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Subject: Commercial Debt Forgiveness

Income Tax ~~ Commercial debt forgiveness ~~ what constitutes a commercial debt?

Question 1

Do the unpaid distributions made to a trust beneficiary fall under the commercial debt forgiveness provisions of Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

If the answer to question 1 is yes, will the total net forgiven amount be applied in accordance with sections 245-115 to 245-195 of the ITAA 1997 for the forgiveness income year in terms of section 245-105(2) of the ITAA 1997 in relation to the rulee?

Answer

Yes

This ruling applies for the following periods:

1 July 2011 to 30 June 2012

Relevant facts and circumstances

The rulee is a trust with a beneficiary which is a discretionary trust.

The rulee made distributions to the beneficiary trust for several years. The majority of the distributions were never received by the beneficiary trust but were retained by the rulee to be used in its operations.

During the 2011-12 income year, the rulee will be wound up holding nil assets with carried forward losses greater than the unpaid distributions to beneficiary trust. The beneficiary trust has been advised that there is no likelihood of any return from the rulee.

The beneficiary trust will declare in the 2011-12 income year that the debt from the rulee is bad and will be written off.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 245

Income Tax Assessment Act 1997 Section 118-305

Income Tax Assessment Act 1997 Section 245-35

Income Tax Assessment Act 1997 Section 245-36

Income Tax Assessment Act 1997 Section 245-37

Income Tax Assessment Act 1997 Section 245-45

Income Tax Assessment Act 1997 Section 245-105(2)

Income Tax Assessment Act 1997 Sections 245-115 to 245-195

Reasons for decision

Question 1

Do the unpaid distributions made to the beneficiary trust fall under the commercial debt forgiveness provisions of Division 245 of the ITAA 1997?

Division 245 of ITAA 1997 contains special rules to remove the tax benefit obtained by a taxpayer when the whole or part of a commercial debt owed by the taxpayer is forgiven. Div 245 of the ITAA 1997 applies when a commercial debt is forgiven by a creditor and the resulting gain is not included in the debtor's assessable income.

Division 245 was rewritten into ITAA 1997 commencing 1 July 2010. It applies to debts forgiven from the 2010-11 income year onwards.

A Commercial debt is a debt on which interest paid or payable is deductible to the debtor. If interest is not deductible because of another provision in the Act (except provisions which make interest non-deductible because it is capital, private or domestic in nature or relates to exempt or non-assessable non-exempt income), the interest is assumed to be deductible. If no interest is payable, the test of deductibility is applied as if interest is payable.

To determine whether a commercial debt exists we have to look at the borrower's purpose and not that of the lender (Federal Commissioner of Taxation v Tasman Group Services Pty Ltd 2009 ATC). If the use of the loan could result in an allowable deduction of interest were interest to be charged, a commercial debt exists.

Further, where only part of the interest that is paid or assumed to be paid in respect of a debt is deductible, the debt is a commercial debt. ATO Interpretative Decision ID 2003/563 also provides that the related interest need not be deductible at all times while the debt is in existence. If the interest was only deductible at some point in time, but not at the time of forgiveness, the debt is regarded as a commercial debt.

A debt is forgiven when:

i) a debt is waived or a debtor is released from his obligation to pay it (section 245-35 of the ITAA 1997)

ii) a debt is assigned by a creditor to an associate of the debtor or by an arrangement to which the debtor and the new creditor are parties (section 245-36 of the ITAA 1997)

iii) proceeds from a share issue by the debtor to the creditor are applied to repay the debt (section 245-37 of the ITAA 1997), or

iv) an "in-substance" forgiveness takes place, i.e. an agreement whereby, for a nominal consideration, a debtor's liability ceases at a fixed future date (section 245-45 of the ITAA 1997).

The mere writing off of a debt is not necessarily a release, waiver or extinguishment of a debt. In Ashwick (Qld) No 127 Pty Ltd & Ors v Federal Commissioner of Taxation 2009 ATC 20-146, among other things, the acknowledgement of the debts in the accounts and in a deed poll executed by the creditor supported the taxpayer's argument that the debts were not forgiven.

In the following circumstances, the forgiveness of a debt is not caught by Division 245 of the ITAA 1997:

i) a forgiveness of a debt that is a fringe benefit

ii) a debt that has been or will be included in the debtor's assessable income (e.g. a loan that is a deemed dividend)

iii) a forgiveness effected under an Act relating to bankruptcy

iv) a forgiveness effected by will

v) a forgiveness for reasons of natural love and affection, and

vi) a debt that is a tax related liability or civil penalty.

A forgiveness effected under an Act relating to bankruptcy is excluded from the application of Division 245 of the ITAA 1997. At present there is only one Act relating to bankruptcy, i.e. the Bankruptcy Act 1966 and therefore this exclusion is only applicable to individuals.

The rulee used the unpaid distributions in its operations and therefore would have been able to claim a deduction for interest on the unpaid distributions if interest were charged. A commercial debt is in existence and the provisions of Division 245 of the ITAA 1997 apply.

Question 2

If the answer to question 1 is yes, will the total net forgiven amount be applied in accordance with sections 245-115 to 245-195 of the ITAA 1997 for the forgiveness income year in terms of section 245-105(2) of the ITAA 1997 apply to the rulee?

Division 245 of the ITAA 1997 provides that an amount equal to the tax benefit obtained known as the net forgiven amount is applied to reduce the taxpayer's tax losses, net capital losses, undeducted expenditures and CGT cost bases which are otherwise available to reduce the taxpayer's assessable income.

Before the net forgiven amount can be determined, the gross forgiven amount must be determined which is the value of the debt when the debt is forgiven less any consideration given in respect of the forgiveness.

Generally, the value of the debt is its market value at the time of the forgiveness assuming the debtor is solvent when the debt is incurred as well as when the debt is forgiven.

The gross forgiven amount is reduced by any amount already taken into account (because of the forgiveness) in determining the debtor's taxable income, to arrive at the net forgiven amount of a debt. This includes amounts included in a debtor's assessable income or amounts which reduce a debtor's deductible expense or CGT asset cost base.

Section 245-115 of the ITAA 1997 provides that the net forgiven amount is first applied to reduce a debtor's tax losses. This can be done in any order the debtor chooses as long as the net forgiven amount is applied to the maximum extent possible.

Section 245-130 of the ITAA 1997 provides that any remaining net forgiven amount is next applied to reduce a debtor's net capital losses. This can be done in any order the debtor chooses as long as the net forgiven amount is applied to the maximum extent possible.

Section 245-145 of the ITAA 1997 provides that any remaining net forgiven amount is next applied to reduce certain undeducted expenditures of the debtor. This can be done in any order the debtor chooses as long as the net forgiven amount is applied to the maximum extent possible.

The expenditure that can be reduced by the remaining net forgiven amount must have the following characteristics:

(i) it must be included in the table of expenditure in section 245-145 of the ITAA 1997

(ii) it must not be excluded under s 245-145(2) of the ITAA 1997

(iii) it must be incurred by the debtor before the forgiveness year, and

(iv) it must be expenditure for which a deduction is otherwise allowable either against income of the forgiveness year or a later income year assuming no event or circumstance occurred that would affect its deductibility (other than a recoupment in the forgiveness year).

Section 245-175 of the ITAA 1997 provides that any remaining net forgiven amount is lastly applied to reduce a debtor's CGT asset cost bases. This rule does not apply to CGT assets which are specifically excluded by section 245-175(2) of the ITAA 1997. These assets are:

¢ pre-CGT assets

¢ CGT assets acquired after the start of the forgiveness year

¢ personal use assets

¢ a dwelling that was the debtor's main residence at any time before the forgiveness year

¢ goodwill

¢ a right covered by section 118-305 of the ITAA 1997 (certain rights relating to a superannuation fund or an approved deposit fund)

¢ an asset which was trading stock of the debtor throughout the period it was owned by the debtor before the forgiveness year

¢ an asset whose cost is deductible expenditure for the purposes of section 245-145 of the ITAA 1997, and in respect of which a balancing adjustment would apply on its disposal (depreciable assets), and

¢ in the case of an asset held by a non-resident at the beginning of the forgiveness year of income - an asset that is not taxable Australian property.

A debtor is free to choose which CGT asset cost bases are reduced as long as the net forgiven amount is applied to the maximum extent possible. An asset's cost base can generally only be reduced by a maximum of its reduced cost base. Special rules apply to CGT assets that are investments in associated entities.

If any net forgiven amount remains after reducing a debtor's tax losses, net capital losses, undeducted expenditure and CGT asset cost bases, the balance is disregarded in all instances except where the debtor is a partnership in terms of section 245-195 of the ITAA 1997. The remaining net forgiven amount of a partnership is allocated to each partner in accordance with their share of the partnership's net income or net loss for the forgiveness income year.

In conclusion, the total net forgiven amount will be applied in accordance with sections 245-115 to 245-195 of the ITAA 1997 for the forgiveness income year in terms of section 245-105(2) of the ITAA 1997 to reduce the rule's tax losses, net capital losses, undeducted expenditures and CGT cost bases which are otherwise available to reduce the rulee's assessable income.