Edited version of your written advice

Authorisation Number: 1013031172241

Date of advice: 22 June 2016

Ruling

Subject: Application CGT provisions and Division 7A forgiveness of loans to the Unit Trust

Question 1

Will the execution of the Deeds of Release by the Unitholders and the trustee of the Unit Trust trigger CGT event C2, and therefore result in the Unitholders making capital losses in relation to the Unitholder Loans?

Answer

Yes.

Question 2

Will the Commissioner exercise his discretion under section 109G(4) of the Income Tax Assessment Act 1936 ( ITAA 1936) to treat the debt forgiveness as not giving rise to a deemed dividend for the Unit Trust?

Answer

Yes.

This ruling applies for the following periods:

1 July 2015 to 30 June 2016

The scheme commenced on:

The scheme has commenced

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

A and B are the controllers of the following entities:

● A Pty Ltd

● B Nominees Pty Ltd as Trustee for the C Trading Trust (“C Trading Trust”)

● B Nominees Pty Ltd as Trustee for the D Trading Trust (“D Trading Trust”).

The M Group conducted a sales and service business throughout various locations in an Australian state.

Until recently, the M Group comprised two main entities including a private company, M Group Holdings Pty Ltd (“MGH”) and M Group Pty Ltd as trustee for the M Group Unit Trust (“Unit Trust”).

The majority of shares in MGH were owned collectively by A Pty Ltd, the C Trading Trust and the D Trading Trust. A holds the majority of shares in A Pty Ltd.

The majority of units in the Unit Trust were and continue to be owned by A Pty Ltd, the C Trading Trust and the D Trading Trust (hereafter collectively referred to as the “Unitholders”.)

The remaining shares in MGH and units in the Unit Trust have been owned by a number of unrelated arm’s length entities outside of A and B’s group.

MGH’s main assets were business goodwill, depreciating assets and the majority of the M Group’s trading stock. The Unit Trust’s main assets included some trading stock and depreciating assets.

The Unit Trust also had significant credit loans in favour of its unitholders (“Unitholder Loans”). It has historically been capitalised through loans rather than unit subscriptions.

The Unitholder loans are not personal use assets. None of the Unitholders are in the business of lending money.

In 20XX, the MGH shareholders entered into a Share Sale and Purchase Agreement for the sale of their shares in MGH to an arm’s length purchaser.

In connection with the share sale, the Unit Trust also entered into an Asset Sale and Purchase Agreement in 20XX for the sale of its trading stock and depreciating assets held at that time.

The purchaser paid what it considered to be market value of the trading stock and depreciating assets at that time. Formal valuations were obtained for this purpose.

Factors affecting the market value include market forces and the demand for such assets, farming conditions in various geographical locations where the dealership trades, and the financial performance of primary producers who purchase that machinery.

The sale proceeds received by Unit Trust were considerably less than the recorded value of its trading stock and depreciating assets, and significantly less than the face value of the Unitholder Loans.

The Unit Trust’s balance sheet now mainly comprises cash at bank and liabilities. The main liability is the Unitholder Loans.

As the Unitholder Loans and other liabilities exceed its assets, the Unit Trust has a negative net asset position in the order of several million dollars.

Due to this reason, there will be insufficient funds to repay the Unitholder Loans in full, even after its other minor assets are realised and converted to cash.

The Unitholders will forgive the shortfall between the face value of the Unitholder Loans and the funds available in the Unit Trust to repay these loans. The trustee of the Unit Trust and the Unitholders will sign Deeds of Release to give effect to this debt forgiveness prior to the vesting of the Unit Trust.

It is proposed that M Group Pty Ltd as trustee will exercise its discretion to vest the Unit Trust on or before 30 June 2016, as it is considered that it no longer serves any commercial purpose.

Further, it is proposed that M Group Pty Ltd will be deregistered as part of this process.

As part of the vesting, Unit Trust will make a partial repayment of the Unitholder Loans out of its remaining funds to the unitholders on a pro-rata basis.

Relevant legislative provisions

Section 109F of the ITAA 1936

Subsection 109G(4) of the ITAA 1936

Subsection 109XA(3) of the ITAA 1936

Section 318 of the ITAA 1936

Section 245-10 of the ITAA 1997

Section 102-20 of the ITAA 1997

Section 104-25 of the ITAA 1997

Section 245-35 of the ITAA 1997

Section 245-40 of the ITAA 1997

Reasons for decision

Question 1

Summary

Will the execution of the Deeds of Release by the Unitholders and the trustee of the Unit Trust trigger CGT event C2, and therefore result in the Unitholders making capital losses in relation to the Unitholder Loans?

Detailed reasoning

Section 102-20 of the ITAA 1997 provides that you make a capital gain or capital loss if and only if a CGT event happens. The gain or loss is made at the time of the CGT event.

For CGT purposes, shares in a company or units in a unit trust are treated in the same way as any other assets. Shares and units acquired on or after 20 September 1985 are a CGT asset. 

The CGT event which is relevant to this case is CGT event C2: Cancellation, surrender or similar endings, as described in section 104-25 of the ITAA 1997.

CGT event C2

CGT event C2 happens if ownership of an intangible CGT asset ends by the asset:

(a) being redeemed or cancelled

(b) being released, discharged, or satisfied

(c) expiring or

(d) being abandoned, surrendered or forfeited.

Debts such as the Unitholder Loans are intangible CGT assets.

The Unitholders and trustee of the Unit Trust will sign Deeds of Release of the debt to each Unitholder, prior to the vesting of the Unit Trust. The time at which the Deeds are executed will therefore be the relevant time for CGT purposes.

Under subsection 104-25(3) of the ITAA 1997, the taxpayers will make a capital loss if those capital proceeds are less than the asset’s reduced cost base.

The cost base of the Unitholder Loans will be equal to their face values, as this is the amount that the Unitholders paid to “acquire” the loans. If the capital proceeds received by the Unitholders are less than the reduced cost base, which is expected given the Trust’s negative asset position, then the taxpayers will make a capital loss under subsection 104-25(3) of the ITAA 1997.

Question 2

Summary

Will the Commissioner exercise his discretion under section 109G(4) of the ITAA 1936 to treat the debt forgiveness as not giving rise to a deemed dividend for the Unit Trust?

Detailed reasoning

Division 245 of the 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. Division 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 of the 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 from 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.

The Unitholders loaned funds to the Unit Trust in order to provide it with capital. The loans were not personal use assets. If interest upon these loans were paid, it would therefore have been deductible to the Unit Trust.

It is considered that the Unitholder Loans to the Unit Trust are commercial debts 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), or

● 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), or

● 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).

The debt will be forgiven for the purposes of subsection 245-35(a) of the ITAA 1997 at the time at which the Deeds of Release by the Unitholders and the trustee of the Unit Trust are executed.

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.

Forgiven debts treated as dividends

Subsection 109F(1) of the ITAA 1936 provides that a private company is taken to pay a dividend to an entity at the end of the company’s income year if during that year the company forgives all or part of a debt owned by an entity who is a shareholder or an associate of a shareholder.

It follows that any loans to the Unit Trust that are treated as “forgiven” by A Pty Ltd for the purpose of Division 7A may be assessable to the Unit Trust as a deemed dividend under subsection 109F(1).

Likewise, subsection 109XA(3) of the ITAA 1936 may also give rise to a deemed dividend where amounts are forgiven by a trustee in favour of a shareholder of a private company or their associate, and the company is or becomes presently entitled to the net income of the trust.

In this case, it is likely that the Unit Trust will be considered an “associate” of A, under paragraphs 318(1)(e) and 318(2)(c) of the ITAA 1936, because A Pty Ltd can benefit from the Unit Trust as a unitholder, and A holds the majority of shares in A Pty Ltd.

Therefore, any debts treated as forgiven by the C Trading Trust and the D Trading Trust may also be assessable to the Unit Trust as deemed dividends.

Subsection 109F(3) of the ITAA 1936 provides that a debt is forgiven for the purposes of this Division at the time it would be forgiven under section 245-35 of the ITAA 1997. That is, as discussed above, at the time at which the Deeds of Release by the Unitholders and the trustee of the Unit Trust are executed.

Subsection 109G(4) of the Income Tax Assessment Act 1936 Commissioner may treat forgiveness as not giving rise to dividend.

A private company is not taken under this Division to pay a dividend because of the forgiveness of a debt owed by an entity if the Commissioner is satisfied that:

(a) the debt was forgiven because payment of the debt would have caused the entity undue hardship; and

(b) when the entity incurred the debt, the entity had the capacity to pay the debt; and

(c) the entity lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond the entity's control.

A. Undue hardship

The term ‘undue hardship’ is not defined in the income tax legislation and therefore takes its ordinary meaning.

The Explanatory Memorandum to Act No 47 of 1998 (EM) 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.

The Macquarie Dictionary (Macquarie Dictionary Online, 2016) defines ‘undue’ as ‘excessive or too great’ and ‘hardship’ as ‘a condition that bears hard upon one; severe toil, trial, oppression, or need’.

In this case, the Unit Trust will have a negative net asset position in the order of several million dollars as the Unitholder Loans and other liabilities exceed its assets. Once the trust is vested and its remaining assets are converted to cash, it will not have enough to repay the Unitholder Loans in full.

Therefore, it is accepted that at the time of the partial debt forgiveness of the Unitholder Loans, the Unit Trust would experience undue hardship if it were to be required to repay the debt.

Accordingly, it is considered that paragraph 109G(4)(a) of the ITAA 1936 is satisfied.

B. Capacity to pay the debt when it was incurred

The Unit Trust has historically been capitalised through loans rather than unit subscriptions. The Unitholder Loans were made for this purpose.

The Unit Trust would have had sufficient funds to pay the Unitholder Loans when they were made. It is submitted that the unitholders would not have lent money to an associated party at first instance if they anticipated those funds could never be repaid in full.

It is accepted that at the time the funds were borrowed, the Unit Trust had the capacity to pay the debt in full.

Accordingly, it is considered that paragraph 109G(4)(b) of the ITAA 1936 is satisfied.

C. Lost the ability to pay the debt through circumstances beyond the control of the Unit Trust

The EM states:

The Commissioner will only exercise his discretion 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 his or her own.

In this case, the Unit Trust lost the ability to pay the Unitholder Loans through the low sales proceeds received from the sales of its trading stock and depreciating assets. The purchaser paid market value based upon formal valuations.

Factors affecting the market value include market forces and the demand for such assets, environmental factors affecting businesses in various geographical locations where the dealership trades, and the financial performance of businesses that purchase that machinery.

It is accepted that the factors that led to the low market value of its trading stock and depreciating assets were outside the control of Unit Trust.

Accordingly, it is considered that paragraph 109G(4)(b) of the ITAA 1936 is satisfied.

Conclusion

All paragraphs in subsection 109G(4) of the ITAA 1936 have been satisfied.

Accordingly, the Commissioner will exercise his discretion to treat the debts released by the Unitholders as not giving rise to deemed dividends to the Unit Trust.