Edited version of your written advice

Authorisation Number: 1012712064332

Ruling

Subject: Bad debt deductions

Question 1

Is the debt that the Company wrote off in respect of money that was lent in the 'ordinary course of its business of money lending' a deductible expense with subparagraph 25-35(1)(b).

Answer

Yes

Question 2

For the purposes of determining whether the requirements in subsection 165-13(2) to carry on a business immediately before the test time is met, does the Commissioner consider that the Company is carrying on a business immediately before the test time even though the Company does not have a loan outstanding?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commences on:

21 June 2007

Relevant facts and circumstances

The Company was incorporated.

The original shareholders were B Pty Ltd and C Pty Ltd each with 50% shareholding.

The Company was initially capitalised by each shareholder contributing an equal amount in share capital.

The Company was established for the purpose of making loans to a specialised market.

The Company made its first loan to an unrelated party in 2007 on, inter alia, the following terms:

• 2 year term

• An annual interest rate

• Exit fees

• Registered mortgages over real property

• Joint and several guarantee and indemnity with directors and related companies of borrower

To enable the Company to make the loan detailed above, the Company used its capital and entered into a loan facility agreement with an unrelated party.

The documentation required by the Company to implement the above loan structure included a loan agreement and security documentation.

Directors of the Company and A Pty Ltd were highly skilled in negotiating and executing loans in the specialised market.

A Pty Ltd and B Pty Ltd are associates in accordance with section 318 of the Income Tax Assessment Act 1936.

In preparing, negotiating, and executing the facility documentation, the directors were supported by numerous employees of A Pty Ltd who were all highly skilled in specialised market.

Prior to making the loan, 'pre-lend' activities took place such as probity checks on the office holders of the Borrower, detailed analysis of the financial position of the Borrower and their related entities and reviews of project feasibility.

In early 20XX receivers and managers were appointed to the Borrower and negotiated with the finance providers to enable the project to be completed.

The Company negotiated with the Receiver in an attempt to recoup its investment.

In late 20XX the Company was asked by the Receivers to release its registered mortgage over some of the project assets so that the first registered mortgagee could exercise its power of sale free from encumbrance. The Company did not provide a release of mortgage in an unsuccessful attempt to obtain a payment from the first mortgagee in return for its co-operation in the sale process.

Notwithstanding the Company's refusal to provide a release of security, the sale of the project was settled in late 20XX.

The project was sold by the Receiver for substantially less than the original forecast for the gross realisation of the completed development.

As a result of the difference between the actual and expected gross realisation of the project, the Company was not able to recover any of its original principle or capitalised interest in relation to the loan.

In an earlier income year the Company decided that the interest and exit fees were un-economical to recover and were written off as bad debts.

The Chief Financial and Operating Officer of the B Pty Ltd directed in writing that the loan principal will need to be written off in the December 20XX accounts because the borrower's assets had been sold and there were no funds available to the Company.

The Company's Financial Report for the year ended 30 June 20YY showed in the Detailed Profit and Loss an expense in the amount of the outstanding loan principal for 'Loss on disposal/revaluation of non current assets'.

In 20ZZ, the Company's Lender agreed to release the Company from its obligations to repay the loan meaning that in very general terms, the economic loss to the Company was equivalent to the original capital and operational costs.

In late 20ZZ B Pty Ltd agreed to purchase C Pty Ltd's shares and control the Company for the purpose of making future loans.

As a result of the acquisition of C Pty Ltd's shares, the Company will not meet the condition in section 165-12 because the conditions in subsection 165-12(2), 165-12(3) and 165-12(4) cannot be met.

The Company remains in the market until a suitable opportunity presents itself.

The Company relied and continues to rely upon the back of office function of A Pty Ltd to assist in its ongoing operation and investment analysis.

A Pty Ltd is the company in the group that surveys the market for opportunities. Initiatives to identify potential loans include employing personnel who are solely dedicated to sourcing financing opportunities and advertising in the print media and on the internet to create awareness about deals negotiated and completed by the group.

Relevant legislative provisions

Income Tax Assessment Act, Section 25-35.

Income Tax Assessment Act, Section 165-13.

Reasons for decision

Question 1

According to subsection 25-35 (1) of the Income Tax Assessment Act 1997 (ITAA 1997) you can deduct a debt (or part of a debt) that you write off as bad in the income year if:

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

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

TR 92/18 Income tax: bad debts (TR 92/18) clarifies the circumstances in which a deduction for bad debts will be allowable under the bad debts provision in section 63 of the Income Tax Assessment Act 1936 (ITAA 1936). The Commissioner's views in TR 92/18 apply to this case to the extent that the previous bad debt provisions and subsection 25-35(1) of the ITAA 1997 are materially similar.

Debt

A debt exists where a taxpayer is entitled to receive a sum of money from another either at law or in equity.

In this case, the Company loaned a principle amount to the Borrower with interest for a term of 2 years. The terms of the loan included exit fees.

On the evidence supplied the Commissioner accepts that there was a legal debt owed to the Company by the Borrower representing outstanding principle owing as at December 20XX.

Bad Debt

Paragraph 3 of TR 92/18 sets out that the question of whether a debt is bad is a matter of judgment having regard to all the relevant facts. Guidelines for deciding when a debt is bad are at paragraphs 31-32. Generally, where a bone fide commercial decision is taken by a taxpayer as to the likelihood of non-recovery of a debt, it will be accepted that the debt is bad. The debt, however, must not be merely doubtful.

Paragraph 31 of TR 92/18 sets out that a debt may be considered to have become bad in any of the listed circumstances. In particular, if the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the whole debt.

In this case, the Receiver was appointed to the Borrower in 20XX and the Borrower's assets were sold by the Receiver.

As a result of the difference between the actual sale price of the asset and its expected gross realisation the Company did not recover any of its original principle or capitalised interest in relation to the loan.

It is accepted that the debt owing by the Borrower to the Company was bad at the time it was written off.

Debt written off in the income year

It is not enough to simply make a provision for a bad debt. The debt has to be written off as a bad debt and it has to be written off before year's end (paragraph 34 of TR 92/18). There is a requirement that the debt has to be physically written off (paragraph 35 of TR 92/18).

It is essential that a debt be in existence in order that it may be written off as bad. A debt cannot be written off after it has been settled, compromised, otherwise extinguished or assigned (paragraph 38 of TR 92/18).

The Chief Financial and Operating Officer directed that the loan be written off in the December 20XX accounts of the Company and provided the directions for the journal entry. Consistent with this direction, the Financial Report of the Company for the year ended 30 June 20YY includes an expense for 'Loss on disposal/revaluation of non-current assets'.

It is accepted that the debt was written off in December 20XX.

It is accepted that the debt was written off in the income year ended 30 June 20YY.

Business of money lending

Paragraph 25-35(1)(b) of the ITAA 1997 allows you to deduct a debt that you write off as bad in the income year if the debt was in respect of money that you lent in the ordinary course of your business of lending money.

General principles on whether a taxpayer is carrying on a business have been developed from case law. Relevant factors considered in determining this issue are expressed in Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11).

TR 97/11, at paragraph 15, stresses that no one indicator is decisive (Evans v. FC of T 89 ATC 4540; (1989) 20 ATR 922), and there is often a significant overlap of these indicators.

The question of whether a taxpayer is carrying on the business of lending money is necessarily a question of fact. Generally, a business requires a degree of system, continuity and repetition (Lapin v Abigail (1930) 44 CLR 166 per Dixon J at p 200; FC of T v Bivona Pty Ltd 90 ATC 4168 at pp 4173-4174). It is not enough that on several occasions, money has been lent at remunerative rates of interest. The activity should be able to be described as 'business operations intended to yield a profit" (Richard Walter Pty Ltd v FC of T 95 ATC 4440 per Tamberlin J at p 4457).

Further, TR 92/18 at paragraph 46 states that a money lender need not necessarily be ready and willing to lend moneys to the public at large or to a wide class of borrowers. It would be sufficient if the taxpayer lends moneys to certain classes of borrowers provided the taxpayer does so in a businesslike manner with a view to yielding a profit from it.

Paragraph 49 of TR 92/18 confirms that the relevant time for the taxpayer to carry on a money lending business is when the loan was made.

The Commissioner is satisfied that there is evidence that at the time that the loan was made in June 2007 the activity of the Company was planned, organised and carried on in a businesslike manner directed at making a profit in lending money in the specialised market.

The Commissioner accepts, on the facts presented, that at the time that the loan was made, the Company was carrying on a business of money lending in the specialised market.

The Commissioner accepts that the debt that the Company wrote off as bad in the year ended 30 June 20YY was in respect of money it lent in the ordinary course of its money lending business in the specialised market.

None of the special rules affecting deduction as set out in subsection 25-35(5) apply in this case.

Question 2

Division 165 sets out the income tax consequences of changing ownership or control of a company.

Generally, a company cannot deduct a tax loss unless

(a) it has the same owners and the same control through the period from the start of the loss year to the end of the income year; or

(b) it satisfies the same business test by carrying on the same business, entering into no new kinds of transactions and conducting no new kinds of business.

In this case the Company had a change of ownership in late 20ZZ. In these circumstances the Company cannot deduct a tax loss unless it satisfies the same business test.

Subsection 165-13(2) of the ITAA 1997 provides that a company must satisfy the same business test for the income year (the same business test period). Apply the test to the business the company carried on immediately before the time (the test time).The test time is worked out from table to subsection 165-13(2):

• where the company satisfies the continuity of ownership test for some of the ownership test period, the test time is when the company first fails to meet the continuity of ownership test (item 1 of the table);

• If it is impractical to satisfy the continuity of ownership test for any period since the start of the lost year, the test time is the start of the loss year (item 2 of the table);

• If it is impractical to satisfy the continuity of ownership test for any period since the start of the loss year and the company came into being during the loss year, the test time is the end of the loss year (item 3 of the table)

The Commissioner's view on the application of the same business test is in Taxation Ruling TR 1999/9 Income tax: the operation of sections 165-13 and 165-210, paragraph 165-35(b), section 165-126 and section 165-132 (TR 1999/9).

The Company has asked the Commissioner to rule on only one aspect of the 'same business test', namely whether the Company is carrying on a business immediately before the test time.

This ruling is limited to consideration of whether the Company is carrying on a business immediately before the test time. This ruling does not consider whether all the other elements of the same business test are satisfied. For example, the Commissioner has not considered whether the same business is carried on throughout the same business test period or whether there has been any disqualifying activity such as entering new kinds of transactions or conduction new kinds of business.

In this case, the test time is when the Company first fails to meet the continuity of ownership test (item 1 of the table to subsection 165-13(2)).

The Company first failed to meet the continuity of ownership test when B Pty Ltd acquired all of C Pty Ltd's shares and became owner of all of the Company's shares in late 20ZZ.

Paragraphs 34 - 36 of TR 1999/9 set out the Commissioner's approach to identifying the business carried on by the company at the change-over time (when the continuity of ownership test is no longer met).

In this case, at the test time, the Company advised that it was in the market looking for a suitable investment relying on the back office function of A Pty Ltd to assist in its ongoing operation and investment analysis. The Company advised that A Pty Ltd surveys the market for opportunities and undertakes various initiatives such as advertising and employing personnel who are solely dedicated to sourcing financing opportunities.

The Company made its first and only loan in June 2007. The borrower defaulted and after external administration of the borrower company and subsequent sale of the property development (at a shortfall) the Company wrote off the bad loan in December 20XX. The Company was not released from its lender until August 20ZZ.

Consistent with the Commissioner's approach set out in paragraph 36 of TR 1999/9, the fact that at the test time there were no loans is not necessarily fatal to a finding in relation to whether a business of money lending was being carrying out at the test time. In this case, the Commissioner is satisfied that the activity undertaken by the Company in respect of attempts to recover the bad loan, negotiating release of its own borrowing in respect of that loan and actively looking for its next lending opportunity are typical activities undertaken in the course of carrying on its business of money lending in the specialised market.

In these circumstances, based on the specific facts and explanations of the time delays up until the Company was in a position to lend again (pending the right opportunity arising) from the last half of December 20ZZ, the Commissioner has formed the view that the Company was carrying on its business of money lending immediately before the test time.

The Commissioner notes that as at the date of this ruling the Company has not yet made another loan but continues to look for opportunities. The Commissioner was not required to take into account activities undertaken by the Company after the test time in order to provide the ruling on whether the Company carries on a business immediately before the test time.

As mentioned above, this ruling does not consider whether all of the elements of the same business test are satisfied. If the Company requires a private binding ruling on whether all of the elements of the same business test are satisfied, it should apply for a ruling for the income year in which it claims a deduction of the losses.