Edited version of private ruling

Authorisation Number: 1011392371882

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Ruling

Subject: Application of paragraph 25-35(1)(b) and section 8-1 of the Income Tax Assessment Act 1997 in relation to bad debt deductions, and Division 245, Schedule 2C of the Income Tax Assessment Act 1936 in relation to the debt forgiveness rules

A special purpose vehicle (SPV) trust subscribed for bonds from an issuer trust and funded the purchase by borrowing money from institutional investors by issuing certain notes to another company, which is the sole beneficiary and unitholder of the SPV trust, established for the purpose of securitisation of assets.

The SPV trust entered into a liquidity facility with a financial institution to repay its borrowings from institutional investors where there is a market disruption affecting repayment of the borrowings.

The issuer trust entered into credit default swaps (CDS).

Under the terms of the bonds, the SPV trust has effectively provided 'insurance' to the issuer trust that it will bear any losses that the issuer trust is exposed to under the CDS.

Adverse credit events have led to a substantial reduction in value of the bonds. These events, which also made new borrowings difficult, have triggered a drawdown from the liquidity facility to repay the borrowings from institutional investors.

As the current market value of the bonds is only a fraction of its face value, it is unlikely that the SPV trust will be able to repay its debt under the liquidity facility.

Question 1

On the assumption that a bona fide commercial decision had been made by the financial institution that an amount of the debt represented by the liquidity facility is 'bad', would the financial institution be entitled to claim a deduction for that amount under either paragraph 25-35(1)(b) or section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997), in the income year in which that bad debt is written off?

Answer

Yes, the financial institution would be entitled to claim a deduction for that amount under paragraph 25-35(1)(b) of the ITAA 1997.

Reason for Decision

The question of whether a taxpayer is carrying on the business of lending money is necessarily a question of fact. 

Paragraph 25-35(1)(b) of ITAA 1997 provides that a taxpayer can deduct a debt (or part of a debt) that the taxpayer writes off as bad if it is in respect of money that the taxpayer lent in the ordinary course of its business of lending money.

It is accepted that the draw down from the liquidity facility represents a debt owed to the financial institution as a result of money lent by it in the ordinary course of its lending business as a financial institution.

The financial institution would therefore be entitled to a bad debt deduction pursuant to paragraph 25-35(1)(b) of ITAA 1997. Therefore, the general deduction provisions under 8-1 of ITAA 1997 does not require consideration in this instance

Question 2

Where the financial institution has written off an amount of debt under the liquidity facility as bad, but not executed a legal discharge or release:

Issue 1

Is there an application of the commercial debt forgiveness rules contained in Division 245, Schedule 2C to the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No.

Reason for Decision

Division 245 of Schedule 2C to the ITAA 1936 applies where a debt or part of a debt ceases to be payable because the obligation to pay the debt or part is released or waived, or is otherwise extinguished (this is referred to as the forgiveness of the debt or part); and there are amounts (reducible amounts) that would otherwise be taken into account in reducing the debtor's taxable income of the year of income in which the debt is forgiven or a later year of income.

The financial institution has not executed a legal discharge or release of the amount of debt that it has written off as bad under the liquidity facility. Hence, that amount remains repayable by the SPV trust.

While the financial institution may write off an amount as bad, there is no agreement to legally discharge the SPV trust of its liability to repay the debt owing to the financial institution. Therefore, there is no 'forgiveness' of debt for the purposes of Division 245 of Schedule 2C.

Issue 2

Does an assessable amount arise to the SPV trust under section 6-5 of the ITAA 1997?

Answer

No.

Reason for Decision

Under section 6-5 of the ITAA 1997, your assessable income includes income according to ordinary concepts. If you are an Australian resident, your assessable income includes the ordinary income you derived directly or indirectly from all sources, whether in or out of Australia, during the income year. In working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.

The SPV trust does not derive any gain, despite the fact an amount has been written off as bad. As the SPV trust is still obliged to repay an amount to the financial institution, the SPV trust cannot be deemed to have received an amount of assessable income. Therefore, there is no amount assessable as income under section 6-5 of ITAA 1997.

Question 3

On the assumption that a bona fide commercial decision has been made that an amount of the debt represented by the Bonds is 'bad' (partially or in full), would the SPV trust be entitled to claim a deduction for that amount under either paragraph 25-35(1)(b) or section 8-1 of the ITAA 1997 in the calculation of its net income under section 95 of the ITAA 1936, in the income year in which that bad debt is written off?

Answer

No.

Reason for Decision

Paragraph 25-35(1)(b) of ITAA 1997

The question of whether a taxpayer is carrying on the business of lending money is necessarily a question of fact.

Paragraph 25-35(1)(b) of ITAA 1997 provides that a taxpayer can deduct a debt (or part of a debt) that the taxpayer writes off as bad if it is in respect of money that the taxpayer lent in the ordinary course of its business of lending money.

In the case of the SPV trust, it derives positive net income from borrowing from the securitisation company and using those funds to acquire bonds. This is because the yield from the bonds exceeded the interest paid on the notes and, later, on the amount drawn down under the liquidity facility.

While on the face of it, the bonds can be akin to a loan, there is a fundamental difference in subscribing for the bonds as compared to lending money under conventional circumstances. Under a typical loan arrangement, a lender can influence the rate charged, while in relation to the subscription of the bonds, there is a set interest rate that is not able to be influenced by the SPV trust. The terms of the repayment of the bonds were also not stipulated by the SPV Trust. This indicates that the activities of the SPV Trust tend to be passive rather than active.

In the case of the SPV trust, even though there was positive net income, there is, however, a lack of repetition and regularity to bond subscriptions, and the bonds were acquired in a passive manner.

As the bonds were purchased in a passive way (as an investment), it is considered that the SPV trust is not carrying on a money lending business. Therefore, the SPV trust will not be able to claim a bad debt deduction under paragraph 25-35(1)(b).

Section 8-1 of ITAA 1997

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

The indicia of 'carrying on a business' involve conducting activities with a profit-making purpose, showing repetition and regularity, on a large scale, in a systematic and business-like way. Relating that indicia to the SPV trust:

§ the SPV trust has received net income from purchasing the bonds with borrowed money;

§ the SPV trust subscribed for the bonds as a securitisation vehicle, at the direction of a SPV manager. The bonds were intended to be held to their maturity date;

§ there was a lack of regularity in relation to bond subscriptions. Further, no other assets were purchased by the SPV trust other than the bonds subscriptions, and there is no certainty any further transactions will be entered into; and

§ the interest rate and the repayment terms on the bonds were not determined by the SPV trust.

The above features do not indicate that the SPV trust purchased the bonds in the course of carrying on a business, but rather point to the SPV trust acquiring the bonds as an investment.

The bonds are considered to be capital in nature, as they:

§ were acquired with the intention of being held until maturity;

§ were held for distributions; and

§ involved a one-off outlay to acquire the bonds to produce periodic assessable income (from the interest payments) rather than from the sale of the bonds.

As the subscription of bonds is not considered to have been acquired in the course of carrying on business, rather it was an investment on capital account, the SPV trust can not deduct the diminution in value of the bonds as a deduction under section 8-1 of ITAA 1997.