Edited version of your written advice

Authorisation Number: 1012797010863

Ruling

Subject: debt forgiveness

Question 1

Will the Deed of Settlement & Release constitute forgiveness of a debt pursuant to section 245-35 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

In calculating the value of the debt can you determine the value of the debt at the date of its forgiveness by reference to its net present value at that date instead of using its market value?

Answer

No

This ruling applies for the following period

Year ending 30 June 2015

The scheme commenced on

1 July 2014

Relevant facts

The entity operates a business.

The entity entered into a loan agreement with a State Government and received $XX to be paid back many years in the future. The loan agreement stated the relevant Minister may convert the loan to a grant at the end of year X.

The loan was used to assist the business.

The Minister entered into a Deed with the entity and entity 2. The Minister and the entity agreed to terminate the original loan agreement and the Minister, the entity and entity 2 entered into this Deed which contains the terms and conditions which all three parties have agreed will apply in respect to the loan.

The Minister, the entity and entity 2 entered into a Deed of Settlement and Release. The Deed stated "At the request of the Borrower the Minister has agreed on the terms of this Deed to accept the Repayment Amount in full and final discharge and release of the Borrower's obligations under the Loan Agreement".

The borrowers were the entity and entity 2.

The Repayment Amount was $X.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 245-35

Income Tax Assessment Act 1997 Section 245-55

Income Tax Assessment Act 1997 Subsection 245-55(1)

Income Tax Assessment Act 1997 Subdivision 960-S

Reasons for decision

Question 1

Section 245-35 of the ITAA 1997 states a debt is forgiven if and when:

(a) The debtor's obligation to pay the debt is released or waived, or is otherwise extinguished other than by repaying the debt in full; or

(b) The period within which the creditor is entitled to sue for the recovery of the debt ends, because of the operation of a statute of limitations, without the debt having been paid.

In this case the entity and the Minister entered into a loan agreement and the entity received a loan of $XX from a State Government. Upon signing the deed the entity and entity 2 became joint borrowers. A Deed of Settlement & Release was entered into and the two borrowers and the Minister agreed that the two borrowers would pay $Y in full and final settlement of the loan. The obligation on the two borrowers was extinguished by entering into the Deed of Settlement & Release therefore the amount of $XX - Y was forgiven.

Question 2

Value of the debt

Section 245-55 of the ITAA 1997 outlines the general rule for working out the value of a debt.

Subsection 245-55(1) of the ITAA 1997 states the value of your debt at the time (the forgiveness time) when it is forgiven is the amount that would have been its market value (considered as an asset of the creditor) at the forgiveness time, assuming that:

(a) when you incurred the debt, you were able to pay all your debt (including that one) as and when they fell due; and

(b) your capacity to pay the debt is the same at the forgiveness time as when you incurred it.

Market value

Under Subdivision 960-S of the ITAA 1997 the expression "market value" is often used in this Act with its ordinary meaning. However, in some cases that expression has a meaning affected by this subdivision.

In this case Subdivision 960-S of the ITAA 1997 has no application therefore the ordinary meaning of "market value" will be used.

The most common definition for "market value" is derived from the High Court decision in Spencer v The Commonwealth (1907) 5 CLR 418 where it was described as the price that a willing, but not anxious, purchaser would, as at the date in question, have had to pay to a vendor who was not unwilling, but not anxious, to sell. In that case, which involved the resumption of land, Isaacs J said (at p 441):

"To arrive at the value of the land at that date, we have, as I conceive, to suppose it sold then, not by means of a forced sale, but by voluntary bargaining between the plaintiff and a purchaser, willing to trade, but neither of them so anxious to do so that he would overlook any ordinary business considerations.

We must further suppose both to be perfectly acquainted with the land, and cognizant of all circumstances which might affect its value, either advantageously or prejudicially, including its situation, character, quality, proximity to conveniences or inconveniences, its surrounding features, the then present demand for land, and the likelihood, as then appearing to persons best capable of forming an opinion, of a rise or fall for what reason so ever, in the amount which one would otherwise be willing to fix as the value of the property."

The High Court also adopted that test in Abrahams v FC of T (1944) 70 CLR 23 where Williams J. said that market value is:

"the price which a willing but not anxious vendor could reasonably expect to obtain and a hypothetical willing but not anxious purchaser could reasonably expect to have to pay ... if the vendor and purchaser had got together and agreed on a price in friendly negotiation."

Some assistance may also be obtained from Brisbane Water County Council v Commr of SD (NSW) 80 ATC 4051, a case concerning the meaning of "market value" under the Stamp Duties Act 1920 (NSW). Waddell J. said that the expression meant the best price which may reasonably be obtained for the property if sold in the general market, adding that:

• if there is no general market, as is the case of shares in a private company, such a market is to be assumed

• all possible purchasers are to be taken into account, even a purchaser prepared for his own reasons to pay a fancy price, and

• the value to be ascertained is the value to the seller.

The primary rule under subsection 245-55(1) of the ITAA 1997 is that the value of the debt when it is forgiven is its market value when it is forgiven assuming that, at the time the debt is incurred and at the time it is forgiven, the debtor is solvent. That is, the debtor is able to repay that debt and all debts as and when they fell due when the debt was incurred and has that same capacity when the debt is forgiven. In effect the debtor who was insolvent when the debt was incurred or when it is forgiven is assumed to have been solvent at those times.

In the absence of the solvency assumption, questions arise as to the value of the debt at the time it is forgiven. For example a debtor company can attempt to justify a merely nominal market value for a forgiven debt on the basis that it was insolvent at the time the debt was incurred making the debt virtually worthless. The solvency assumption prevents such an outcome.

An example of the above principle is as follows:

Anna borrows $10,000 from Ben in an arm's length dealing. Two years later the debt is forgiven for no consideration as Anna, technically bankrupt cannot pay. The value of the debt is $10,000. This is not affected by Anna's failure to disclose to Ben at the time of the borrowing that Anna was already in severe financial difficulties in relation to the payment of her existing debts (solvency assumption)

Other factors which may also affect the market value of the debt are the movement in the foreign exchange rate, interest rate movements, and changes in repayment terms or term of the debt or rights of the debtor under the debt.

In this case the entity entered into a loan arrangement with a State Government and received the proceeds of the loan of $XX.

The Minister subsequently entered into a Deed with the entity and entity 2. The Minister and the entity agreed to terminate the original loan agreement and the Minister, the entity and entity 2 entered into this Deed which contains the terms and conditions which all three parties agreed will apply in respect to the loan.

The State Government, the entity and entity 2 entered into Deed of Settlement & Release. As outlined in the Deed of Settlement & Release it was agreed that the entity and entity 2 would pay $Y in full and final settlement of the $XX loan.

In the above example (with Anna & Ben) the main point of the example was that despite the fact that Anna was technically bankrupt at the time of the forgiveness, the amount forgiven was the market value of the debt at the time of forgiveness. The original amount of the debt and the forgiven amount remain at $10,000 (which is its market value) not the Net Present Value of the debt at the time of it being forgiven. It is the actual value of the debt at the time of its forgiveness.

You have argued that the following factors impacted upon the market value of the debt:

• the period of repayment of the loan

• the interest free nature of the loan

• the unsecured nature of the loan; and

• the size, industry and credit risk of the taxpayer.

It is considered that none of these factors had an impact on the market value of the debt.

There were no other factors such as movement in the foreign exchange rate, interest rate movements, change in repayment terms or term of the debt or rights of the debtor under the debt which impacted on the market value therefore the market value (for purposes of section 245-55) of the debt at the date of forgiveness was $XX - Y and not the Net Present Value of the debt.

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