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Ruling

Subject: Unpaid present entitlement

Question

Does the amount written off which represents unpaid distributions constitute a deductible bad debt in terms of section 25-35 of the ITAA 1997?

Answer

No.

This ruling applies for the following period

Year ended 30 June 2010

The scheme commenced on

1 July 2009

Relevant facts

The Trust held units in a Unit Trust for many years.

Any net income of the Unit Trust was distributed to the unit holders.

The Trust returned the distributions it was entitled to as assessable income.

Over the years, the distributions exceeded the actual amounts paid to the Trust by the Unit Trust.

As a result of a business fallout, all loans and obligations were 'written off'.

The Trust wrote off its entitlement to receive the balance of its loan account, which represented the unpaid present entitlements.

Relevant legislative provisions

Section 25-35 of the ITA 1997

Section 104-25 of the ITAA 1997

Reasons for decision

Section s25-35 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that you can deduct a bad debt that you write off as bad in the income year if:

(a) it was included in your assessable income for the income year or for an earlier income year; or

(b) it is in respect of money that you lent in the ordinary course of your business of lending money.

A debt must exist before it can be written off as bad.

The word "debt" is defined in neither of the Income Tax Assessment Acts. Accordingly, it is necessary to apply the rules of statutory interpretation to attempt to determine the meaning intended by the legislature in drafting the provision.

Australia's leading text on statutory interpretation is Pearce and Geddes'

Statutory Interpretation in Australia. With respect to the interpretation of words with a legal technical meaning, the approach to be followed is, according to those authors, "best stated" by O'Connor J in Attorney-General (NSW) v. Brewery Employés' Union of New South Wales (1908) 6 CLR 469 at 531:

Where words have been used which have acquired a legal meaning it will be taken, prima facie, that the legislature has intended to use them with that meaning unless a contrary intention clearly appears from the context. To use the words of Denman J in R v. Slator ((1881) 8 QBD 267 at 272): 'but it always requires the strong compulsion of other words in an Act to induce the Court to alter the ordinary meaning of a well known legal term'.

35. The legal technical meaning of the word "debt" is defined in Butterworths

Australian Legal Dictionary 1997, Butterworths, NSW:

2. A sum of money owed: Director of Public Prosecutions v. Turner [1073] 3 All ER 124 at 126. A debt is a sum of money which is now payable or will become payable in the future by reason of a present obligation. It is a right which a creditor has to enforce by taking action.

When a beneficiary of a trust is made presently entitled to an amount that is not paid, trust property representing the unpaid present entitlement (UPE) is (in effect) held by the trustee on a separate trust, arising in equity, in respect of which the unpaid beneficiary is the sole beneficiary (paragraph 35 of TR 2010/3).

In the case of an unpaid beneficiary, the beneficiary's interest in the separate trust is proprietary in nature. That is, they have an equitable interest in the corpus, and in the income of the assets of the separate trust.

The key difference between an unpaid present entitlement and a debt is that an unpaid present entitlement does not result in an enforceable obligation imposed by law (as distinct from the rights that attach to a creditor). Rather, the rights of an unpaid beneficiary arise in equity only - and not in law. It is for this reason that an unpaid beneficiary cannot "sue for their entitlement"

To "sue" is "to bring a civil proceeding against a person"; and a "civil proceeding" is a proceeding or an action "commenced in the civil jurisdiction of a court of law" (both definitions from Butterworths Australian Legal Dictionary 1997, Butterworths, NSW).

A beneficiary's cause of action is in the equitable jurisdiction of a court (a beneficiary's interest not being recognised at law). Whilst the rules of law and equity may be administered concurrently in the various State Supreme courts in Australia, a clear distinction between equitable and legal causes of action remains.

Taxation Ruling TR 92/18 provides that a debt exists where a taxpayer is entitled to receive a sum of money from another either at law or in equity. However, the context of the ruling must be considered as a whole. A debt in these circumstances is clearly contemplating a debt that arose as a result of a debtor-creditor relationship during the course of carrying on a business.

An unpaid beneficiary has rights in equity and not as a result of any debtor-creditor relationship (paragraph 34 of TR 2010/3).

There is considerable authority that supports the principle that money owed to trust beneficiaries as UPE's have a materially different character to money owed to creditors.

The Federal Court decision of Euroasian Holdings Pty Ltd v Ron Diamond Plumbing Pty Ltd (in liquidation) (1996) 64 FCR 147 confirmed that a UPE was not a debt.

Further, in the context of TR 92/18, if there was considered to be a debt, the debt must be bad and the debt must have been included in assessable income.

Is the debt bad?

Paragraph 31 of TR 92/18 provides that a debt may be considered to have become bad in any of the following circumstances:

(a) the debtor has died leaving no, or insufficient, assets out of which the debt may be satisfied;

(b) the debtor cannot be traced and the creditor has been unable to ascertain the existence of, or whereabouts of, any assets against which action could be taken;

(c) where the debt has become statute barred and the debtor is relying on this defence (or it is reasonable to assume that the debtor will do so) for non-payment;

(d) if the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the whole debt, or the part claimed as a bad debt;

(e) where, on an objective view of all the facts or on the probabilities existing at the time the debt, or a part of the debt, is alleged to have become bad, there is little or no likelihood of the debt, or the part of the debt, being recovered.

In terms of (e) above, paragraph 32 of TR 92/18 provides:

While individual cases may vary, as a practical guide a debt will be accepted as bad under category (e) above where, depending on the particular facts of the case, a taxpayer has taken the appropriate steps in an attempt to recover the debt and not simply written it off as bad. Generally speaking such steps would include some or all of the following, although the steps undertaken will vary depending upon the size of the debt and the resources available to the creditor to pursue the debt:

(i) reminder notices issued and telephone/mail contact is attempted;

(ii) a reasonable period of time has elapsed since the original due date for payment of the debt. This will of necessity vary depending upon the amount of the debt outstanding and the taxpayers' credit arrangements (e.g. 90, 120 or 150 days overdue);

(iii) formal demand notice is served;

(iv) issue of, and service of, a summons;

(v) judgment entered against the delinquent debtor;

(vi) execution proceedings to enforce judgment;

(vii) the calculation and charging of interest is ceased and the account is closed, (a tracing file may be kept open; also, in the case of a partial debt write-off, the account may remain open);

(viii) valuation of any security held against the debt;

(ix) sale of any seized or repossessed assets.

While the above factors are indicative of the circumstances in which a debt may be considered bad, ultimately the question is one of fact and will depend on all the facts and circumstances surrounding the transactions. All pertinent evidence including the value of collateral securing the debt and the financial condition of the debtor should be considered. Ultimately, the taxpayer is responsible for establishing that a debt is bad and bears the onus of proof in this regard.

In this instance, there is not enough information provided to ascertain if the UPE is a "bad" debt in the context contemplated in TR 92/18 or whether the Trust has simply written it off as such. An analysis of the Unit Trust's financial position and the steps the beneficiary has taken to recover the UPE would be required to determine this. However, for the purposes of this Ruling, this analysis is not required.

Has the debt has been included in assessable income in the current or an earlier income year?

As explained above, an unpaid entitlement is an equitable right. It arises from a resolution made by the trustee in accordance with the trust deed and general law of trusts to allocate or appoint all or part of the income or capital of the trust to a beneficiary. Importantly, it is not the income or capital appointed under the trustee resolution that is included in a beneficiary's assessable income.

The amount included in a beneficiary's assessable income is the item of statutory income determined under Division 6 of the ITAA 1936. Under section 97 of the ITAA 1936, a beneficiary includes in assessable income a share of the net income of the trust estate. Net income is calculated in accordance with section 95 of the ITAA 1936.

The share is the fractional interest the beneficiary has in the distributable income of the trust estate calculated in accordance with the general law of trusts and the trust deed (Bamford v FC of T 2010 ATC 20-170).

That is, what the Trust has previously been taxed on is a share of the unit trust's taxable income, which in strict technical terms is a tax fiction and therefore cannot be written off in the sense contemplated by section 25-35 of the ITAA 1997.

We also note that if the UPE has been converted into a loan, within the strict legal meaning of the term, a deduction under s25-35 is only available if the money was lent in the ordinary course of a money lending business.

Capital gains tax:

Although you have not specifically asked us to rule on the application of capital gains tax (CGT) even C2, you have indicated your expectation that it would apply. We therefore make the following comments:

A capital loss occurs when you dispose of a CGT asset and the proceeds you receive for the disposal are less then the reduced cost base of the asset.

In this instance, it may be possible that a CGT event C2 has occurred in accordance with section 104-25 of the ITAA 1997. That is, the Trust has disposed of an intangible asset - the right to receive the UPE by "writing off" the balance of the loan.

However, the cost base of that right is considered to be nil, as it did not cost the Trust anything to acquire the right to receive the UPE - that right was already in existence by virtue of the Trust holding the units in the Unit Trust, which gave the entitlement to a share of the net income of the Unit Trust.

Further, the capital proceeds for the disposal of the right to receive the UPE would also be nil based on the information provided. Therefore, there would be no capital loss in this situation.

Please note that the above discussion does not apply in respect of a CGT event on any disposal or cancellation of the actual units, which would be a separate CGT event.

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