Edited version of private advice

Authorisation Number: 1052338578082

Date of advice: 5 December 2024

Ruling

Subject: Bad debt deduction

Question

Is the company entitled to a deduction for a debt that has been written off as a bad debt under paragraph 25-35(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) in each of the income years?

Answer

Yes.

This ruling applies for the following periods:

Income year ended 30 June 20XX

Income year ended 30 June 20XX

The scheme commenced on:

X/XX/XXXX

Relevant facts and circumstances

1.            The taxpayer is a company.

2.            Mr X and Mrs Y are directors of the company.

3.            Prior to making its first loan the company operated as an investment company deriving income from shares and other investments, that is, from passive investments. Prior to this date, Mr X decided to establish a business of money lending because he was dissatisfied with the returns from holding capital on deposit. The company identified a good opportunity to yield strong returns and profits from regular moneylending activities on a secured basis, which was moderate to low risk.

4.            In relation to the lending of money:

(a)          the company, through Mr X, spent XX hours per week on this activity

(b)          the company earned substantial interest income from loans made

(c)          the activity of money lending as described is a business activity in itself and is not ancillary or incidental to any other business carried on by the company

(d)          a large volume of emails has been sent or received as part of the loan vetting process, as well as subsequent monitoring and loan recovery process, with XX of these emails relating to the establishment, negotiating and settlement of the loans relating.

5.            The company is not required to, and does not, hold an Australian Credit Licence.

6.            The maximum amount the company was willing to loan out was $X million, as this was the amount available for the company to loan out at that time. It is expected the maximum amount could increase over time with reinvestment earnings The amounts loaned are sourced from entities related to the company, with no external debt.

7.            To determine what loan opportunities to enter into, the company has an unwritten business plan that includes the following set of criteria.

(a)          the loan to value ratio (LVR) must not exceed XX percentage

(b)          the term of the loan had to be 12 months or less.

(c)           interest in the loan must be paid on establishment

(d)          the loan must be secured by way of mortgage that ranks first in priority in favour of the company

(e)          the interest rate on the loan must be at least X percentage

8.            The company utilised the services of an unrelated company, the broker, to identify prospective borrowers and to arrange valuations of real property held by the borrower. The company engaged the broker as its sole broker to source loan opportunities but intends using other brokers. The company has no formal agreement in place with the broker and does not pay it a fee for its services - the broker derives its fees from borrowers.

9.            The broker acts as an intermediary between lenders and potential borrowers. They are engaged by lenders such as the company to source loan opportunities, negotiate terms with potential borrowers, prepare documentation for lenders and borrowers, and engage with lawyers to complete mortgages in respect of loans advanced.

10.          The company does not have the resources to seek out loan opportunities and has outsourced this task to a broker, as this is more cost effective and utilises their expertise.

11.          The company was presented with XX loan opportunities in a period of XX months.

12.          Upon receiving a loan opportunity from the broker, Mr X, on behalf of the company, viewed properties secured, conducted research, analysed the loan terms and assessed using the criteria developed, to evaluate and determine what loan opportunities are entered into. This included the company relying on the property valuations organised by the broker using an independent certified professional valuer.

13.          The loan opportunities provided by the broker to the company set out what the company needed to do to proceed, which included instructing the lawyers to prepare the mortgage security documentation and whether it accepted the valuation report provided.

14.          Where the company agreed to proceed with a loan opportunity, it would sign a loan agreement.

15.          Whilst the broker negotiates the terms of the loan opportunities with borrowers seeking to finance their investments, which the company either accepts or rejects a loan opportunity, the company could ask the broker to negotiate with a borrower if it is interested in a loan (like an increase in interest rate, more frequent repayments or to make upfront interest payments).

16.          The company ended up accepting XX loan opportunities in the relevant income years. The balance of the loan opportunities was rejected primarily on the basis they did not meet the company's loan criteria.

17.          The company has written off in its books and records as 'bad' an amount in each of the income years, representing loans made to X borrowers. The amounts written off as bad has been determined as the difference between the principal amounts loaned and the settlement amounts received, on the basis that there is little or no likelihood of these amounts being recovered.

18.          In respect to these X loans, upon default of the borrower, the company identified the market value of the security under the mortgages was insufficient to cover the outstanding debt including accrued interest (Default Loans). The company made a bona fide assessment based on sound commercial considerations, of the extent to which the debts are bad. The assessment process the company goes through in reaching a decision to write off a debt as bad included substantial correspondence and interactions that included, but not limited to, the following: conducting searches to try to recover the debts from the borrower(s), guarantor(s), valuer(s), the broker, lawyers, and instructions to lawyers to foreclose the secured property (or properties) and the shortfall in the debt due and payable could be reliably measured. A number of professionals are involved in the assessment and recovery process.

19.          In relation to the Default Loans, action has been taken against the borrower(s) and/or guarantor(s) by forcing the sale of the mortgaged properties. No further legal action has been taken against them to date, to recover the outstanding amounts, as various searches have been conducted by lawyers which have not identified assets sufficient to make it worthwhile to justify taking such further legal action.

20.          Litigation funders have been sought to recover the outstanding amounts from the other parties.

Relevant legislative provisions

Income Tax Assessment Act 1997 subsection 25-35(1)

Income Tax Assessment Act 1997 paragraph 25-35(1)(b)

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise stated.

Question 1

Is the company entitled to a deduction for a debt that has been written off as a bad debt under paragraph 25-35(1)(b)?

Summary

The company is entitled to a deduction, for a debt that has been written off as a bad debt, in each of the income years, as it is in respect of money lent in the ordinary course of the business of money lending.

Detailed reasoning

1.            Subsection 25-35(1) states:

You can deduct a debt (or part of a debt) that you write off as bad in the income year if:

(a)        it was included in your assessable income for an 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.

2.             In order for a bad debt to be claimed as a deduction under paragraph 25-35(1)(b) in an income year requires the following to be examined.

3.             For a bad debt to be deductible, the taxpayer in the business of money lending must satisfy the following 3 conditions:

(a)        a debt must exist

(b)        the debt must be a bad debt

(c)         the debt must be written off as bad in the income year.

4.            Key aspects of paragraph 25-35(1)(b) are that it:

(a)        applies to debts in respect of money lent by the taxpayer

(b)        requires the debt to arise from money lent in the ordinary course of a business of money lending.

5.            Taxation Ruling TR 92/18 Income tax: bad debts (TR 92/18) provide guidance in determining what is a bad debt, and when a deduction can be claimed for the bad debt under paragraph 25-35(1)(b).

Debt

6.            To obtain a bad debt deduction under subsection 25-35(1), a debt must exist before it can be written off as bad. A debt exists where a taxpayer is entitled to receive a sum of money from another, either at law or in equity.[1]

7.            The company was presented loan opportunities by its broker. Where the company agreed to proceed with a loan opportunity, it would sign the loan agreement and return it to the broker and this document became the loan agreement that required the borrower to agree to make principal and interest repayments to the company.

8.            As the company entered into a loan agreement for each amount lent out demonstrates that it is entitled to receive a sum of money from another and therefore a debt existed in each instance.

Bad Debt

9.            Whether a debt is bad depends upon an objective consideration of all the relevant circumstances of each case.[2] As long as the commercial judgment pointing to the relevant facts indicates that a debt is bad for the time being, the debt is accepted as bad.[3] Although the debt need not be bad in the strict sense it must nonetheless be more than merely doubtful.[4] Paragraph 31 in TR 92/18 lists the circumstances where a debt may be considered to have become bad and of particular relevance is category (e) which states:

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.

10.          Paragraph 32 in TR 92/18 states:

Whilst individual cases may vary, as a practical guide a debt will be accepted as bad under category (e) where, depending on the circumstances of the case, the taxpayer has taken the appropriate steps in an attempt to recover the debt, and not simply written it off. Generally, these steps would include some or all of the following, depending on the circumstances:

                                    (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.

11.          A deduction for a bad debt is allowable in the income year in which the debt is written off. It is not enough to simply make a provision for a bad debt, there is a requirement that the debt has to be physically written off. The debt has to be written off as bad and it has to be written off before year's end.[5]

12.          In Case 33 (1941) 10 TBRD 101 at 103, the Taxation Board of Review expressed the following view of the term 'written off':

... the writing off of a bad debt does not necessitate a particular form of book entry or even a book entry at all. It is sufficient, we think, if there are written particulars - there must, of course, be something in writing - which indicates that the creditor has treated the debt as bad.

13.          From the information provided, the company used an appropriate assessment process and relevant professionals in trying to recover the outstanding amount for each Default Loan. It has written off the loans to each of the Borrowers in its relevant financial accounts as bad debts due to there being little or no prospect of recovery.

14.          On this basis, the debts written off by the company are considered bad debts.

Who is a 'money lender'?

15.          For the company to be able to deduct a debt written off as bad in an income year will depend on whether the money lent was in the ordinary course of carrying of the business of lending money.

16.          The question of whether a taxpayer is carrying on the business of lending money is a question of fact: Newton v Pyke (1908) 25 TLR 127. However, the following passage of Bowen CJ in F.C. of T. v. Marshall and Brougham Pty Ltd 17 FCR 541, 87 ATC 4522, 18 ATR 859 at ATC p. 4528, ATR p. 866 provides some useful general guidelines on determining whether a taxpayer is a money-lender:[6]

It is generally accepted that in order to be regarded as carrying on a business one must demonstrate continuity and system in one's dealings. In the case of money lending it has been said that a person must hold himself out as willing to lend money generally to all and sundry (subject to credit-worthiness): see Litchfield v. Dreyfus [1906] 1 KB 584. It is not decisive whether the lender is a registered money-lender or not, although this will be a factor to take into account. It should be mentioned that it need not be the only business or the principal business of the taxpayer. It will be insufficient, however, if it is merely ancillary or incidental to the primary business. In the end, it will be a question of fact for the court to decide by looking at all the circumstances involved: see Newton v. Pyke (1908) 25 TLR 127.

17.          Paragraph 44 in TR 92/18 states:

The frequently quoted statement of Farwell J in Litchfield v. Dreyfus [1906] 1 KB 584 at 589 that:

'Speaking generally, a man who carries on a money-lending business is one who is ready and willing to lend to all and sundry, provided that they are from his point of view eligible'

should not restrict the meaning of 'money-lender' for taxation purposes in light of the more recent Australian cases of Fairway Estates Pty Ltd v. F.C. of T. (1970) 123 CLR 153, 70 ATC 4061, 1 ATR 726; F.C. of T. v. Marshall and Brougham Pty Ltd (supra); and F.C. of T. v. Bivona Pty Ltd 90 ATC 4168, 21 ATR 151.

18.          Accordingly, for the purposes of paragraph 25-35(1)(b), a money lender need not necessarily be ready and willing to lend moneys to the public at large or to a wide class of borrowers. It would be sufficient if the taxpayer lends moneys to certain classes of borrowers provided the taxpayer does so in a businesslike manner with a view to yielding a profit from it.[7]

19.          Prior to the company making its first loan, it operated as an investment company deriving income from shares and other investments, that is, from passive investments. Mr X decided to establish a business of money lending in the company because he was dissatisfied with the returns from holding capital on deposit, which was generally below X% pa. He identified money lending as a good opportunity to yield strong returns and profits from regular moneylending activities on a secured basis, which was moderate to low risk.

20.          At the time this decision was made, the company was willing to loan out a maximum of $X million to any entity which met its loan criteria. The company used its broker to bring loan opportunities to it. In the relevant income years, the broker presented the company with XX loan opportunities with the company entering into XX loan agreements.

21.          It is therefore accepted the company is a money lender.

Money lent in the ordinary course of the business of lending money by a taxpayer who carries on that business

22.          Barwick CJ considered the meaning of 'ordinary course' of the business of the lending of money in Fairway Estates Pty Ltd v FCT (1970) 123 CLR 153; 1 ATR 726. His Honour stated at CLR 162; ATR 732 that:

(a)           'ordinary course' refers to the particular business of lending money carried on at the relevant time by the taxpayer, and

(b)           a loan may be in the 'ordinary course' even if it is of a new type or kind for the taxpayer.

23.          In TR 92/18, the Commissioner expresses the view that, while the moneylending business must have been carried on at the time the loan was made, it is not so clear that a taxpayer must also be carrying on a moneylending business at the time the debt is written off. While there are judicial statements pointing either way, the Commissioner accepts 'on balance' that a taxpayer does not have to be carrying on a business of moneylending at the time the debt is written off in order to satisfy the requirements for a bad debt deduction. [8]

Carrying on a business

24.          The question of whether a business is being carried on is a question of fact and degree.

25.          Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11) outlines the factors to be considered in determining whether a taxpayer is carrying on a business.

26.          Whilst each case might turn on its own particular facts, the determination of the question is generally the result of a process of weighing all the following relevant indicators that has been decided from various court decisions[9] including:

(a)           whether the activity has a significant commercial purpose or character

(b)           whether the taxpayer has more than just an intention to engage in business

(c)           whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

(d)           whether there is repetition and regularity of the activity

(e)           whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business

(f)            whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit

(g)           the size, scale and permanency of the activity, and

(h)           whether the activity is better described as a hobby, a form of recreation or a sporting activity.

27.          Based on the following information provided, it is considered that the company was carrying on the business of money lending at the time the Default Loans were entered into:

(a)          the activity carried on had a significant commercial purpose and character as evidenced by the company using a set of criteria before agreeing to lend out its money and utilising the services of a broker to identify loan opportunities, viewing properties secured and conducting its own research and analysis of the loan terms

(b)          the company had more than just an intention to engage in carrying on a money lending business, Mr X spent XX hours a week on the business that saw him consider loan opportunities using loan criteria devised by himself, dealing with a high volume of emails, consulting with experts and negotiating loan terms.

(c)          included in the loan criteria devised by Mr X was to lend on short secured terms with a view to high yielding financing opportunities available in the market to maximise profit making that resulted in the company deriving interest income

(d)          the broker presented the company with loan opportunities that resulted in the company entering into loan agreements with different borrowers over the relevant income years

(e)          the loans entered into by the company are of the type expected of an entity that would carry on a similar business of money lending - short term loans that was secured by mortgage and/or guarantor and charging higher interest rates commensurate with the risk taken

(f)           the activity carried on by the company was planned, organised and carried on in a business-like manner as evidenced by researching and analysing each loan opportunity using its loan criteria, ensuring each loan taken on was secured and/or guarantor provided, valuations obtained, business records were kept and seeking out advice from relevant professionals

(g)          at the time the company began loaning out money, it had $X million available and advanced most of this amount to different borrowers

(h)          the activity carried on by the company is clearly not a hobby, a form of recreation or sporting activity.

28.          Therefore, the company is entitled to claim a deduction for the debts it wrote off as a bad debt under paragraph 25-35(1)(b) in each of the income years.

[1] Paragraphs 2 and 25 in TR 92/18.

[2] Paragraph 26 in TR 92/18.

[3] Paragraph 29 in TR 92/18.

[4] Paragraph 30 in TR 92/18.

[5] Paragraphs 34 and 35 in TR 92/18.

[6] Paragraph 43 in TR 92/18.

[7] Paragraphs 7 and 46 in TR 92/18.

[8] Paragraphs 49 to 52 in TR 92/18.

[9] Paragraph 13 in TR 97/11.

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