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Ruling

Subject: Debt forgiveness, CGT and winding up company

Question 1

Does the gift of the shareholders' shares in the company to a family member amount to a commercial debt forgiveness, within the meaning of division 245 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Do the commercial debt provisions in Division 245 of the ITAA 1997 apply in respect of the debt owed by a shareholder to the company and which is proposed to be offset against his entitlement as shareholder?

Answer

No

Question 3

Will Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) result in any taxable dividends pursuant to the transaction?

Answer

No, provided the loan agreement meets the requirements of section 109N of the ITAA 1936.

Question 4

Will person 3 be deemed to have received any assessable dividends from the company in the course of winding up the company?

Answer

No

Question 5

Will CGT event K6 in section 104-230 of the ITAA 1997 result in a capital gain on the transfer of the shares in the company from the shareholders to person 3?

Answer

No

This ruling applies for the following periods:

Income year ending 30 June 2012

The scheme commences on:

1 July 2011

Relevant facts and circumstances

The company was incorporated prior to 20 September 1985 and there have been no changes in shareholding in the company since incorporation.

The company currently has 3 shareholders, all family members.

The company owns part of a property, which was purchased prior to 20 September 1985.

There have been no capital improvements undertaken on the property since 19 September 1985.

The company has no assets apart from the property.

The company currently has the following liabilities:

· loan A payable to person 1; and

· loan B payable to the family business partnership.

There is no loan documentation in existence in relation to either of these 2 loans.

The company has not paid any interest in relation to either of these 2 loans.

The family business is operated through a partnership of two individual family members (person 1 and 2) and two family trusts.

The family is working on a succession planning proposal under which person 1 & 2 plan to retire from the business and transfer the property to person 3.

As part of the succession plan the family want to take advantage of the intergenerational stamp duty exemption on the transfer of the property to person 3. The stamp duty exemption is available only if the property is transferred direct from the company to person 3.

It is proposed that the transfer of, and payment for, the property will occur as follows:

The company will sell the property to person 3 at market value. This will be documented in a legally binding contract and subsequent transfer. There will be no conditions attached to the transfer.

The company will lend the purchase price to person 3 subject to the terms of an agreement that complies with section 109N of the ITAA 1936.

The capital gain derived by the company will be credited to a pre-CGT capital profits reserve in its accounts.

All shareholders of the company will transfer their shares in the company to person 3 as a gift. The shares were acquired by them before 19 September 1985. The transfer will be effected by means of a simple transfer document with no conditions.

Person 1 will assign loan A to person 3. The assignment will be a simple assignment whereby person 1 agrees to assign all rights to repayment of the loan to person 3 with no conditions.

The family trusts will transfer their share of loan B to person 1 and person 2 by way of book entry. The transfer of the trusts' share of the loans will be by way of a capital distribution by the trusts to person 1 and person 2 as beneficiaries. The relevant trust deeds give the trustee the wide discretionary powers to make such payments.

Person 1 and person 2 will then assign loan B to person 3. The assignment will be a simple assignment whereby person 1 and person 2 agree to assign all rights to repayment of the loan to person 3 with no conditions.

The amount owed to the company by person 3 will then be offset against his entitlement as shareholder and the loan to him by book entry.

The company having neither assets nor liabilities will then be deregistered under section 601AA of the Corporations Act 2001.

The applicant has advised that the transfer of the trusts' share of loan B at step (f) is being undertaken because it is considered that the power of the trustee to make a capital distribution of trust assets is clearer than the power of the trustee to join in the gift of a partnership asset.

In addition to the above transactions, person 1 will be transferring his part of the property to person 3 so that after all transfers are complete, person 3 will own the entire property.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 44,

Income Tax Assessment Act 1936 section 47,

Income Tax Assessment Act 1936 Division 7A,

Income Tax Assessment Act 1997 Division 245 and

Income Tax Assessment Act 1936 section 104-230.

Reasons for decision

Question 1

Summary

The gift of the shareholders' shares in the company to person 3 will not be a 'commercial debt forgiveness', within the meaning of division 245 of the ITAA 1997.

Detailed reasoning

Division 245 of the ITAA 1997 relates to the forgiveness of commercial debts.

Section 245-15 states that Division 245 of the ITAA 1997 also applies

... to a *non-equity share issued by a company as if it were a debt to which section 245-10 applies that is owed by the company to the relevant shareholder.

Subsection 995-1(1) of the ITAA 1997 defines the following terms:

Equity interest in an entity has the meaning given by:

In the case of a company - Subdivision 974-C; and

In the case of a trust or partnership - section 820-930.

Non-equity share means a *share that is not an *equity interest in the company.

Share

in a company means a share in the capital of the company, and includes stock; and ......

Item 1 in the table in subsection 974-5(1) of the ITAA 1997 provides that an equity interest will be

An interest in the company as a member or stockholder of the company.

Therefore, the shares that person 1 and person 2 hold in the company will be equity interests.

Accordingly, the gifting of these shares will not be covered by the commercial debt forgiveness provisions in Division 245 of the ITAA 1997.

Question 2

Summary

The commercial debt provisions in Division 245 of the ITAA 1997 will not apply in respect of the debt owed by person 3 to the company and which is proposed to be offset against his entitlement as a shareholder.

Detailed reasoning

Division 245 of the ITAA 1997 relates to the forgiveness of commercial debts.

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

· 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

· 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

· 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 8-12(a), (b) and (c)) that has the effect of preventing a deduction.

· Section 245-35 of the ITAA 1997 states that a debt is forgiven if and when:

· 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

· 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.

The debt will also be forgiven in certain circumstances where the creditor assigns the right to receive payment to another entity (section 245-36 of the ITAA 1997).

Section 245-40 of the ITAA 1997 lists specific circumstances where the forgiveness of a debt will not come within the operation of Division 245 of the ITAA 1997.

Person 3's debt to the company will only come within the provisions of Division 245 of the ITAA 1997 if he will be entitled to claim a tax deduction for the interest payable on the loan.

However, as the loan will be repaid in full by way of distributions from the company to person 3, there will be no debt forgiveness in terms of subsection 245-35(a) of the ITAA 1997.

Accordingly, Division 245 of the ITAA 1997 will have no application when person 3's loan to the company is repaid in full by distributions from the company.

Question 3

Summary

Division 7A of the ITAA 1936 will not result in any taxable dividends pursuant to the transaction.

Detailed reasoning

Generally, Division 7A of Part III of the ITAA 1936 (Division 7A) applies where a private company has made a payment or loan to, or forgiven the debt of, an entity in an income year and in that income year either:

The entity was a shareholder or shareholder's associate of the private company at the time the payment, loan or debt forgiveness was made, or

A reasonable person would conclude that the loan, payment or debt forgiveness was made because the entity had been a shareholder or shareholder's associate at some time.

An entity includes an individual (section 109ZD and paragraph 960-100(1)(a) of the ITAA 1936).

An associate includes a relative of an entity (section 109ZD of the ITAA 1936 and section 318 of the ITAA 1936).

The general rule is that a private company is taken to pay a dividend to an entity at the end of the income year in which the payment or loan is made or the debt is forgiven. (Refer to section 109C, section 109D and section 109F of ITAA 1936) Such dividends are included in the assessable income of the shareholder or associate under section 44 of the ITAA 1936.

However, section 109D will not apply to loans made by a private company where the loan meets the criteria specified in section 109N of the ITAA 1936.

Person 3 is related to person 1 and person 2 (shareholders in the company). Therefore, he will be an associate of the company for the purposes of Division 7A at the time that the company lends him the purchase price of the property.

However, provided the terms and conditions attached to that loan comply with the requirements of section 109N of the ITAA 1936, the provisions of Division 7A will not apply to that loan.

Under the proposed transactions the company is not forgiving any debts, therefore it is not necessary to consider the application of section 109F of the ITAA 1936 which relates to debt forgiveness.

Accordingly the proposed transactions will not result in any deemed dividends pursuant to Division 7A, provided the loan that the company makes to person 3 meets all the criteria specified in section 109N of the ITAA 1936.

Question 4

Summary

Person 3 will not be deemed to have received any assessable dividends from the company in the course of winding up the company.

Detailed reasoning

Subsection 47(1) of the ITAA 1936 deems certain amounts distributed to shareholders of a company by a liquidator in the course of winding up a company to be a dividend where the amounts distributed by the liquidator represent income derived by the company (whether before or during liquidation), other than income which has been properly applied to replace a loss of paid-up capital.

Subsection 47(1A) of the ITAA 1936 extends the meaning of income for the purposes of subsection 47(1) of the ITAA 1936 to include:

An amount (other than a net capital gain) that is included in the company's assessable income for the year, or

A net capital gain that would be included in the company's assessable income for a year of income if the Income Tax Assessment Act 1997 required a net capital gain to be worked out as follows:

Method statement
Step 1.	Work out each capital gain (except a capital gain that is disregarded) that the company made during that year of income. Do so without indexing any amount used to work out the cost base of a CGT asset.
Step 2.	Total the capital gain or gains worked out under Step1. The result is the net capital gain for that year of income.

Subsection 47(2A) of the ITAA 1936 applies where there is an informal winding up of a company.

Subsection 47(2A) of the ITAA 1936 states:

[Informal winding up] Where:

· the business of a company has been, or is in the course of being, discontinued otherwise than in the course of a winding up of the company under any law relating to companies;

· in connexion with the discontinuance, any moneys of the company have been or other property of the company has been, on or after 19 October 1967, distributed, otherwise than by the company, to shareholders of the company; and

· the moneys or other property so distributed are not, for the purposes of this Act, dividends;

· the distribution shall, subject to subsection (2B), be deemed to be, for the purposes of this section, a distribution to the shareholders by a liquidator in the course of winding up the company.

Subsection 47(2B) of the ITAA 1936 states that subsection 47(2A) only applies where the company ceases to exist within 3 years after the distribution, or such further period as the Commissioner allows.

Subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income any dividends as defined in subsection 6(1), paid to the shareholder out of profits derived by the company from any source if the shareholder is a resident of Australia.

Subsection 44(1) however does not apply to a dividend to the extent to which it is either assessable or exempt under another provision of the ITAA.

The term 'dividend' in subsection 6(1) of the ITAA 1936 includes any distribution made by a company to any of its shareholders, whether in money or other property (paragraph (a)), or any amount credited by a company to any of its shareholders as shareholders (paragraph (b)). However, paragraph (d) specifically excludes a distribution from the definition of 'dividend' if the amount of the distribution is debited against an amount standing to the credit of the share capital account of the company.

At the conclusion of the proposed transactions (step (i)) the company is to be deregistered under section 601AA of the Corporations Act 2001, which deals with voluntary deregistrations. Therefore, there will be an 'informal' winding up of the company.

At step (h) of the proposed transactions, the amount owed to the company by person 3 will be offset against his entitlement as a shareholder, and his loan to the company. Thus in effect, person 3 will be receiving payment from two sources: the capital profits reserve, and equity account.

The capital profits reserve consists of the capital gain made by the company on the sale of the property to person 3. As the property was purchased by the company prior to 20 September 1985, the gain made on its disposal is disregarded (subsection 104-10(5) of the ITAA 1997).

Therefore, provided the company is deregistered within three years of step (i) occurring, a distribution to person 3 of the amount in the capital profits reserve will be excluded (as a result of paragraph 47(1A)(b)) from being a deemed dividend under section 47 of the ITAA 1936.

The distribution of paid up capital is not a distribution of income and therefore will not be assessable as a deemed dividend under section 47 of the ITAA 1936.

Subsection 44(1) will not apply to the distribution to person 3 from the capital profits reserve as this amount will be treated as a distribution by a liquidator made in the course of winding up the company under section 47.

Question 5

Summary

There will be a NIL capital gain from CGT event K6 in section 104-230 of the ITAA 1997 on the transfer of the shares in the company from the shareholders to person 3.

Detailed reasoning

CGT event A1 happens if you dispose of a CGT asset (section 104-10 of the ITAA 1997). A CGT asset is any kind of property or a legal or equitable right that is not property (section 108-5 of the ITAA 1997). You dispose of a CGT asset if a change of ownership occurs from you to another entity.

A capital gain or capital loss from CGT event A1 is disregarded if the relevant asset was acquired before 20 September 1985 (paragraph 104-10(5)(a) of the ITAA 1997).

The transfer to person 3 of the company shares by person 1 and person 2 will be a CGT event A1 for person 1 and person 2. However, as these shares were acquired by them prior to 20 September 1985, any capital gain or loss made in relation to that CGT event A1 will be disregarded.

CGT event K6 in section 104-230 of the ITAA 1997 happens if all of the following conditions are satisfied:

· a specific CGT event happens in relation to shares in a company or an interest in a trust you acquired pre-CGT (paragraphs 104-230(1)(a) and 104-230(1)(b) of the ITAA 1997);

· there is no roll-over for the other CGT event (paragraph 104-230(1)(c) of the ITAA 1997); and

· immediately before the other event happens the market value of the post-CGT property of the company or trust is at least 75 per cent of the net value of the company or trust (paragraph 104-230(1)(d) and subsection 104-230(2) of the ITAA 1997).

Thus, CGT event K6 only happens if, just before the other CGT event happened (in this case CGT event A1), the market value of post-CGT property of the company is at least 75% of the net value of the company.

Taxation Ruling TR 2004/18 Income tax: capital gains: application of CGT event K6 (about pre-CGT shares and pre-CGT trust interests) in section 104-230 of the Income Tax Assessment Act 1997 discusses what is meant by the term 'property' for CGT event K6 purposes. TR 2004/18, at paragraph 53, says that the reference to 'property' in subsection 104-230(2) will include, amongst other things, debts owed to the company.

Immediately prior to the transfer of shares, the company will have one asset only - the loan to person 3. This loan will be taken out at step (b) of the proposed transactions and therefore will be post CGT property of the company.

The 'net value' is defined in subsection 995-1(1) to mean, for an entity, 'the amount by which the sum of the market values of the assets of the entity exceeds the sum of its liabilities'.

TR 2004/18 states at paragraph 99:

In the context of section 104-230, the term 'liabilities' extends to legally enforceable debts due for payment and to presently existing obligations to pay either a sum certain or ascertainable sums. It does not extend to contingent liabilities, future obligations or expectancies.

Immediately prior to CGT event A1 happening to the shares, the only liabilities of the company will be the loan to person 3. The amounts in the Capital Profits Reserve and Equity accounts are not liabilities of the company. Therefore, the 'net value' of the company will be the difference between the loan made by the company to person 3 and the loan payable by the company to person 3.

The market value of the post CGT property (the sum of the market value of the post-CGT property taken into account under paragraph 104-230(2)(a), in this case person 3's loan to the company) is greater than the net value of the company, therefore subsection 104-230(2) is satisfied.

TR 2004/18 outlines a two step process for calculating the capital gain for CGT event K6.

Step 1 (Paragraph 29 of TR 2004/18)

Step 2 (Paragraph 32 of TR 2004/18)

The step 1 amount = capital proceeds x 1 (the Market value of post CGT property will be the same as the Market value of all property).

The step 2 amount will be NIL. The Market value of the post CGT property (the loan to person 3) will be equal to the cost base of that loan, therefore there will be no market value excess.

Accordingly, there will be a NIL capital gain for CGT event K6.