Edited version of your written advice

Authorisation Number: 1012982004182

Date of advice: 9 March 2016

Ruling

Subject: Bad Debts

Question 1

Can you claim a deduction under section 25-35 of the Income Tax Assessment Act 1997 (ITAA 1997) in the income year ending 30 June 20YY of X as a bad debt?

Answer

No.

Question 2

Can you claim a deduction under section 25-35 of the ITAA 1997 in the income year ending 30 June 20ZZ of X as a bad debt?

Answer

No.

Question 3

Can you claim a deduction under section 8-1 of the ITAA 1997 for the amount of X, being a loss you incurred in the income year ending 30 June 20YY?

Answer

No.

This ruling applies for the following periods

Year ended 30 June 20YY

Year ending 30 June 20ZZ

The scheme commences on

1 July 20XX

Relevant facts and circumstances

You were incorporated to carry on a business

You sold property, under unconditional contracts, before construction was completed and the titles were issued.

The settlements for property began to take place in XXXX.

The purchasers of X of the property were not able to raise the funds to pay the balance of the purchase price due to the change in the financier's lending policies and the decrease in value of property as a result of the decline of the local economy.

The contracts for the X property involved approximately X to settle. After taking into account the maximum first mortgage borrowing that the purchasers could obtain from the bank, the equity funds that the purchasers had committed with the deposit payment and any extra money that the purchasers could contribute from their personal resources, the purchasers of the property were $X short in total.

You did not anticipate this situation and had not experienced it before in your time in the industry.

You made a commercial decision to offer vendor finance to the purchasers of the property to enable settlements to be made on the basis that it would be uncommercial to pursue your rights under the contracts and you expected that the value of the unit would recover and the loans could be financed on better terms in some later periods.

The purchasers of the units accepted the offer and entered into loan agreements with you. A total amount of $X was approved as loans to these purchasers. As a result, all X contracts of sale were settled in full.

The standard loan agreement contain the following terms:

a. The borrower must repay the loan on or before X years from the date of the loan.

b. For the period, the interest payable will be calculated on the rate of X% per annum, or X% per annum if certain conditions are met.

c. For the period, the interest payable will be calculated on the rate of X% per annum, or X% per annum if certain conditions are met.

d. If the value of the unit increases by X% or more, then the borrower must use its best endeavours to repay the loan.

e. You as the lender will have an interest in the property and the borrower must not deal with the property before repaying the loan. In the event of default, the borrower must immediately repay the loan and any outstanding interest.

Your interest in the property is not secured against the property.

The terms were set to encourage the borrowers to make all endeavours to replace the loan from you with loans from the lending industry.

It is not your intention to remain as a lender because you are not set up administratively to oversee the efficient collection of monthly interest and any arrears that occur.

You will be wound up when all the loans have been repaid or written off as irrecoverable.

You recorded the following book entries - crediting sales by $X and debiting loan asset by $X.

You included an amount of $X from the sale of the property in your assessable income for the income years ending 30 June 20WW and 30 June 20XX.

As at 30 June 20YY, an amount of $X remains owing from the total loan amount approved.

Variation Deed

$X of $X was lent to A to assist with the purchase of two properties.

You were approached by A, through your marketing and sales agent.

After the directors met with the marketing and sales agent, you formed the view that there was an inability to recover the full amount and that cost of legal recovery could result in distress to all parties. No formal minute of the decision was recorded.

On XXXX, under an undated Variation Deed, you agreed to accept payment of $X in full satisfaction of the $X advanced under the loan agreement on the condition that $X was paid simultaneously with the execution of the deed.

On XXXX you received the payment.

Your solicitor advised your directors by email that, by oversight, you had not executed the Variation Deed and requested this be done as soon as possible. This was rectified.

When your local chartered accountant was completing your financial accounts and income tax return for the income year ending 30 June 20YY, the physical writing off of the amount of $X was completed by journal entry.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 25-35

Reasons for decision

Question 1

Summary

The debt was not written off in the income year ending 30 June 20YY and before it was extinguished, the amount is not deductible that income year under section 25-35 of the ITAA 1997.

Question 2

Summary

The debt was extinguished on XXXX, there was no debt in existence from that time. The write-off was made on or after 1 July 20YY and was therefore ineffective for the purposes of section 25-35 of the ITAA 1997.

Detailed reasoning

Subsection 25-35(1) of the ITAA 1997 provides for a deduction for a bad debt in two situations:

(a) the debt was incurred by a taxpayer not carrying on a business of lending money and was included in assessable income; or

(b) the debt was incurred by a taxpayer in respect of money lent in carrying on a business of lending money.

On the facts you have provided, you did not carry on a business of lending money but provided vendor finance to certain purchasers for a limited period due to their particular circumstances. This was done outside the ordinary course of your business of property development for sale.

In your circumstances, there are four conditions that must be satisfied before you can claim a deduction for a bad debt under paragraph 25-35(1)(a) of the ITAA 1997 with these being:

1. a debt must exist

2. the debt must be bad

3. the bad debt must be written off in the income year for which the deduction is claimed, and

4. the amount of the debt must have been included in your assessable income for that income year or an earlier income year.

The Commissioner's view of the operation of the bad debt provisions is set out in Taxation Ruling TR 92/18. Whilst that ruling refers to former section 63 of the Income Tax Assessment Act 1936 (ITAA 1936), it applies equally to section 25-35 of the ITAA 1997, which replaced former section 63 of the ITAA 1936.

Condition 1: a debt must exist

Relevant to your circumstances, where a debt has been extinguished under a settlement or compromise, the creditor is no longer entitled to a sum of money at law or in equity. Therefore, from the time of the settlement or compromise, there is no debt that can be written off for the purpose of claiming a deduction under section 25-35 of the ITAA 1997. Support for this principle can be found in the following High Court authorities: Point v Federal Commissioner of Taxation 70 ATC 4021; Franklin's Selfserve v Federal Commissioner of Taxation 70 ATC 4079; GE Crane Sales Pty Ltd v Federal Commissioner of Taxation 71 ATC 4268.

As noted in TR 92/18 at paragraph 38, where a taxpayer intends to extinguish a debt, it is necessary to write off the debt prior to the extinguishment in order to qualify for the deduction.

Condition 2: the debt must be bad

It is a matter of commercial judgment whether a debt is bad; there is no requirement that all legally available steps have been taken to recover the debt. What is required is a bona fide assessment based on sound commercial considerations.

Condition 3: the debt must be written off as bad before the end of the income year for which the deduction is claimed

Relevant to your circumstances, it is not necessary that the debt be physically written off by an accounting entry in order to satisfy this condition. However, if a person wishes to rely on a decision made prior to physically writing off the debt in the accounts, the decision to treat the debt as bad in the accounts must be recorded in writing.

No deduction can be claimed for an income year if the debt is written off after the income year's end at the time when the books of account are being prepared. However, a deduction may be claimed for the following income year (in which the debt was written off), provided all the other conditions are met.

Condition 4: the debt must have been included in your assessable income in that income year or a prior income year

The amount of the bad debt must have been included in your assessable income. This may involve an inquiry into the character of the amount. For example, if an amount was included in assessable income as revenue from sales, has the character of the debt changed so that it no longer has the same character as the original amount?

Applying the four conditions of deductibility to your circumstances

You entered into the Variation Deed and A paid the amount of $X owing to you under the Deed on the same day.

Whilst your directors met with your marketing and sales agent and decided to extinguish the debt prior to that date, there is no contemporaneous written record of a decision to treat the debt of $X as bad for accounting purposes. The debt was therefore extinguished before it was purported to be written off your books of account. As the debt had been extinguished, it could not be written off.

The first condition was therefore not met in relation to either the income year ending 30 June 20YY or the income year ending 30 June 20ZZ.

It is accepted that the debt was bad for sound commercial reasons. The second condition was therefore met.

Note that, as your chartered accountant made book entries to write off the debt after the end of the income year ending 30 June 20YY, even if the debt not been extinguished, the third condition would not have been met for the income year ending 30 June 20YY. However, had the debt not been extinguished, the third condition would have been met for the income year ending 30 June 20ZZ.

It is accepted that the debt of $X retained the character of proceeds of sale of the units purchased by A. Circumstances prevented you realising an amount of $X, of which debt was a part, at the time of settlement. You offered the vendor financing arrangement in order to realise the full contract price to which you were entitled under the contract of sale. Therefore, it is accepted that the amount of $X was included in your assessable income in an earlier income year being the income year ending 30 June 20XX. The fourth condition was met.

Question 3

Summary

The loss incurred was capital, or of a capital nature, and is therefore not deductible under section 8-1.

Detailed reasoning

As stated in TR 92/18 at paragraph 10, where a bad debt is not deductible under section 25-35 of the ITAA 1997, the loss may nevertheless be deductible under section 8-1 of the ITAA 1997.

Under section 8-1 of the ITAA 1997, you can deduct any loss or outgoing to the extent that it is incurred in gaining or producing your assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. However, a loss or outgoing of capital or of a capital nature it is not deductible.

It is accepted that you incurred a loss of $X for the purposes of section 8-1 of the ITAA 1997 when you entered into the Variation Deed with A (see paragraph 11 of TR 92/18).

It is also accepted that that loss was incurred in gaining or producing your assessable income from the sale of the units to A, as it resulted from your commercial decision to offer vendor finance in order to enable settlement to go ahead and for you to recover the full sale price of the property.

Whether or not such loss is capital, or of a capital nature, depends on a consideration of the facts and circumstances in each case. As explained in paragraphs 67 and 68 of TR 92/18, it is necessary to ascertain the circumstances which occasioned the loss and the relations that these circumstances bear to the taxpayer's income-earning activities.

In determining whether a loss is incurred on capital or revenue account, Australian courts begin with the tests set down in Sun Newspapers Ltd & Anor v. Federal Commissioner of Taxation (1938) 61 CLR 337 at 363 by Dixon J:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

In GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124 at 137, the High Court stated the first of these tests to be 'the chief, if not the critical, factor in determining the character of what is paid'.

The immediate cause of the loss of $X was the inability of A to fully repay the loan principal due to their circumstances and your decision to compromise the debt to avoid distress for both parties. However, the character of the advantage in the Sun Newspapers sense is to be found in the vendor financing arrangement (an outgoing from an accounting perspective) that occasioned the loss.

Applying the tests in Sun Newspapers

Character of the advantage sought

On the one hand, it could be argued that you provided vendor finance as a measure to complete the income-earning process of your property development business and therefore it was no more than a step in that process or incidental to that process. Accordingly, the provision of vendor finance related to the process of conducting your business operations and was a matter of revenue.

On the other hand, of the contracts in the development, you provided vendor finance only for X. Your provision of vendor finance had the character of an extraordinary measure with two objects - (i) to avoid exercising your rights of rescission, which would have been uncommercial, and (ii) to enable the realisation, over time, of the full amount of the profit to which you had a contractual right under those contracts. The full amount of the profit was not immediately realisable due to the unforeseen market downturn and the personal circumstances of the purchasers of those properties.

The better view is that your incurring of vendor finance was not made as a step in the profit-yielding process or as incidental to it. Rather, it related to the preservation and realisation in money of capital benefits that you held when you became ready to deliver possession of the units to the purchasers, namely, your rights to receive the full purchase price under each of the contracts. The preservation of those rights was made once and for all. Their realisation in money would also be made once and for all, though incrementally.

The character of the advantage sought points to the loss being on capital account.

Manner in which the advantage is to be used, relied upon or enjoyed

You applied this advantage only in the case of the sale contracts that were in jeopardy due to the personal circumstances of the purchasers. Vendor finance was not part of your overall business strategy and your intent was to provide it for as short a time as practicable.

This indicator points to the loss being on capital account rather than having been incurred in the process of gaining your assessable income.

Means adopted to obtain the advantage

You offered the vendor finance as an emergency measure. In determining the interest rates, your intention was not so much to earn income from the loans as to incentivise the borrowers to find alternative, cheaper finance and repay the principal owing to you as early as possible.

This indicator also points to the loss being on capital account, reinforcing the view taken of the character of the advantage sought.

Conclusion

The loss of $X was incurred by you was capital, or of a capital nature, and for that reason is excluded from being deductible under paragraph 8-1(2)(a) of the ITAA 1997.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).