Edited version of your written advice

Authorisation Number: 1051282872836

Date of advice: 14 September 2017

Ruling

Subject: Capital loss upon the forgiveness of a commercial debt

Question 1

Do you make a capital loss under subsection 104-25(3) of the Income Tax Assessment Act 1997 (ITAA 1997) when you forgive a loan you have provided to the Company?

Answer

Yes.

This ruling applies for the following period:

Income year ended 30 June 2017

The scheme commences on:

26 May 2015

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

You are the Trustee of an Australian resident Trust. You hold 100% of the shares in the Company.

You loaned an amount to the Company in the income year ended 30 June 2015. A Loan Agreement documenting the loan was signed on that date and was subsequently registered with an amount of duty paid on the loan.

The property of the Trustee was provided as security for the loan. A caveat was lodged over the property of the Company’s directors as security for the loan.

The Company conducted a small business at the time the loan was made. At this time there was a genuine expectation that the business would grow and be able to pay dividends in the future.

Throughout the life of the loan, the Company made some repayments and interest was charged on the loan. The Company used the loan funds in its business, and hence the interest charged on the loan was deductible.

In the income year ended 30 June 2017, the Company sold the small business. As the Company has ceased trading, it intends to de-register. Due to the closure of the business, the Company is unable to repay the outstanding loan balance.

Due to the Company’s incapacity to repay the loan, you forgave the loan. This was recorded in the Company’s meeting minutes, with a recording that the rules in Division 245 of the ITAA 1997 would be applied for the following reasons:

● When the Trust lent the money that the company was solvent.

● When the Debt was forgiven the company was insolvent as it was sold.

● The loan was not a “personal use asset” and that the Trust lent money to the company so that it could generate future Dividends (income producing purpose).

● There was a genuine expectation that dividends will be paid and that way the reason the Trust lent the money.

Therefore:

● The Trust will treat the balance of the loan amount as a capital loss.

● The Company will have no effect (not income and not capital) except that the balance of the loan will reduce any carried forward tax losses and carried forward capital losses.

Assumption

The Company was solvent at the time the loan was made.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 102-20

Income Tax Assessment Act 1997 esction 104-5

Income Tax Assessment Act 1997 subsection 104-25(2)

Income Tax Assessment Act 1997 section 104-25(3)

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 subsection 108-20(1)

Income Tax Assessment Act 1997 paragraph 108-20(2)(d)

Income Tax Assessment Act 1997 Subdivision 110-A

Income Tax Assessment Act 1997 Subdivision 110-B

Income Tax Assessment Act 1997 subsection 110-55(6)

Income Tax Assessment Act 1997 section 112-20

Income Tax Assessment Act 1997 section 116-30

Income Tax Assessment Act 1997 subsection 116-30(3)

Income Tax Assessment Act 1997 subsection 116-30(2)

Income Tax Assessment Act 1997 Division 245

Reasons for decision

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. CGT Determination Number 2 TD 2 Capital Gains: What are the CGT consequences for the lender (Creditor) when a debt is waived? also specifically states that a debt is an asset of the lender.

The loan you made to the Company is considered to be an intangible asset to which CGT event C2 applies. The forgiveness of the loan 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 when you forgive the loan you have made to the Company.

Subsection 104-25(2) of the ITAA 1997 states that the timing of CGT event C2 is when a contract is entered into that results in the asset ending or otherwise when the asset ends. This is the time when the loan to the Company is forgiven.

Subsection 104-25(3) of the ITAA 1997 provides that when CGT event C2 happens, you make a capital gain if the capital proceeds from the disposal are more than the asset's cost base. You make a capital loss if the capital proceeds are less than asset's reduced cost base.

Reduced cost base

Subdivision 110-B of the ITAA 1997 provides for the rules about the reduced cost base of a CGT asset. Items of expenditure can only be included in your reduced cost base if they fit within the following five elements:

1. money or property given for the asset

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

3. any balancing adjustment 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

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 title or rights to your asset.

These elements are the same as those included in the cost base of a CGT asset in Subdivision 110-A of the ITAA 1997 with the exception of element three.

However, subsection 110-55(6) of the ITAA 1997 provides that expenditure does not form part of your reduced cost base to the extent of any amount you have received as recoupment of it, except so far as the amount is included in your assessable income.

In your case, the first element of the reduced cost base of the loan will include the loan amount less any recoupment of that amount, that is, any principal repaid by the Company during the term of the loan. Additionally, any other expenses incurred under the other four elements outlined above will also be included in the reduced cost base of the loan.

Capital proceeds

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.

However, the market value substitution rule in subsection 116-30(2) of the ITAA 1997 applies in respect of CGT event C2 where the capital proceeds received are more or less than the market value of the asset. This rule provides that the capital proceeds from the CGT event are replaced with the market value of the CGT asset as at the time of the event. 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.

Paragraph 41 of Taxation Ruling TR 2001/9 Income tax: agency development loans provides that if the debt is released or cancelled because it is worthless, then the market value will be nil. As the Company was insolvent at the time the debt was forgiven, then the application of the market value substitution rule in subsection 116-30(3) of the ITAA 1997 will deem the capital proceeds you have received upon the forgiveness of the loan to the Company to be nil.

Personal use asset

Subsection 108-20(1) of the ITAA 1997 provides that a capital loss you make from a personal use asset is disregarded in working out your net capital gain or net capital loss. Under paragraph 108-20(2)(d) of the ITAA 1997, a debt is a personal-use asset if it arises other than:

(i) in the course of gaining or producing your assessable income, or

(ii) from your carrying on a business.

Paragraph 47 of Taxation Ruling TR 96/23 Income tax: capital gains: implications of a guarantee to pay a debt states that the test of what is a personal-use asset requires a finding that the debt came to be owed for a primary purpose other than that of gaining or producing income or in carrying on of a business.

In your case, you lent the funds to the Company so they could be used in the small business to generate future dividends, which is assessable income. This means the CGT asset is not a personal use asset and a capital loss will not be disregarded under subsection 108-20(1) of the ITAA 1997.

Consequently, you will make a capital loss if the capital proceeds are less than the reduced cost base of the CGT asset consisting of the loan you have made to the Company. Using the values provided by you, this will result in a capital loss.

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