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Subject: Bad Debts

Income Tax ~~ Deductions ~~ bad debts

Question 1

Can the rulee, which is a discretionary trust, claim a bad debt deduction in the 2011-12 income year in terms of section 25-35 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

Question 2

Can the rulee, which is a discretionary trust, claim a bad debt deduction in the 2011-12 income year in terms of section 8-1 of the ITAA 1997?

Answer

No

This ruling applies for the following periods:

1 July 2011 to 30 June 2012

Relevant facts and circumstances

The rulee is a discretionary trust which is a beneficiary of another trust.

The rulee received distributions from the trust over a period of several years. The majority of the distributions were never received by the rulee but were retained by the distributing trust to be used in its operations.

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

The rulee included the distributions from the distributing trust in its assessable income during the relevant year of distribution as the amounts were credited to the "beneficiary entitlement" account in the books of the distributing trust and an asset in the books of the rulee as an "unpaid beneficiaries' entitlement".

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

The rulee lodged a family trust election in 1998 which covers the period of the unpaid distributions. As such, the rulee is an excepted trust and does not have to meet the tests contained in Schedule 2F of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1936 Schedule 2F

Income Tax Assessment Act 1997 Section 25-35

Income Tax Assessment Act 1997 Subsection 25-35(1)

Income Tax Assessment Act 1997 Subsection 8-1

Reasons for decision

Question 1

Can the rulee, which is a discretionary trust, claim a bad debt deduction in the 2011-12 income year in terms of section 25-35 of the ITAA 1997?

Under subsection 25-35(1) of the ITAA 1997, you can deduct a debt (or part of a debt) that you write off as bad in the income year if.

(a)    the debt was included in your assessable income for the income year or for an earlier income year or

(b)    the debt is in respect of money that you lent in the ordinary course of your business of lending money.

Taxation Ruling TR 92/18 looks at the circumstances in which a bad debt is allowable as a tax deduction. Paragraph 24 of Taxation Ruling TR 92/18 states that the following four conditions must be satisfied in order to qualify for a bad debt deduction:

(a)      a debt must exist

(b)      the debt must be bad

(c)      the debt must be written off as a bad debt during the year of income in which the deduction is claimed and

(d)      the debt must have been brought to account as assessable income in any year or, in the case of a money lender, the debt must be in respect of money lent in the ordinary course of the business of lending of money by a taxpayer who carries on that business.

Condition (a)

Paragraph 25 of Taxation Ruling TR 92/18 states that a debt may be defined as a sum of money due from one person to another.

A proportion of the distributions from the distributing trust to the rulee remains unpaid and as such, based on the facts supplied, a debt exists and this condition is satisfied.

Condition (b)

Paragraph 29 of Taxation Ruling TR 92/18 states that as long as the commercial judgement pointing to the relevant facts indicates that a debt is bad for the time being, the debt is accepted as bad. It is not essential that a creditor take all legally available steps to recover the debt. What is necessary is that the creditor make a bona fide assessment, based on sound commercial considerations, of the extent to which the debt is bad.

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

This would indicate that at this time there is little or no likelihood of the debt, or part of the debt, being recovered, and the debt could be considered to have become bad.

This condition is satisfied.

Condition (c)

Paragraph 5 of Taxation Ruling TR 92/18 states that the writing-off of a bad debt does not necessarily require highly technical accounting entries. It is sufficient that some form of written record is kept to evidence the decision of the taxpayer to write off the debt from the accounts.

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

Based on the above, this condition will be satisfied.

Condition (d)

The debt has not been brought to account by the rulee as assessable income in any year, and the rule did not carry on a business as a money lender at the time that the rulee made the loan to the distributing trust. The origin of the funds on loan to the distributing trust is not relevant as the distribution made to the rulee is separate to the funds being made available to the distributing trust for operations.

This condition is not satisfied.

Summary for section 25-35 of the ITAA 1997

As you do not satisfy condition (d) above, a deduction for the bad debt is not allowable under section 25-35 of the ITAA 1997.

Question 2

Can the rulee, which is a discretionary trust, claim a bad debt deduction in the 2011-12 income year in terms of section 8-1 of the ITAA 1997?

For a loss or outgoing to be an allowable deduction under section 8-1 of the ITAA 1997 it must have been incurred in gaining or producing your assessable income, or necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income. In addition, the loss must not be of a capital, private or domestic nature.

Paragraph 59 of Taxation Ruling TR 92/18 confirms that an important consideration will be whether a loss occasioned by a bad debt is of a capital nature. Paragraph 66 of Taxation Ruling TR 92/18 continues to state that the availability of a deduction for a loss occasioned by a bad debt is dependant upon the loss not being of a capital nature. This is further explained in paragraph 67 of Taxation Ruling TR 92/18:

67. The question of whether or not such a loss is of a revenue or capital nature depends upon a consideration of the facts and circumstances of each case. It is necessary to ascertain the circumstances which occasioned the loss and the relation that these circumstances bear to the taxpayer's income earning activities. If the loss is an ordinary incident of the taxpayer's income earning activities then the loss will be on revenue account. For example, a bad debt loss incurred by a financial institution would generally be expected to be a revenue loss.

The rulee was not carrying on a business which included the lending of money at the time that the loan was made. The loss in relation to the bad debt was therefore not an ordinary incident of the income earning activities, and is therefore of a capital nature.

A deduction for the bad debt is therefore also not available under section 8-1 of the ITAA 1997.