Edited version of private ruling

Authorisation Number: 1011682131985

This edited version of your ruling will be published in the public Register of private binding rulings after 28 days from the issue date of the ruling. The attached private rulings fact sheet has more information.

Please check this edited version to be sure that there are no details remaining that you think may allow you to be identified. Contact us at the address given in the fact sheet if you have any concerns.

Ruling

Subject: Deductibility of bad debts

Issue 1: Debt/equity interest

Question

Are the loans advanced from AA to BB (BB loans) debt interests for tax purposes under section 974-15 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2009

The scheme commences on:

1 July 2008

Issue 2: Deductibility of bad debts

Question

Is AA entitled to a deduction under section 8-1 of ITAA 1997 in respect of the loss suffered on the part of the BB loans forgiven?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2009

The scheme commences on:

1 July 2008

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.

AA is an Australian unit trust and registered managed investment scheme. AA provides investment capital (IC) and has advanced loans to parties in Australia, and various overseas countries. Each loan was established with specific loan terms under separate agreements. The IC loans predominantly consisted of loans to unrelated parties, and the terms of each loan were arm's length terms. Each new IC advance was made only after a thorough due diligence process was carried out.

AA entered into a transaction with an unrelated external party located in an overseas country (CC). The transaction involved AA providing unsecured loans denominated in the foreign currency to CC. This was done by AA providing loans to BB (BB loans), which in turn provided identical loans to CC.

BB is an entity wholly owned by AA, and is a controlled foreign company (CFC) of AA for Australian tax purposes whose only purpose was to undertake this transaction. The amounts lent by AA to BB, and BB to CC were on terms that exactly mirrored each other. AA financed the BB loans with the proceeds of capital raised from external investors in AA.

The loans advanced by BB to CC consisted of two underlying loans:

§ Ordinary Loan: Interest was contingent on CC earning profits, and no interest arose during the period AA held this loan.

§ Preferred Loan: Interest accrued at a fixed rate. The accrued interest was payable on a quarterly basis. If interest remained unpaid by the fourth quarter after it became payable, it was to be capitalised into the loan balance.

The loans repayments were due in four years.

The terms of the Preferred Loan were amended to reduce the interest rate on the Preferred Loan, and interest ceased to accrue on the interest that had been accrued. A further amendment was that all accrued interest on the Preferred Loan was capitalised to a new loan. These amendments were driven by the expectation CC would have difficulty paying any further amounts of accrued interest due to its own financial difficulties.

The amounts of interest income were accrued and returned as assessable income of AA specifically in relation to the BB loans.

The BB loans were transferred to a related party (JV) of which AA was a joint owner, at market value. The market value of the BB loan was based on detailed external valuations, but was also a figure agreed to by AA's joint venture partner.

Prior to AA transferring the loans to the new joint venture, AA carried out a debt forgiveness in relation to each loan which was equal to the difference between the face value and the market value of each loan.

The forgiveness of the loans first occurred to any accrued interest outstanding on the loan, then to the capitalised interest component of the loan principal, and finally to the original loan principal component of the loans. This was executed via a deed of forgiveness. As a result of the debt forgiveness carried out by AA, AA made a loss.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 section 974-15

Income Tax Assessment Act 1997 section 974-20

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA of the ITAA 1936, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Issue 1: Debt/equity interests

For a loan to give rise to a debt interest under section 974-15 of the ITAA 1997 it must be a scheme that, at the time the scheme comes into existence, satisfies the debt test in subsection 974-20(1) of the ITAA 1997.

A scheme is broadly defined in subsection 995-1(1) of the ITAA 1997. The issue of the BB Loans would constitute a scheme under subsection 995-1(1). Therefore, the debt test is satisfied if the following criteria are satisfied.

Subsection 974-20(1)(a) of the ITAA 1997 - the scheme is a financing arrangement

Financing arrangement is widely defined in section 995-1 of the ITAA 1997 to have the meaning in section 974-130 of the ITAA 1997. It includes a scheme entered into or undertaken for the purpose of raising finance for the entity, or to fund another scheme or a return that is a financing arrangement. The scheme will be considered a financing arrangement as defined in section 974-130 of the ITAA 1997 as it will raise finance for BB.

Subsection 974-20(1)(b) of the ITAA 1997 - the issuer will receive financial benefits

Financial benefit is defined in section 995-1 of the ITAA 1997 to have the meaning in section 974-160 of the ITAA 1997. It includes anything of economic value. BB will receive financial benefits, being the loan amount.

Subsection 974-20(1)(c) of the ITAA 1997 - there is an effectively non-contingent obligation (ENCO) for issuer to provide a financial benefit

An ENCO is defined in section 995-1 of the ITAA 1997 to have the meaning in section 974-135 of the ITAA 1997. There is an ENCO to take an action under a scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation to take that action. An obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity of that entity), other than the ability or willingness of that entity or connected entity to meet the obligation.

The ENCO criterion applies to both the provision of financial benefits under the scheme and to the termination of the scheme under subsection 974-135(2) of the ITAA 1997.

The Loans repayments were due in four years. The loan term was subsequently amended to have six years. Hence, the loan principal is considered to be a non-contingent obligation of BB.

For the Ordinary Loan, the payment of interest was contingent on CC earning profits. Accordingly, the interest is considered to be a contingent obligation of BB. For the Preferred Loan Note, interest accrued at a fixed rate. This interest was payable on a quarterly basis and if any interest payments remained outstanding by the fourth quarter after it became payable, it was to be capitalised into the loan balance. Accordingly, the interest is considered to be a non-contingent obligation of BB.

Subsection 974-20(1)(d) of the ITAA 1997 -the value provided will be at least equal to the value received

The general rules for the valuation of financial benefits are contained in section 974-35 of the ITAA 1997. The value of the financial benefits is calculated in nominal terms if the performance period in relation to a financing arrangement ends no later than 10 years.

As the repayment period of the loans ends no later than 10 years, the value of the financial benefits provided would be determined using nominal terms. For the Ordinary Loan the value of the benefits is equal to the repayment of the loan principal, and the value provided is at least equal to the value received.

For the Preferred Loan the value of the benefits is equal to the repayment of the loan principal plus interest and the value provided is greater than the value received.  

Subsection 974-20(1)(e) of the ITAA 1997 - The value provided and the value received are not both nil

Both the value received and the value provided by BB are positive amounts.

Under section 974-110 of the ITAA 1997, the effect of a material change to an existing scheme can have the effect of changing the characterisation of an interest as debt or equity. The amendments made to the Preferred Loan did not alter the requirement to repay all amounts of principal advanced by the maturity date. Hence, the amendment will not change the characterisation of the loan.

As the criterion of the debt test in section 974-20(1) of the ITAA 1997 are satisfied, the loans are considered debt interests under section 974-15 of the ITAA 1997.

Issue 2: Deductibility of bad debts

A loss is deductible under section 8-1 of the ITAA 1997 if it is incurred in gaining or producing assessable income or in carrying on a business for the purpose of gaining assessable income. In addition, the loss must not be of a capital nature.

AA incurred the loss on the BB loans at the time that the relevant portion of the loans was forgiven. Section 8-1 of the ITAA 1997 would be satisfied if the loss was incurred in gaining or producing assessable income or in carrying on a business for the purpose of gaining assessable income and the loss was not a capital nature.

The question whether or not such a loss is of revenue or capital nature depends upon the consideration of the facts and circumstances in each case. Taxation Ruling TR 92/18 states that if the loss is an ordinary incident of the taxpayer's income earning activities then the loss will be on revenue account.

In Avco Financial Services Limited v. FCT 82 ATC 4246, Gibbs CJ commented that:

Where a taxpayer carries on the business of borrowing and lending money, the moneys used for that purpose are analogous to trading stock - the taxpayer in effect deals in the money.

Accordingly, if AA is considered to be carrying on a business of money lending in relation to its IC, the BB loans would be on revenue account. In addition, the loss on the BB loans would be incurred in carrying on AA's business of money lending for the purposes of gaining assessable income.

Whether a business of money lending is being carried on is a question of fact. TR 92/18 indicates that in assessing the facts a money lender may not necessarily need to be willing to lend to the public or a wide class of borrowers. Further, the taxpayer may lend to only certain classes however this must be done in a business like manner with a view to yielding a profit from that activity.

In FC of T v. Marshall and Brougham Pty Ltd 87 ATC 4522: 18 ATR 859 Bowen CJ made the following observations regarding a business of money mending:

It is generally accepted that in order to be regarded as carrying on a business one must demonstrate continuity and system in ones 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)…

Further, in the case of Richard Walter Pty Ltd v. FC of T 95 ATC 4440 Tamberlin J stated that:

…it is not enough merely to show that a person has on several occasions lent money at remunerative rates of interest; there must be a certain degree of continuity and system about the transactions. The activity should be capable of being described as business operations intended to yield a profit.

In Fairway Estates Pty Ltd v. FC of T 70 ATC 4061, Barwick CJ said that 'provided there is an intention to carry on a money lending business, such a business can exist even though only one loan has been made'. Therefore, it is possible for an entity to carry on a money lending business with only a few borrowers.

The IC is an important part of AA's overall business. The IC business was conducted in a systematic and businesslike manner, with appropriate due diligence and risk management processes in place governing the generation of new business, and the administration of existing IC positions. The financial performance of the IC business was reported as a separate business segment in the financial reports of AA.

The loans were made on an interest bearing basis at a commercial interest rate and were advanced by AA with a view to obtain a profit. The loans were advanced to an unrelated third party.

AA obtained a profit from the loans advanced which was returned as assessable income. The greatest proportion of AA's income was derived from interest on moneys lent.

On the balance of the facts presented, it is considered that AA was carrying on a business of money lending in relation to its IC. As such, the loss suffered on the part of the loans forgiven was incurred in carrying on a business of money lending for the purpose of gaining assessable income. Furthermore, the loss was not a capital nature. Accordingly, AA is entitled to a deduction of the loss under section 8-1 of ITAA 1997.