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Ruling

Subject: Forgiveness of a commercial debt

Question 1

Are the loans (as defined in the agreement) a 'debt' for the purposes of the former section 245-15 of Schedule 2C of the Income Tax Assessment Act 1936 ('ITAA 1936')?

Answer

Yes

Question 2

If the answer to question 1 is 'Yes', are the loans (as defined in the agreement) a 'commercial debt' for the purposes of the former section 245-25 of Schedule 2C of the ITAA 1936?

Answer

No

Question 3

If the answers to questions 1 and 2 are both 'Yes', would the payment by Applicant under clause 2.9 of the Deed of Termination constitute forgiveness of debt or 'debt parking' under former section 245-35 of Schedule 2C in the ITAA 1936?

Answer

It is not necessary to answer this question as the answers to Question 1 and 2 are both not yes.

This ruling applies for the following period:

Year ending 30 June 2010

Relevant facts and circumstances

The Applicant is the head company of a tax consolidated group engaged in construction, land development, and infrastructure activities. The Applicant entered into a Joint venture agreement to develop land.

The Agreement is a deed entered into by the Applicant and two of the companies of a separate corporate group (together referred to as an Owner or Owner 2). The three companies are described as the owners in the Agreement. A nominee company is established to carry out all tasks of the joint venture. The Applicant owns 50% of the shares in the nominee. The remaining 50% of the shares are owned by Owner 2.

The Agreement is an unincorporated joint venture for the purpose of acquiring and developing a particular parcel of land. The activities of the joint venture are conducted by the nominee, who is appointed as the agent of the owners. The land was acquired by the agent as agent for purchaser.

The Agreement specifies that

1. that the relationship constituted by the deed between the owners is that of a joint venture (and not that of a partnership),

2. the obligations and liabilities imposed and the rights and benefits conferred on the owners under and/or arising out of the deed and/or the relationship constituted by the deed will only extend to and include each of the respective owners severally and not jointly or collectively, and

3. an owner has no authority or power to make any contract, pledge any credit, incur any obligation or liability or otherwise act as an agent for or on behalf of any other owner without the prior written consent of the other owner.

The Agreement provides:

Any funds received by the nominee in connection with the development will be distributed in accordance with the Agreement. The owners agree that the distribution will be subject to the availability of sufficient cash to make the distribution and that the funds received by the agent in connection with the development are intended to be distributed in the following order:

(a) too repay all outstanding external loans;

(b) to pay any other debts or creditors of the joint venture;

(c) to repay outstanding loans from the owners; and

(d) the balance to the owner's pro rata..

A distribution by the nominee is calculated after deducting from the net sale income, the external loans, costs, loans from the owners and equity.

Contributions by the Owners

The Agreement provides that the owners have initially contributed funds each by way of loan to the nominee.

The Agreement states that provision of the loans by the owners:

i. will constitute loans in respect of the joint venture and unless otherwise agreed by the owners, loans will bear interest capitalising monthly;

ii. will be used to fund the development;

iii. will be repayable to the owners prior to any distribution of profits to the owners; and

iv. will be secured by the provision of securities.

The nominee is acting under the directions contained in the Agreement. The Agreement provides for a number of things including that the nominee:

1. in its capacity as agent of the owners is appointed to acquire and hold property and rights in respect of the joint venture as the owners may direct,

2. enter into and perform its obligations and those of the owners under any agreements as the controllers may determine,

3. holds any interest in the joint venture assets as agent of the owners as tenants in common, and

4. must obtain the signature of at least one director on all contracts, agreements, documents, expenditure or the like to be entered into by the agent in relation to the development which purports to or does bind the agent.

The Agreement provides that the bank accounts of the joint venture will be kept in the name of the nominee at any bank determined by the owners

Loans have been recorded in the liabilities section of the balance sheet, and are referred to as 'Loan - Owner 1 (Contributions)' and 'Loans - Owner 2 (Contributions)'

Termination of Joint Venture

The Agreement was terminated by the subsequent Termination Deed.

The Termination Deed dealt with the owners' interest in the land acquired, shares in the nominee, sale of remaining joint venture assets, and joint venture liabilities.

The Termination Deed provided that:

1. Owner 2 authorised the agent to sell its interest in the land on its behalf to a third party.

2. Owner 1 was to procure a party to enter into a contract with the nominee to acquire Owner 2's interest,

3. Upon entry into the contract of sale of land, owner 2 directs that the nominee must deal with the proceeds it receives from the sale of its interest in the land under the contract for sale of land as owner 1 directs.

4. Owner 2 must transfer all of its shares in the agent to owner 1 for the sum of $1.00.

5. Owner 2 must transfer its interest in the joint venture assets other than the land to Owner 1 for the sum of $1.00

6. Owner 1 agreed to pay Owner 2 an amount in full and final satisfaction of Owner 2's rights in relation to the Joint Venture Liabilities, i.e. namely the amounts owed to Owner 2 in respect of the joint venture.

7. Owner 2 released the nominee from all claims, obligations and liabilities under or in connection with the Agreement including the obligation to repay the loans.

8. Despite any other provision of the Termination Deed, or the Agreement, no distribution will be made to Owner 2 from the joint venture.

9. The parties acknowledged and agreed that the Agreement and the joint venture are terminated.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 6(1),

Income Tax Assessment Act 1936 Former section 245-15 of Schedule 2C ,

Income Tax Assessment Act 1936 Former section 245-25 of Schedule 2C ,

Income Tax Assessment Act 1936 Former subsection 245-25(1) of Schedule 2C,

Income Tax Assessment Act 1936 Former subsection 245-25(2) of Schedule 2C,

Income Tax Assessment Act 1936 Former subsection 245-25(3) of Schedule 2C,

Income Tax Assessment Act 1936 Former subsection 245-25(4) of Schedule 2C,

Income Tax Assessment Act 1936 Former Section 245-35 of Schedule 2C,

Income Tax Assessment Act 1936 Division 5 of Part III ,

Income Tax Assessment Act 1997 Section 8-1,

Income Tax Assessment Act 1997 Subsection 8-1(1) and

Income Tax Assessment Act 1997 Subsection 995-1(1).

Reasons for decision

All legislative references are to ITAA 1936 unless otherwise provided.

At issue in question 1 is whether the loans, as defined in the agreement, are a 'debt' for the purposes of the former section 245-15 of Schedule 2C. Schedule 2C was repealed by Tax Laws Amendment (Transfer of Provisions) Act 2010 with effect from 1 July 2010. As settlement occurred prior to the repeal of these provisions the former Schedule 2C includes the relevant provisions for consideration.

Debt defined

The former section 245-15 in Schedule 2C to the ITAA 1936 defines debt as 'an enforceable obligation imposed by law on a person to pay an amount to another person'.

The Loan Funds

The provision of loans by an owner is governed by the contractual terms within the Agreement. Pursuant to the Agreement, the owners have contributed certain amounts to the agent.

The Agreement provides detail of the nature of the loans. It says:

The provision of loans by the owners:

i. will constitute loans in respect of the joint venture and the loans will bear interest capitalising monthly;

ii. will be used to fund the costs of the development;

iii. will be repayable to the owners prior to any distribution of profits to the owners; and

iv. will be secured by the provision of appropriate securities.

As can be seen above the parties have described the loans as a loan. It is clear that interest is capitalising monthly on the loans.

Further and of some significance the agreement states that loans will be repayable to the owners prior to any distribution of profits to the owners. In addition the Agreement also indicates that loans will be repaid after external creditors and other external debts or creditors of the joint venture have been repaid. Together these clauses lead to a conclusion that indeed there is an obligation to repay the loans, albeit contingent.

This obligation to repay must now be assessed to determine if it is one that satisfies the description of debt in the former section 245-15 in Schedule 2C. Whether an enforceable obligation arises is to be determined with regard to the factual scenario with a focus on the legal rights that arise (see: Federal Commissioner of Taxation v. Tasman Group Services Pty Ltd 2009 ATC 20-138).

Are the loans a debt of a tax law partnership?

The statutory definition of a partnership under the Partnership Act 1958 (Victoria) is extended under the Income Tax Assessment Act 1997 ('ITAA 1997') for the purpose of calculating the taxation liability of a taxpayer under Division 5 of Part III of the ITAA 1936. The definition of partnership in subsection 995-1(1) provides that partnership includes:

(a) an association of persons (other than a company or a *limited partnership) carrying on a business as partners or in receipt of *ordinary income or *statutory income jointly; or

(b) a limited partnership.

It is accepted that the Agreement did not give rise to a general law partnership and therefore it does not satisfy the description of an association of persons carrying on a business as partners.

The result of these arrangements is that the owners, through their nominee, are in receipt of ordinary income jointly. As the owners are in receipt of income jointly, and notwithstanding that a partnership at general law does not exist, a partnership arises pursuant to the definition of partnership in subsection 995-1(1)(a) of the ITAA 1997. This partnership consists of the owners for the purposes of the Income Tax Assessment Acts.

The consequences of the existence of a tax law partnership, in the context of the Goods and Services Tax law, was considered in Goods and Services Tax Ruling GSTR 2004/6 Goods and services tax: tax law partnerships and co-owners of property. Referring to Case 12/95, 95 ATC 175, GSTR 2004/6 at paragraph 103 states:

'We agree with the Tribunal's view that a tax law partnership does not have capital. We further take the view that partners in a tax law partnership have neither interests in the capital of a partnership, nor interests in the partnership. The only interest that a partner in a tax law partnership has is an interest in the property, coupled with a right to a share of the net income or losses in accordance with that interest.'

Further, a tax law partnership is not imbued with the same characteristics of a general law partnership by subsection 995-1(1) of the ITAA 1997. In Case 12/95 the AAT stated at 181:

'the deeming provisions are required by their nature to be construed strictly and only for the purpose for which they are resorted to and it is improper to extend by implication the express application of such a statutory fiction. This fiction does not, in our opinion, cloak an arrangement of the kind now being contemplated with the additional refinements of partnership assets and liabilities and partners capital accounts. On that basis the Tribunal finds that there are no partnership assets or liabilities nor are there capital accounts capable of being accessed by the applicant or his spouse. What remains is a relationship of co-ownership as joint tenants which is more accurately described as an investment rather than as partners in a business operation' (emphasis added)

It is important to note that the purpose of the subsection 995-1(1) of the ITAA 1997 definition of partnership is to identify the types of arrangements to which the taxation treatment set out in Division 5 of Part III of the ITAA 1936 then applies. That is, the definition is merely serving to secure a particular taxing result. That definition includes arrangements that would qualify as general law partnerships and also includes arrangements that would not so qualify. Merely by being brought within the term 'partnership' as it is used in the tax law does not imbue the arrangement with all the characteristics of a general law partnership and no assumption or deeming is required to achieve the intended result of taxation under Division 5.

In the present circumstances, the contribution of loans by an owner did not establish an enforceable obligation at law on a person, being the tax law partnership to repay to an Owner the loans. The Agreement goes to some length to provide that the loans are provided by the owners individually and not jointly to the joint venture. And in this regard there is no joint liability of each owner to the loans provided. This further supports the position that the loans are not a debt of the partnership.

The nominee

It is also necessary to consider where a debt arose between the owners and the nominee. The Agreement provides for a number of things including that the nominee:

1. in its capacity as agent of the owners is appointed to acquire and hold property and rights in respect of the joint venture as the owners may direct,

2. enter into and perform its obligations and those of the owners under any agreements as the owners may determine,

3. holds any interest in the joint venture assets as agent of the owners as tenants in common, and

4. must obtain the signature of at least one director on all contracts, agreements, documents, expenditure or the like to be entered into by the agent in relation to the Arrangement which purports to or does bind the agent.

Dal Pont in 'Law of Agency' 2^nd Edition, LexisNexis Butterworths, 2008, provides the following definition of agent at page 5:

'The narrowest legal definition of 'agent' connotes 'an authority or capacity in one person to create legal relations between a person occupying the position of principal and third parties'. A broader conception covers 'a person who is able, by virtue of the authority conferred upon him, to create or affect legal rights and duties as between another person, who is called his principal, and third parties. Wider again is the characterisation of an agent as 'a person who has authority to act on behalf of a principal, either generally or in respect of some particular act or matter'. Each of these definitions recognise agency as giving to the maxim qui facit peralium facit per se - a person who acts through another is deemed to act in person. Each also reveals that agency is defined in terms of its consequences. The definition differs in so far as the act - perhaps more correctly, the scope of the authority - in question is concerned.' (case citations and footnotes omitted)'

This definition can be applied to the particular circumstances and facts relating to the joint venture, with the conclusion that the nominee is the agent of the owners. The Agreement expressly states that the nominee is the agent of the owners. It expressly states that the nominee performs the obligations of the owners. These specific requirements all point to the nominee acting as an agent for the owners rather than carrying on the business of the joint venture as a principal. It is accepted that the nominee incurs all obligations in relation to the joint venture as agent of the owners.

However, the fact that the nominee acts as an agent for each owner will not affect the conclusion that the Agreement can result in an enforceable obligation at law on the nominee to pay an amount to an owner in connection with the loans. An agent is not entitled to retain funds which are the property of a principal past the time for repayment.

The use of the term 'loans', in the Agreement demonstrates that the amounts are intended to be repaid before the proceeds of the joint venture are distributed, i.e. the joint venture distribution is calculated having repaid the loans.

In Federal Commissioner of Taxation v. Tasman Group Services Pty Ltd (2009 ATC 20-138) the Full Federal Court considered whether loans from one party used to partly fund the acquisition of a business were a debt and subsequently a commercial debt for the purposes of former section 245-15 in Schedule 2C. It was argued that the respondent was not under a legally enforceable obligation to repay the debt because Letters of Comfort had issued which indicated that the loans would not be called for until certain conditions were satisfied. However, the Full Federal Court unanimously held that the respondent had an enforceable obligation imposed by law to repay the debt notwithstanding that the loan provider had no practical expectation that it would be repaid because there is a significant difference between expectations and legal rights.

In the current circumstances, the Agreement makes it clear that the owners have initially contributed the funds by way of loans to the nominee. The Agreement states that the loans are repayable to the owners prior to any joint venture distribution being made.

Accordingly focusing on the legal rights that arise under the Agreement it is apparent that the owners could enforce this right to the extent that the nominee purported to make a distribution without repayment of the loans. Consequently, the loans constitute a debt for the purposes of former subsection 245-15(1) in Schedule 2C.

Conclusion

As set out above, the Agreement gives rise to a tax law partnership between the owners, but the loans provided by the owners do not result in a debt as defined in the former subsection 245-15(1) in Schedule 2C of that tax law partnership. However, the loans constitute in a debt for the purposes of the former subsection 245-15(1) in Schedule 2C as between each owner and the nominee.

Question 2

Former subsection 245-25(1) of Schedule 2C states that a debt is a commercial debt if subsection (2), (3) or (4) provides that the debt is a commercial debt.

Former subsections 245-25(3) of Schedule 2C dealing with interest free loans and 245-25(4) of Sechedule 2C dealing with non-equity shares are not relevant to the circumstances of the joint venture.

The relevant subsection is former subsection 245-25(2) of Schedule 2C which states that a debt is a commercial debt if the whole or any part of interest, or of an amount in the nature of interest, paid or payable in respect of the debt:

(a) is or would be allowable as a deduction to the debtor; or

(b) would be so allowable apart from the operation of an exception provision.

In the present circumstances the exception provisions do not apply to the loans, leaving for consideration whether the capitalised interest on loans is or would be allowable as a deduction to the nominee or tax law partnership, identified above, between the Owners.

Is the interest allowable as a deduction to the tax law Partnership?

It was concluded above that the loans do not constitute a debt of the tax law partnership. Given this the loans cannot constitute a commercial debt, which requires the existence of a debt (see former subsection 245-25(1) of Schedule 2C).

Is the nominee entitled to a deduction?

In the case of the joint venture the loans were provided to the nominee and the nominee was to capitalise interest on those loans pursuant to the Agreement . As set out in Question 1 above, these amounts constitute a debt for the former subsection 245-15(1) of Schedule 2C.

The interest will only be deductible if the requirements of section 8-1 of the ITAA 1997 are met. Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing incurred in gaining or producing assessable income, or that is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income except to the extent that such loss or outgoing is, inter alia, of capital, or of a capital nature.

The Agreement does not provide for the nominee to retain any of the monies or to make a profit in relation to any of the transactions conducted on behalf of the joint venture. The nominee is not itself engaged in a profit making enterprise and does not earn income separately from the joint venture. The nominee does not carry on a separate business to the business which it conducts as agent on behalf of the owners.

As a consequence, the capitalisation of interest on the loans is not, nor would be deductible as required by the former subsection 245-25(2) of Schedule 2C is not satisfied. The result of this is that the debt is not a commercial debt as defined in the former subsection 245-25(1) of Schedule 2C.

Conclusion

The debt identified in question 1 is not a commercial debt for the purposes of former section 245-25 of Schedule 2C to the ITAA 1997.

Question 3

It is not necessary to answer this question as the answers to Question 1 and 2 are both not yes.