Edited version of private advice

Authorisation Number: 1051999008477

Date of advice: 28 June 2022

Ruling

Subject: Commercial debt forgiveness

Question

Will the debt forgiveness result in a net forgiven amount for the purposes of Division 245 of the ITAA 1997?

Answer

No. Consequently, there will be no impact for the head company of the consolidated group, which means that, for example, the head company does not have to make any adjustment to carry forward tax losses, carry forward net capital losses, adjustable value of depreciating assets and cost base of the CGT assets held by the head company under the single entity rule.

This ruling applies for the following period: XXXX

Relevant facts and circumstances

The loan from Company A to Company B was made before Trust A acquired all the shares in Company B before 19XX. (The loan is not a qualifying or traditional security.)

Company B acquired the loan for carrying on a business or income producing purpose.

The loan was not made by Company A in the ordinary course of a business of lending money carried on by Company A.

Trust A owned all the shares in Company B from when it acquired it until it transferred the shares to Head Company in 20XX.)

Trust A acquired the debt from Company A by way of assignment when it acquired Company B for a nominal amount.

Trust A and Company A are associates for the purposes of section 318 of the ITAA 1936.

Trust A and Company B treated the debt as an interest free unsecured loan, with no fixed repayment date. Trust A has not declared any interest income and Company B has not claimed any interest deductions with respect to the loan. Trust A has never made any demands for repayment and Company B has never made any repayments with respect to the loan.

The debt assignment did not give rise to a new loan. Trust A merely stepped into the creditor's shoes, without requiring payment.

The loan was not made by Trust A in the ordinary course of a business of lending money carried on by Trust A.

Company C owes Company B an amount that is more than the amount Company B owes Trust A.

Company B is solvent at all times. It may repay the amount it owes to Trust A by calling on Company C to repay the amount owed to it.

Company C is solvent at all times.

Company C is a wholly owned subsidiary of Head Company at all times.

Company B and Company C are wholly owned subsidiaries of Head Com- they elected to become a consolidated group on XXXX.

Trust A is the sole shareholder of Head Company.

Proposed transaction

Trust A will release Company B from the debt.

Then, Company C will discharge the debt owed to Company A by way of set-offs of inter-company debts within the Consolidated Group.

Relevant legislative provisions

Reasons for decision

Issue

Summary

There is no net forgiven amount in these circumstances as the market value of the debt, at the time of the forgiveness, is equal to the amount offset.

Detailed reasoning

Commercial debt forgiveness

The commercial debt forgiveness rules set out in former Division 245 in Schedule 2C of the ITAA 1936 were largely reproduced in the current Division 245 of the ITAA 1997 pursuant to the Tax Laws Amendment (Transfer of Provisions) Act 2010, which continues the rewriting of the ITAA 1936, to reflect current drafting styles without changing original ideas and meanings unless expressly provided.

Division 245 of the ITAA 1997 applies when a commercial debt (or part of a commercial debt) is forgiven from the 2010-11 income year onwards.

Commercial debt

Section 245-10 of the ITAA 1997 provides that a debt will be a 'commercial debt' if:

a)    the whole or any part of interest, or of an amount in the nature of interest, paid or payable by you in respect of the debt has been deducted, or can be deducted, by you; or

b)    interest, or an amount in the nature of interest, is not payable by you in respect of the debt but, had interest or such an amount been payable, the whole or any part of the interest or amount could have been deducted by you; or

c)    interest or an amount mentioned in paragraph (a) or (b) could have been deducted by you apart from the operation of a provision of this Act (other than paragraphs 8-1(2)(a), (b) and (c)) of the ITAA 1997 that has the effect of preventing a deduction.

To determine whether a commercial debt exists it is necessary to consider the borrower's purpose and not that of the lender (Federal Commissioner of Taxation v Tasman Group Services Pty Ltd 2009 ATC). If the purpose of the borrowing means that if interest had been payable on the loan, it would have been deductible to the borrower, the loan constitutes a commercial debt.

The loan

Company B acquired the loan from Company A for the purpose of carrying on its business or for the purpose of producing or gaining assessable income. Therefore, if interest were charged by Trust A and was payable on the loan by Company B it would be deductible under section 8-1 of the ITAA 1997. Accordingly, the loan is a commercial debt and falls within the provisions of Division 245 of the ITAA 1997.

Forgiveness of a debt

A debt is forgiven under section 245-35 of the ITAA 1997 when a debtor is released or waived from their obligation to pay the debt or the period within which the creditor is entitled to sue for recovery of the debt ends.

Section 245-35 of the ITAA 1997 states that 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 debt will be forgiven as it is proposed that Company B, as debtor, will be released from its liability to pay the amount owing to Trust A.

Gross forgiven amount

The amount of forgiveness (called the gross forgiven amount) for the debtor reflects the loss that the creditor makes for tax purposes. It is worked out in 2 steps:

a)    The value of the debt when it was forgiven is worked out on the basis that the debtor was solvent both then and when the debtor incurred the debt; and

b)    The value of the debt is then offset by any consideration given for the forgiveness of the debt.

The difference between the value of the debt and the amount offset is the gross forgiven amount.

Value of the debt

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

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

a)    When the debt was incurred, the debtor was able to pay all their debts as and when they fell due; and

b)    The debtor's capacity to pay the debt is the same at the forgiveness time as when the debtor incurred it.

However, the value of the debt is the amount worked out under subsection 245-55(2) of the ITAA 1997 if it is less than the amount determined under the basic rule.

The assumption in paragraph 245-55(1)(a) of the ITAA 1997, however, does not apply when calculating the value of the debt if the creditor was an Australian resident at the forgiveness time, the debt was not a moneylending debt and the debtor and the creditor were not dealing with each other at arm's length in respect of incurring the debt (subsection 245-55(3) of the ITAA 1997). In these circumstances, the basic (market value) rule applies in determining the value of the debt; but, without any assumption regarding the debtor's solvency at the time the debt was incurred. The value of the debt depends on its value when the debt was incurred by reference to the financial capacity of the debtor at that time.

The Explanatory Memorandum to the Taxation Laws Amendment Bill No 2 1996, that accompanied the introduction of former Division 245 in Schedule C of the ITAA 1936, explains that the assumption is unnecessary in these circumstances due to the operation of the market value substitution rule (now in section 112-20 of the ITAA 1997), that is, when a creditor and debtor are not engaged in an arm ' s length dealing, the market value substitution rule deems the creditor to have given market value consideration for the acquisition of the asset (i.e. the debt) which affects the creditor's loss on the forgiven debt:

Gross forgiven amount calculation

6.31 Subdivision 245-C sets out how to calculate the gross forgiven amount of a debt. That gross amount will be reduced (if required) by the amounts specified in Subdivision 245-D to arrive at the net forgiven amount of a debt.

6.32 The starting point in calculating the gross forgiven amount is to determine what constitutes the forgiven debt. Ordinarily, it is simply the debt or part of the debt which the creditor releases or waives or is otherwise taken to be forgiven by the operation of section 245-35. If consideration is given for the forgiveness, the amount of the forgiven debt is the part of the debt no longer payable and the part of the debt extinguished by the consideration. [Section 245-50]

...

6.34 The gross forgiven amount of a debt is its notional value less any amount of consideration in respect of the forgiveness of the debt. [Section 245-75]

Notional value of the debt

6.35 The basic rule is that the notional value of a debt is the amount that would be the value of the debt on forgiveness if the debtor's capacity to pay the debt on termination was the same as it was at the time when the debt was initially incurred [subsection 245- 55(2)], on an assumption that the debtor was solvent when the debt was incurred. This is called the first applicable amount.

6.36 The assumption contained in the basic rule of the debtor's initial solvency would affect a case where, notwithstanding that parties to a debt arrangement are at arm's length, a debt has arisen in circumstances where the debtor may not have been solvent at that time. For example, a bank may have lent money to a company in the belief that it was solvent when it was not.

6.37 The assumption will prevent a debtor being able to put only a nominal value on the debt, on the basis that it was close to worthless at the time it was incurred because the debtor was then insolvent. Thus, there will be a requirement to value the debt as if the debtor was solvent at the time it was incurred and that its capacity to pay at the time it was forgiven is the same as when it was incurred. The value of the debt will therefore be determined by reference to its arm's length terms.

6.38 The assumption of initial debtor solvency does not apply where the debtor and creditor were not dealing with each other at arm's length in relation to the debt and the debt is not a moneylending debt [subsection 245-55(4)]. The reason is that, in such circumstances, relevant capital gains rules (subsection 160ZH(9)) would treat the creditor as having given market value consideration for the debt when it was acquired as an asset by the creditor. If the creditor forgives a non-arm's length debt of nominal value and is (by subsection 160ZH(9)) thereby denied entitlement to a substantial capital loss, it is appropriate to treat the debtor as having been forgiven a debt of the same nominal value. (A moneylending debt is defined in section 245-245. It is one which results from a loan made by the creditor in the ordinary course of a business of money lending.)

The general rule is subject to the special rules for working out the value for a non-recourse debt or of a previously assigned debt.

Relevantly, it is only necessary to consider whether there is an assignment of debt for the purposes of section 245-36 of the ITAA 1997.

Debt assignment rules apply

If a debt is assigned

Section 245-36 of the ITAA 1997 states:

A debt is forgiven if and when the creditor assigns the right to receive payment of the debt to another entity (the new creditor) and the following conditions are met:

(a) either the new creditor is the debtor's *associate or the assignment occurred under an *arrangement to which the new creditor and debtor were parties;

(b) the right to receive payment of the debt was not acquired by the new creditor in the ordinary course of *trading on a market, exchange or other place on which, or facility by means of which, offers to sell, buy or exchange securities (within the meaning of Division 16E of Part III of the Income Tax Assessment Act 1936) are made or accepted.

Note 1:

Division 16E of Part III of the Income Tax Assessment Act 1936 brings to account gains and losses on some securities on an accruals basis.

Note 2:

This Division also applies if an assigned debt is subsequently forgiven by the new creditor. Section 245-61 tells you how to work out the value of the debt in that case.

Note 2 indicates section 245-61 applies when the assigned debt is subsequently forgiven by the new creditor.

Section 245-61 of the ITAA 1997 provides that:

If your debt has been assigned as mentioned in section 245-36 and is later *forgiven by the new creditor, the value of that debt when it is later forgiven is:

(a) if the debt was not a *moneylending debt and the creditor and the new creditor were not dealing with each other at *arm's length in connection with the assignment - the *market value of the debt at the time of the assignment; or

(b) in any other case - the sum of:

(i) the amount or market value of the consideration (if any) you paid or gave, or are required to pay or give, to the creditor in respect of the assignment; and

(ii) the amount or market value of the consideration (if any) the new creditor paid or gave in respect of the assignment.

The term 'assigns' or 'assignment' is not defined in the ITAA 1997 or the ITAA 1936. Therefore, it takes its general law meaning, having regard to the well- established rule of interpretation as noted in Attorney-General (NSW) v Brewery Employés Union of New South Wales (1908) 6 CLR 469, that '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', and the qualification in R. v Slator 8 Q.B.D., 267 '... 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".

In Norman v FCT (1963) 109 CLR 9 at 26, Windeyer J stated:

Assignment means the immediate transfer of an existing proprietary right, vested or contingent, from the assignor to the assignee. Anything that in the eye of the law can be regarded as an existing subject of ownership, whether it be a chose in possession or a chose in action, can to-day be assigned, unless it be excepted from the general rule on some ground of public policy or by statute.

The assignment may satisfy the condition in section 245-36 of the ITAA 1997 that 'the creditor assigns the right to receive payment of the debt to another entity (the new creditor)'.

Paragraph 245-36(b) of the ITAA 1997 is satisfied, because the right to receive payment was not acquired by the new creditor (BF Trust) in the ordinary course of trading on a market, exchange or other place on which, or facility by means of which, offers to sell, buy or exchange securities (within the meaning of Division 16E of Part III of the ITAA 1936) are made or accepted.

The issue then is whether, under paragraph 245-36(a) of the ITAA 1997, either:

•         the new creditor (Trust A) is the debtor's associate (as defined in section 318 of the ITAA 1936); or

•         the assignment occurred under an arrangement to which the new creditor (Trust A) and debtor were parties.

Association

As Company B is a company, the relevant provisions of section 318 of the ITAA 1936 are subsections 318(2) and 318(6):

An associate of a company is determined in accordance with the rules set out in section 318 of the ITAA 1936. Amongst other things, the Explanatory Memorandum to the Taxation Laws Amendment (Foreign Income) Bill 1990 explains the intended operation of the association rules with respect to companies:

In broad terms, the associates are those entities that, by reason of family or business connections, might appropriately be regarded as being associates of a particular entity.

Subsection 318(2) specifies who will be an associate of a company (other than a company in the capacity of trustee). These are as follows:

•         a partner of the company or a partnership in which the company is a partner (paragraph (2)(a));

•         where the partner of a company is a natural person - that person's spouse or child (paragraph (2)(b));

•         where the company, or an entity that is an associate of the company because of paragraph (2)(a), (b), (d), (e) or (f), benefits under a trust (see notes on paragraph 318(6)(a)) - the trustee of the trust (paragraph (2)(c));

•         another entity that, acting alone or with another entity or entities, sufficiently influences the company (subparagraph (2)(d)(i));

•         an entity that, either alone or together with associates, holds a majority voting interest in the company (subparagraph (2)(d)(ii));

•         a second company that is sufficiently influenced by:

o   the company (sub-subparagraph (2)(e)(i)(A));

o   an entity that is an associate of the company because of paragraph (2)(a), (b), (c), (d) or (f) (sub-subparagraph (2)(e)(i)(B));

o   a third company that is an associate of the company because of sub-subparagraph (2)(e)(i)(A), (B) or (D) or subparagraph (2)(e)(ii) (sub-subparagraph (2)(e)(i)(C)); or

o   two or more entities that are associates of the company because of sub-subparagraph (2)(e)(i)(A), (B) or (C) (sub-subparagraph (2) (e)(i)(D));

•         a second company in which a majority voting interest is held by:

o   the company (sub-subparagraph (2)(e)(ii)(A));

o   entities that are associates of the company because of subparagraph (2)(e)(i) and paragraphs (2)(a), (b), (c), (d) and (f) (sub-subparagraph (2)(e)(ii)(B)); or

o   both the company and entities that are associates of the company because of subparagraph (2)(e)(i) and paragraphs (2)(a), (b), (c), (d) and (f) (sub-subparagraph (2)(e)(ii)(C)); and

•         an associate of an entity that is an associate of the company because of paragraph (2)(d) (paragraph (2)(f)).

Relevantly, subsection 318(6) of the ITAA 1936 provides that:

1. ....
2. a company is sufficiently influenced by an entity or entities if the company, or its directors, are accustomed or under an obligation (whether formal or informal), or might reasonably be expected, to act in accordance with the directions, instructions or wishes of the entity or entities (whether those directions, instructions or wishes are, or might reasonably be expected to be, communicated directly or through interposed companies, partnerships or trusts); and
3. an entity or entities hold a majority voting interest in a company if the entity or entities are in a position to cast, or control the casting of, more than 50% of the maximum number of votes that might be cast at a general meeting of the company.

In this case, Trust A is an associate of Company B - it is the sole shareholder of Head Company and Company B is a wholly owned subsidiary of Head Company. That is, broadly:

•         Trust A, acting with Head Company, sufficiently influences Company B (subparagraph 318 (2)(d)(i));

•         Trust A is an associate of Head Company which is an associate of Company B because Company B is sufficiently influenced by Head Company and/or the majority voting interests in Company Bis held by Head Company (paragraph 318(2)(f)).

Accordingly, the assignment of the debt under which Trust A is the new creditor satisfies the first limb of paragraph 245-36(a) of the ITAA 1997.

The value of the previously assigned debt is its market value when it was assigned. Relevantly paragraph 245-61(a) of the ITAA 1997 provides that where a previously assigned debt for the purposes of section 245-36 of the ITAA 1997 is later forgiven by the new creditor, the value of that debt when it is later forgiven is, if the debt was not a moneylending debt and the creditor and the new creditor were not dealing with each other at arm's length in connection with the assignment, the market value of the debt at the time of the assignment. In this case it is reasonable to conclude that the parties were not acting on an arm's length basis - as it relates to interest, repayments, security and forgiveness when Company B had capacity to repay the debt.

Did the assignment occur under an arrangement to which the new creditor and debtor were parties?

The deed or agreement that effected an assignment would constitute an 'arrangement', which is defined in subsection 995-1(1) of the ITAA 1997 to mean:

any arrangement, agreement, understanding, promise or undertaking, whether express or implied, and whether or not enforceable (or intended to be enforceable) by legal proceedings

The deed or agreement was an express agreement that was enforceable (or intended to be enforceable) by legal proceedings.

Trust A was a party to the assignment of the debt under which it is the assignee and new creditor. However, the debtor (Company B) was not a party to the assignment of the debt.

A debtor "is not a party" to an assignment of the debt which they owe. In Olsson v Dyson (1969) 120 CLR 365 at 388, Windeyer J stated (albeit dissenting, with Barwick CJ, on the outcome of the case):

The ultimate distinction, in juristic analysis, between a transfer of a debt by assignment and by novation is simple enough. Novation is the making of a new contract between a creditor and his debtor in consideration of the extinguishment of the obligations of the old contract: if the new contract is to be fully effective to give enforceable rights or obligations to a third person he, the third person, must be a party to the novated contract. The assignment of a debt, on the other hand, is not a transaction between the creditor and the debtor. It is a transaction between the creditor and the assignee to which the assent of the debtor is not needed. The debtor is given notice of it; for notice is necessary to complete an assignment pursuant to the statute or in the case of an equitable assignment to preserve priorities. But the debtor's assent is not required. He is not a party to the transaction.

[emphasis added]

The majority judgment of the High Court in ALH Group Property Holdings Pty Ltd v Chief Commissioner of State Revenue (NSW) (2012) 245 CLR 338; [2012] HCA 6 at 349 [26] refers to Windeyer J's observations in discussing the difference between novation and assignment. The facts indicate that there was an assignment, and not a novation, of the debt.

Therefore, the assignment of the debt does not satisfy the second limb of paragraph 245-36(a) of the ITAA 1997.

Conclusion

In this case, the special rule in section 245-61 of the ITAA 1997 applies. The value of the previously assigned debt is its market value when it was assigned, which, in this case, is the amount Company B owed Company B when the debt assignment occurred (the face value).

Amounts offset against the value of the debt

The rules to determine the amount that can be offset against the value of a debt (consideration) are set out in section 245-65 of the ITAA 1997. In broad terms, section 245-65 of the ITAA 1997 sets out the rules to determine the consideration given by the debtor to the creditor in respect of the forgiveness of a debt, which reduces the value of the debt (determined here under section 245-55 of the ITAA 1997) to arrive at the gross forgiven amount of the debt.

Debt assignment rules appl

The special rules for assigned debts (items 4 and 5), relate to a debts that are deemed to be forgiven pursuant to section 245-36 of the ITAA 1997: it does not apply to the forgiveness of a previously assigned debt referred to in section 245-61 of the ITAA 1997 - the basic rules apply unless the debt is reassigned by the new creditor to a third creditor.

Debt assignment rules do not apply

If the requirements of section 245-36 of the ITAA 1997 are not relevant or are not met, relevantly, Item 3 provides that the amount offset against the value of the debt will be the market value of the debt at the time of the forgiveness if:

•         the debt is not a moneylending debt,

•         the conditions in subsection 245-65 (2) of the ITAA 1997 are met, and

•         Items 4, 5 and 6 do not apply.

Items 4, 5 and 6 do not apply as the debt was not assigned and there were no debt for equity swaps.

Subsection 245-65(2) of the ITAA 1997 states the conditions for the purposes of item 3 of the table in subsection (1) which are:

(a) at least one of the following is satisfied:

(i) at the time when the debt was forgiven, the creditor was an Australian resident;

(ii) the forgiveness of the debt was a CGT event involving a CGT asset that was taxable Australian property; and

(b) at least one of the following is satisfied:

(i) there is no amount, and no property, covered by column 2 of item 2 of the table;

(ii) the amount worked out under item 2 of the table is greater or less than the market value of the debt at the time of the forgiveness and the debtor and creditor did not deal with each other at arm ' s length in connection with the forgiveness.

In this case, Trust A and Company B would not be dealing with each other at arm's length, Trust A will be an Australian resident at the time when the debt is forgiven, and no consideration will be paid by Company B for the forgiveness of the debt. Therefore item 3 will apply for the purposes of section 245-65 of the ITAA 1997. Consequently, the amount offset against the value of the debt is the market value of the debt at the time of the forgiveness.

In accordance with paragraph 245-75(2)(a) of the ITAA 1997, if the market value of the debt, at the time of the forgiveness, is equal to or less than the amount offset there is no gross forgiven amount in respect of the debt. Company B was capable of meeting its obligations. Therefore, the market value of the debt is the face value. This value will be offset against the value of the debt. Therefore, the gross forgiven amount under section 245-75 of the ITAA 1997, and in turn the net forgiven amount under section 245-85 of the ITAA 1997, will be nil.

This outcome reflects the intended objectives where debt forgiveness occurs between related parties that are not dealing on an arm's length basis. Relevantly, Division 245 of the ITAA 1997 recognises that section 116-20 of the ITAA 1997 would apply such that the creditor will not obtain a capital loss as they will be deemed to have received market value for the debt forgiveness (in this case, the face value of the principal and interest). Item 3 is designed to achieve the same/similar outcome for the debtor as the forgiveness does not give rise to a genuine gain in these circumstances.

Application of net forgiven amounts

Subdivision 245-E of the ITAA 1997 sets out the rules relating to the application of the net forgiven amounts of a debtor.

In broad terms, the total of the net forgiven amounts of all your debts forgiven in an income year is applied to reduce 4 classes of amounts that could otherwise reduce your taxable income in the same or later income year. It is applied in the following order:

a)    to your tax losses from previous income years;

b)    to your net capital losses from previous income years;

c)    to the deductions you would otherwise get in the income year, or in a later income year, because of expenditure from a previous year (for example, the capital allowance deductions you would get for expenditure on acquiring a depreciating asset);

d)    to the cost bases of your CGT assets.

The net forgiven amount will affect the carry forward tax losses, adjustable value of the Division 40 assets and cost base of the CGT assets held by the head company under the single entity rule (SER).

In this case, as discussed above, there is no net forgiven in these circumstances. Consequently, Head Company does not have to make any adjustment to carry forward tax losses, carry forward net capital losses, adjustable value of depreciating assets and cost base of the CGT assets held by the head company under the SER.

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