact sheet, 'Market valuation for tax purposes' reflects these guidelines and applies them to market value generally.

The fact sheet states that market value is not defined in the 'Definitions' part of the ITAA 1997 and as a result 'market value' usually takes on its ordinary meaning. It states that business valuers in Australia typically define market value as the price that would be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious buyer and a knowledgeable, willing but not anxious seller acting at arm's length.

It is not the role of the Australian Taxation Office in providing a Private Ruling to question the valuation of the loans made to your related entities. We rely and provide advice based upon the facts that you have provided to us. You have stated that both the amount of the loans provided and the market value of the loans at the time they have been forgiven, are the amounts that you loaned to your related entities.

Conclusion

As you did not deal at arm's length in providing the loans to you related entities, the market value substitution rule will apply to the first element of the reduced cost base of the loans. This rule will deem these elements to be the market value of the amounts you provided to acquire the asset consisting to the debt owed to you. This will be the amount that you collectively loaned to your related entities.

As you received no capital proceeds upon the forgiveness of the loans, the market value substitution rule will also deem the amount of the capital proceeds as the market value of the loans at the time they were forgiven. You have stated that this amount is the same as the amount of the loans that were provided.

Subsection 104-25(3) of the ITAA 1997 provides that you make a capital loss upon CGT event C2 if the capital proceeds are less than the asset's reduced cost base. As the first element of the reduced cost base of the debts owed to you, and the capital proceeds you received upon the forgiveness of the loans are taken to be the same amount after the application of the market value substitution rule, you will not make a capital loss.

Please note, this calculation does not include the remaining four elements of the reduced cost base that are listed above.

Alternate view

As mentioned above, it is not our role in providing a Private Ruling to question the market value of the loans provided to your related entities. However the following information on an alternative view is provided to assist you in valuing the loans. The application of the market value substitution rule using this alternate method does not alter the fact that you have not made a capital loss. It simply alters the method used to come to this conclusion.

A recent case heard in the Administrative Appeals Tribunal, QFL Photographics Pty Ltd v. Commissioner of Taxation [2010] AATA 758 discusses the application of CGT event C2 in a very similar case where debts made to a related company were forgiven.

The Tribunal stated in paragraph 67 that the market value substitution rule requires the determination of whether a willing but not anxious lender lend an amount to a related company in that company's circumstances or would a willing but not anxious person pay an amount for an assignment of a debt obligation of that amount owed by the company in that company's circumstances.

In determining this question, the financial situation of the related debtor was taken into account as well as the goodwill owned by the debtor. The debtor company had liabilities equalling the amount loaned to it, did not have any assets nor any current income producing activities. The Tribunal was not satisfied that an arm's length party would lend money in those circumstances and consequently the application of the market value substitution rule would reduce the cost base of the debt at the time the loan was made to nil. The capital proceeds were also taken to be nil.

This view can be applied in your situation as you also lent money to related entities that did not have any assets and/or income producing activities, or otherwise did not make a profit. This alternate view will reduce the first element of the cost base of the CGT asset, being the debts owed to you, to zero. The capital proceeds received upon the forgiveness of the loans will also be reduced to zero for similar reasons and consequently you will not make a capital loss.

Question 2

Summary

As concluded at question 1, you did not made a capital loss under subsection 104-25(3) of the ITAA 1997 when loans you provided to certain related entities were forgiven, due to the application of the market value substitution rule. Therefore in your circumstances, no capital loss exists to be applied to reduce a capital gain you made in the same financial year pursuant to subsection 102-15 of the ITAA 1997.

Question 3

Summary

The treatment of the loans by the related entities in accordance with the Commercial Debt Forgiveness Rules in Schedule 2C to the ITAA 1936 does not impact on your calculation of a capital loss under subsection 104-25(3) of the ITAA 1997.

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