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Ruling

Subject: Debt forgiveness

Question 1

Can Trust 1 forgive a debt owed to it by Trust 2 for reasons of love and natural affection and therefore be excluded from the debt forgiveness provisions in Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2013

The scheme commences on:

1 July 2012

Relevant facts and circumstances

Trust 2 owes a debt to Trust 1.

The debt is in a form of a loan.

The loan was used by Trust 2 to acquire farm land.

The loan is in existence and is recorded in the current assets of Trust 1.

The applicant states that the debt is a commercial debt because Trust 2 could claim a tax deduction for any interest charged on the debt by Trust 1.

Trust 1 proposes to forgive the debt owed by Trust 2 for reasons of natural love and affection.

Trust 1 and Trust 2 are controlled by two individuals who are also siblings and their respective families.

The applicant states that Trust 2 is able repay the debt

Relevant legislative provisions

Section 245-10 of the ITAA 1997

Section 245-40 of the ITAA 1997

Reasons for decision

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.

The meaning of a 'commercial debt' is provided in section 245-10 ITAA 1997 and applies to a debt if:

· The whole or any part of interest, or if 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 form the operation of a provision of this Act (other than paragraphs 8-1(2)(a), (b) and (c)) that has the effect of preventing a deduction

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 Interpretive Decision ATO ID 2003/563 Income tax: Commercial debt forgiveness - debt used for private purposes at time of forgiveness 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.

In this case, Trust 2 obtained a loan from Trust 1 to fund the acquisition of farms lands. Trust 2 could obtain a tax deduction if any interest was charged by Trust 1. It is therefore considered that a 'commercial debt' exists for the purposes of subsection 245 -10(b) ITAA 1997.

A debt is forgiven when:

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

· 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)

· 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

· 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).

Section 245-40 of the ITAA 1997 provides the following circumstances in which the forgiveness of debt rules in Division 245 of the ITAA 1997 do not apply:

· a forgiveness of a debt that is a fringe benefit

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

· a forgiveness effected under an Act relating to bankruptcy

· a forgiveness effected by will

· a forgiveness for reasons of natural love and affection, and

· a debt that is a tax related liability or civil penalty.

Section 245-40 of the ITAA 1997 does not specify that the creditor or debtor must be a natural person. It only requires that the debt is 'forgiven for reasons of natural love and affection'. This is further supported by ATO Interpretive Decision ATO ID 2003/589 Income Tax: Commercial debt forgiveness - can a company forgive a debt for reasons of natural love and affection? which specified that a director of a creditor could forgive the debt based on the director's love and affection for the debtor. Therefore the emphasis is on whether the forgiveness of the debt was motivated by natural love and affection rather than whether the creditor or debtor is a natural person.

In this case, Trust 1 is proposing to forgive a debt owed to it by Trust 2 based on reasons of natural love and affection.

ATO Interpretive Decision ATO ID 2003/590 Income Tax: Commercial debt forgiveness - debt forgiven because of inability to repay and reasons of love and affection provides that part of a debt may be forgiven for reasons of natural love and affection. This may be the case when there are multiple reasons for forgiving the debt. For example, a debt is forgiven for reasons of natural love and affection and the debtor's inability to repay part of the debt. Only the part of the debt, that the debtor had the ability to pay, can be forgiven for reasons of natural love and affection as it is the only reason for the debt forgiveness.

As Trust 1 is controlled by one sibling and their family and Trust 2 is controlled by another sibling and their family, it is considered that both families would hold natural love and affection for each other. Further Trust 2 has the ability to pay the debt and therefore the only reason for forgiving the debt is natural love and affection.

Therefore, the debt forgiveness provisions in Division 245 do not apply as the debt is excluded.