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Ruling

Subject: Debt forgiveness, capital gains tax and winding up a company

Question 1

Do the commercial debt provisions in Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997) apply in respect of the gift of Shareholder B's interest in the debts?

Answer

No

Question 2

Do the commercial debt provisions in Division 245 of the ITAA 1997 apply in respect of the gift of Shareholder A's shares in the company to Shareholder B and subsequent offset of Shareholder B's debt?

Answer

No

Question 3

Do the commercial debt provisions in Division 245 of the ITAA 1997 apply in respect of the debt owed by Shareholder B and Shareholder A to the company and which is proposed to be offset against their entitlement as shareholders?

Answer

No

Question 4

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 5

Will Shareholder B or Shareholder A receive any assessable dividends from the Company in the course of winding up the Company?

Answer

Yes

Question 6

Does Capital Gains Tax 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 Shareholder A to Shareholder B?

Answer

Yes

Question 7

Will CGT event C2 happen when the Company is deregistered?

Answer

Yes

This ruling applies for the following periods:

1 July 2011 to 30 June 2012

1 July 2012 to 30 June 2013

The scheme commences on:

1 July 2011

Relevant facts and circumstances

The Company owns property, which was acquired prior to 1985. However a building has been constructed on one property after 1985 and is acknowledged to be a separate and post-CGT asset.

Shareholder A has been absolutely entitled to the issued shares in the Company shares since before 1985.

The Company has no assets apart from the properties and some cash.

The Company has the following liabilities:

a) Loan payable to Shareholder A and B ("Shareholder A & B Loan"),

b) Loan payable to a third party ("third party loan"), and

c) Loan payable to a related entity ("related entity loan").

The family is working on a succession planning proposal under which Shareholder A plans to retire from the family business and the Company plans to transfer part of the properties to Shareholder B ("Shareholder B's Property") and part of properties to Shareholder A("Shareholder A's Property").

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

Step A - The Company will revalue the properties in its books to market value.

Step B - The Company will:

(i) lend the purchase price for Shareholder B's Property to Shareholder B, and

(ii) lend the purchase price for Shareholder A's Property to Shareholder A

in both cases subject to the terms of an agreement that complies with section109N of the ITAA 1936.

Step C - The Company will sell Shareholder B's Property to Shareholder B and Shareholder A's property to Shareholder A, both at market value. This will be documented in legally binding contracts and subsequent transfers. The capital gain made by the Company will be credited to a pre-CGT capital profits reserve and a post-CGT capital profits reserve in its accounts.

Step D - Shareholder B will:

(i) repay the third party loan;

(ii) assign their interest in the Shareholder A & B loan to Shareholder A. The assignment will be a simple assignment whereby Shareholder B agrees to assign all rights to repayment of the loan to Shareholder A with no conditions; and

(iii) assign their interest in the related entity loan to Shareholder A. The assignment will be a simple assignment whereby Shareholder B agrees to assign all rights to repayment of the loan to Shareholder A with no conditions.

Step E - The losses in the Company will be written off.

Step F - Shareholder A will lend an amount to Shareholder B.

Step G - Shareholder B will pay an amount to the Company (comprising the loan from Shareholder A and additional cash).

Step H - The Debt to Shareholder A will be repaid.

Step I - The Debt to Shareholder B will be offset against the Debt from Shareholder B.

Step J - Each issued share will be split into multiple shares.

Step K - Shareholder A will then transfer a number of the shares to Shareholder B as a gift. The transfer will be effected by means of a simple transfer document with no conditions.

Step L - The amount owed to the Company by Shareholder A will be offset against part of Shareholder A's entitlement as a shareholder by book entry. Shareholder A will also receive an amount of cash as full entitlement as a shareholder.

Step M - The amount owed to the Company by Shareholder B will be offset against Shareholder B's entitlement as shareholder by book entry.

Step N - The Company, having neither assets nor liabilities will be deregistered under section 601AA of the Corporations Act 2001.

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

Income Tax Assessment Act 1997 section 104-230

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 118-20

Income Tax Assessment Act 1997 Sub-division 108-D

Reasons for decision

Division 245 of the ITAA 19997 - commercial debt forgiveness

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

Section 245-15 sates 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:

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

(b) 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

(a) 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, shares in the Company will be equity interests and will not come within the operation of Division 245 of the ITAA 1997.

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

(a) 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

(b) 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

(c) 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:

(a) 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

(b) the period within which the creditor is entitled to sue for the recovery of the debt ends, because of the operation of a statue of limitations, without the debt having been paid.

Under section 245-36 of the ITAA 1997, the assignment of a debt will also constitute debt forgiveness where:

· the new creditor is an associate of the debtor, or the assignment occurs under an arrangement to which the debtor and new creditor are parties, and

· the assignment does not occur in the ordinary course of trading on a securities market.

Except in certain circumstances, the value of the debt forgiven will be its market value (section 124-55 of the ITAA 1997).

Where the value of the debt forgiven is equal to or less than the amount of the offset calculated under section 245-95 of the ITAA 1997, the Commercial Debt Forgiveness provisions will have no application (subsection 245-75(2) of the ITAA 1997).

Under item 5 of the table in subsection 245-65(1) of the ITAA 1997, where a debt is assigned and is deemed to be forgiven by the operation of section 245-36 of the ITAA 1997, the amount of the offset will be the market value of the debt at the time of the assignment.

In your case, if the loans received by the company from Shareholder A and Shareholder B and the related entity were for income producing purposes, the company would have been entitled to an income tax deduction, and the debt will be a 'commercial debt' for the purposes of Division 245 of the ITAA 1997. However, the value of the debt deemed to be forgiven will be equal to or less than the amount of the offset calculated under section 245-95 of the ITAA 1997. Therefore, Division 245 of the ITAA 1997 will have no application.

Division 7A

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

Shareholder B and Shareholder A are both shareholders in the Company.

However, provided the terms and conditions attached to the loans that the Company makes to Shareholder B and to Shareholder A at step B comply with the requirements of section 109N of the ITAA 1936, the provisions of Division 7A will not apply to those loans.

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 loans that the Company makes to Shareholder B and to Shareholder A meets all the criteria specified in section 109N of the ITAA 1936.

Sections 44 and 47 of the ITAA 1936

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:

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

(b) 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:

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 sates:

[Informal winding up] Where:

(a) 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;

(b) 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

(c) 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) of the ITAA 1936 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 shareholder (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 the Company is to be deregistered under section 601AA of the Corporations Act 2001, which deals with voluntary deregistration. Therefore, there will be an 'informal' winding up of the Company.

At steps I, L and M of the proposed transactions, the amounts owed to the Company by Shareholder B and by Shareholder A will be offset against their entitlements as a shareholder, and their loans to the Company. Thus in effect, Shareholder B and Shareholder A will be receiving payments from several sources: the capital profits reserve, and the share capital account.

The capital profits reserve consists of the capital gain made by the Company on the sale of the properties to Shareholder B and Shareholder A.

Under subsection 104-10(5) of the ITAA 1997, the capital gain made by the Company in relation to that part of the properties that had been acquired by the Company prior to 20 September 1985 is disregarded. Therefore, under paragraph 47(1)(b) of the ITAA 1936, Shareholder B's and Shareholder A's share of that capital gain will be excluded (as a result of paragraph 47(1A)(b)) from being a deemed dividend under section 47 of the ITAA 1936 (provided that the Company is deregistered within three years of step M occurring).

However, the building was constructed by the Company after 19 September 1985 and will be a separate CGT asset (refer Subdivision 108-D of the ITAA 1997), and any capital gain made by the Company on the transfer of that property will not be able to be disregarded at step 1 in the method statement contained in paragraph 47(1A)(b) of the ITAA 1936.

Therefore, that portion of the distribution that Shareholder B and Shareholder A receive from the Company on winding up, that relates to the capital gain made on the building, will be deemed to be a dividend under subsection 47(1) of the ITAA 1936 (as a result of the operation of paragraph 47(1A)(a) of the ITAA 1936).

CGT event K6

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 Shareholder B of a portion of Shareholder A's shares in the Company will be a CGT event A1 for Shareholder A ('Shareholder A's CGT event A1'). However, as these shares were acquired by Shareholder A 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 Shareholder A's 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) of the ITAA 1997 will include, amongst other things, debts owed to the company.

Immediately prior to the transfer of shares at step K, the Company will have three assets - the loan to Shareholder B, the loan to Shareholder A and Cash. The loans to Shareholder A and Shareholder B 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) of the ITAA 1997 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 Company will not have any liabilities as the amounts in the capital profits reserve, or equity account are not liabilities of the Company. Therefore, the net value of the Company will be the sum of the outstanding loan amounts and the cash on hand.

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 the Company's loans to Shareholder B and Shareholder A and Cash on hand) is equal to the net value of the Company, therefore subsection 104-230(2) of the ITAA 1997 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 1 amount = Capital proceeds x	Market value of post CGT property
	Market value of all property

Step 2 (Paragraph 32 of TR 2004/18)

Step 1 amount x	Market value excess
		Market value of post CGT property

The step 1 amount will be equal to the capital proceeds as the market value of the 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 loans to Shareholder B and Shareholder A and Cash on hand) will be equal to their cost bases, therefore there will be no market value excess.

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

CGT event C2

CGT event C2 will happen when shares that you own are cancelled, surrendered or redeemed (section 104-25 of the ITAA 1997).

A company ceases to exist on deregistration, and therefore any issued shares in that company will be cancelled at the time that the company is deregistered.

In accordance with Taxation Determination TD 2000/7 Income tax: capital gains: when does a CGT event happen to shares in a company, for the purposes of Part 3-1 and Part 3-3 of the Income Tax Assessment Act 1997, if the company is deregistered under the Corporations Law, the time that the CGT event C2 happens is when the company is deregistered in accordance with subsection 601AA(4) of the Corporations Law.

A taxpayer makes a capital gain as a result of CGT event C2 happening if the capital proceeds from the asset ending are more than the cost base of that asset. They make a capital loss if those capital proceeds are less than the asset's reduced cost base.

As the transfer of a parcel of Shareholder A's shares in the Company to Shareholder B at step K is undertaken for NIL consideration and Shareholder A and Shareholder B are not dealing at arm's length, the market value substitution rule in section 112-20 of the ITAA 1997 will apply. Therefore Shareholder B is deemed to have acquired the shares at market value.

The full amount of a final distribution made on the winding-up of a company constitutes the capital proceeds from the ending of the shareholder's shares in the company (TD 2001/27). Therefore the total proceeds received by Shareholder A and Shareholder B on the winding-up of the Company will be the total of the capital profits reserve and equity account.

Paragraph 104-23(5)(a) states that you can disregard any capital gain or capital loss that you make from CGT event C2 if you acquired the asset prior to 20 September 1985.

At the time of winding up the Company, the shares held by Shareholder A were acquired by Shareholder A prior to 20 September 1985 (TD 2000/10). Therefore any capital gain or loss made by Shareholder A in relation to those shares will be disregarded.

As Shareholder B acquired shares in the Company after 19 September 1985, Shareholder B will make a capital gain if the proceeds are greater than the cost base of the shares. The capital gain will be equal to the excess. Shareholder B will make a capital loss if the proceeds are less than the reduced cost base of the shares.

However, under section 118-20 of the ITAA 1997, any capital gain made from CGT event C2 can be reduced by any amount that is included in your assessable income or exempt income under any other provision of the ITAA.

Therefore, any capital gain from CGT event C2 that Shareholder B may make on winding up of the Company, will be reduced by those amounts that are included in Shareholder B's assessable income under subsections 44(1) or 47(1) (refer to the answer to question 5 and the discussion under the heading 'Sections 44 and 47 of the ITAA 1936' above).