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Ruling

Subject: Debt forgiveness - Commissioner's discretion

Question

Does subsection 109G(4) of the Income Tax Assessment Act 1936 operate allowing the forgiveness of the debt to not give rise to a dividend?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 2011

The scheme commences on:

1 July 2010

Relevant facts and circumstances

The deceased was a director and shareholder of Company X.

Prior to their death, the deceased was working for the company on the design and marketing of a product. It was anticipated that the product had high potential and could prove to be very profitable for the deceased and Company X.

The deceased possessed all of the knowledge and intellectual property required for the completion and implementation of the product.

Company X had loaned the deceased funds under a loan agreement that met the requirements of section 109N of Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936).

The loan funds were used by the deceased to pay for day to day living expenses. The deceased chose to take out a loan from the company rather than pay himself a salary.

Principal and interest loan repayments had been made by the deceased prior to their death.

Prior to their death, the deceased's ability to repay the debt comprised of the equity of the house he owned as joint tenants with their spouse, the potential income that would be derived as a result of the completion of the product and the ability to pay himself a salary from the company.

The deceased died during the 2010-11 income year.

At the time of death, there was a balance remaining on the loan.

As a result of the death, the completion and marketing of the product was not possible.

Company X forgave the remaining debt.

The deceased's spouse was their only dependant.

The deceased's estate has no remaining assets. The only major asset was the deceased's residence which was held as joint tenants with the deceased's spouse. The ownership of the house transferred to the deceased's spouse at the time of death. The only remaining asset was cash that was used to pay other remaining debts.

Company X has no assets. They have a large tax debt which is currently in the process of being settled. The company will be wound up in the 2011-12 income year.

The deceased's spouse has since had to sell the residence to pay outstanding credit card debts and help pay for the costs associated with the death of the deceased.

Remaining proceeds from the sale of this house were also used by the deceased's spouse to purchase a 50% share in a house. This is now the deceased's spouse residence.

The deceased's spouse also currently holds the following assets:

· Shares

· Cash investments

It is anticipated that the deceased's spouse will be required to liquidate the above assets in the future to enable her to purchase the remaining 50% share of her residence.

The only other income source for the deceased's spouse is a government pension.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 7A

Income Tax Assessment Act 1936 Section 109C

Income Tax Assessment Act 1936 Section 109D

Income Tax Assessment Act 1936 Section 109F

Income Tax Assessment Act 1936 Section 109G

Income Tax Assessment Act 1936 Section 109Y

Income Tax Assessment Act 1936 Section 109ZD

Income Tax Assessment Act 1997 Section 960-100

Reasons for decision

Generally, Division 7A of Part III of the ITAA 1936 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 section 318 of the ITAA 1936 and paragraph 960-100(1)(a) of the Income Tax Assessment Act 1997 (ITAA 1997)).

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.

Section 109F Forgiveness of debts treated as dividends

A private company is taken to pay a dividend to an entity under subsection 109F(1) of the ITAA 1936, subject to section 109Y of the ITAA 1936 if during that year it forgives all or part of a debt owed by an entity when the entity is a shareholder or an associate of a shareholder.

If the debt is forgiven after the entity ceases to be a shareholder or their associate, it may still be a dividend if a reasonable person would conclude that the debt was forgiven because the entity was a shareholder or their associate at some time.

The total of all dividends a private company is taken to pay under Division 7A is limited to its distributable surplus for that income year (section 109Y of the ITAA 1936).

Section 109G Debt forgiveness that does not give rise to a dividend

A debt forgiveness is not treated as a dividend where:

· a private company forgives a debt owed to it by another company, unless the other company owed the debt in its capacity as trustee;

· the debt is forgiven because the entity becomes a bankrupt or because of Part X of the Bankruptcy Act 1966;

· the debt that has been forgiven results from a loan that has been treated as a dividend under Division 7A (or section 108(1) of the ITAA 1936) in the current year or a previous year; or

· the Commissioner of Taxation exercises their or her discretion not to treat the debt forgiveness as a dividend.

Subsection 109G(4) ITAA 1936 stipulates that to exercise their discretion, the Commissioner of Taxation must be satisfied that:

· the debt was forgiven by the private company because repayment of the debt would have caused the entity undue hardship; and

· the entity had the capacity to repay the debt at the time it was incurred; and

· the entity lost the ability to repay the debt in the foreseeable future as a result of circumstances beyond their control.

Undue hardship

The Explanatory Memorandum to the Taxation Laws Amendment Act (No 3) 1998 states:

The Commissioner has a power to exclude a forgiven debt from the operation of this Division where the Commissioner is satisfied that the shareholder or associate would suffer undue hardship. In exercising their power, the Commissioner will take into account the ability of the shareholder or associate to repay the loan at the time it was granted, at the time it was forgiven and at any foreseeable future time. The Commissioner will only exercise their power if he is satisfied that the shareholder had the ability to pay at the time of receipt of the loan and lost the ability to pay, permanently, through no fault of their or her own.

The term undue hardship is not defined in the tax law and must be given its ordinary meaning. In Wilson and Minister for Territories (1985) 7 ALD 225, undue hardship has been described as hardship that is excessive in the circumstances. It denotes something which is disproportionate to the circumstances out of which the hardship arises. There are value judgments involved as to whether hardship will be considered as excessive in a particular circumstance (Powell v Evreniades and Others (1989) ATC 4415).

Practice Statement Law Administration PS LA 2011/17 provides guidance on various debt relief situations, including in circumstances where a taxpayer is seeking release from their obligation to pay certain tax-related liabilities due to 'serious hardship'. In particular, paragraphs 39 and 40 state:

39.The assessment of hardship is not limited only to the person's present circumstances; it may also consider the future prospect of an inability to provide food and clothing, for family members or others for whom the person has responsibility.

40. Conversely, although a person's immediate situation may suggest inability to meet the combined total of the tax debt and family expenditures, that factor will not indicate hardship if the income or asset positions of other members of the family are such as to suggest that the person cannot reasonably be regarded as responsible for all relevant outgoings. For example, the separate earnings, allowances or benefits received by other family members will be relevant to an assessment of the person's overall financial circumstances.

PS LA 2011/17 also provides advice in situations where the debt relief related to a deceased estate. In these cases it must be shown that payment of the amount would cause serious hardship for the dependants of the deceased person.

In this case, for section 109G(4) to apply it must be considered that the payment of the outstanding balance of the loan would cause undue hardship for the deceased's dependants, being the deceased's spouse.

Subsequent to the death of the deceased, the deceased's spouse was forced to sell the residence she owned to pay down outstanding credit card debts and facilitate the payment of expenses relating to her husband's death.

The balance of the sale proceeds were used to purchase a share in another house that would become her residence. Although the deceased's spouse has some other assets, it is anticipated that these will all need to be liquidated to purchase the remaining share of her home. The only current source of other income for the deceased's spouse is a government pension. As a widow, there are no other relevant family member's earnings that should be considered in determining her hardship.

It is accepted that the repayment of the loan would have caused undue hardship for the deceased's spouse taking into account her present circumstances and also the prospect of her ability to provide for herself in the future.

Capacity to repay debt at the time loan it was incurred

At the time of entering into the loan agreement it was expected that the software development would result in higher profits for the company providing the deceased with higher company returns. At the time the deceased also had equity in their house and the potential to pay himself a salary from the company.

Therefore at the time of entering into the loan, the deceased did have the capacity to repay the loan.

Unforeseeable circumstances

It is accepted that at the time of entering into the loan, the deceased had the capacity to repay the loan within the requirements of the loan agreement. The death of the deceased caused the cessation of the creation of the product he was working on, resulting in unrealised profits for the company and returns for the deceased. The ownership of the deceased's main asset, the family home, passed onto their spouse upon their death and was sold to clear outstanding credit card debts and pay expenses arising as a result of the death.

It is accepted that the death of the deceased resulted in the capacity to repay the loan being lost and that the death was not a foreseeable circumstance at the time that the loan was drawn down.

Conclusion

The Commissioner is satisfied that:

· the debt was forgiven because payment of the debt would have caused the deceased's dependant undue hardship;

· at the time that the loan was drawn down, the deceased did have capacity to pay the debt in full; and

· the deceased's death was an unforeseeable circumstance occurring after the loan was drawn down which resulted in the capacity to pay the debt being lost.

Therefore, pursuant to subsection 109G(4), Company X is taken not to have paid a dividend to the deceased's estate because of its forgiveness of the debt owed by the deceased.