Edited version of your written advice

Authorisation Number: 1013118993259

Date of advice: 4 November 2016

Ruling

Subject: Commercial debt forgiveness and deemed dividends

Question 1

Will the gain received by Company X as a result of a commercial debt forgiveness be a deemed dividend under section 47 of the Income Tax Assessment Act 1936 (ITAA 1936) when the gain is distributed to the shareholders of Company X in the course of winding up the company?

Answer

No

This ruling applies for the following period

Income year ended 30 June 20ZZ

The scheme commenced on

1 June 20YY

Relevant facts and circumstances

Company X is an unlisted Australian resident public company.

Company X requested financial assistance from a Government entity to assist in meeting the cost of the establishment and operation of a facility.

In expectation of the beneficial impacts, the Government entity agreed to make a loan to Company X.

The loan was an interest free loan to be repaid on the termination date.

The Government entity agreed to accept a repayment amount in full and final discharge and release of the obligation to repay the interest-free loan made to Company X.

The forgiveness of the loans provided to Company X fell within the commercial debt forgiveness rules contained in Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997).

The forgiveness of the loan left an amount (the gain) in the loan account ledger balance of Company X to be written back to shareholder reserves.

Company X is expected to be liquidated at a future date.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 47

Income Tax Assessment Act 1936 Schedule 2C (repealed)

Income Tax Assessment Act 1997 Division 245

Income Tax Assessment Act 1997 Section 245-10

Income Tax Assessment Act 1997 Section 245-40

Reasons for decision

Question 1

Summary

The gain received by Company X as a result of a commercial debt forgiveness will not be a deemed dividend under section 47 of the ITAA 1936 when the gain is distributed to the shareholders of Company X in the course of winding up the company.

Detailed reasoning

Liquidator's distributions

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 share 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 (except a net capital gain) that is included in the company's assessable income for the year of income, or

(b) a net capital gain that would be included in the company's assessable income for a year of income if the ITAA 1997 required a net capital gain to be worked out as per the method statement included in this provision.

Subsection 47(2A) of the ITAA 1936 provides that in the case of an informal winding up, and in connection with the discontinuance of the company, where money or other property is distributed to the shareholders otherwise than by the company, the distribution shall be deemed to be a liquidator's distribution if the company ceases to exist within three years of that distribution.

Commercial debt forgiveness

The commercial debt forgiveness rules are contained in Division 245 of the ITAA 1997. These rules remove the tax benefit a taxpayer may obtain (if any) when a commercial debt (or part of a commercial debt) owed by the taxpayer is forgiven.

A commercial debt refers to a debt where the whole or any part of interest, or an amount in the nature of interest, paid or payable in respect of the debt is allowable as a deduction to the borrower. Where no interest is payable in respect of a debt (for instance, an interest-free loan), the debt is a commercial debt if, had interest been payable, it would have been deductible to the borrower (section 245-10 of the ITAA 1997).

Division 245 was rewritten into the ITAA 1997 under the enacted Tax Laws Amendment (Transfer of Provisions) Act 2010 which repealed the former Division 245 rules in Schedule 2C of the ITAA 1936.

The explanatory memorandum (EM) to the Taxation Laws Amendment Act (No. 2) 1996, which introduced the former Division 245 rules in Schedule 2C of the ITAA 1936, provides the following guidance at paragraph 6.2 on the application of the commercial debt forgiveness provisions:

The amendments will ensure that there are appropriate taxation outcomes when a commercial debt is forgiven. The present law contains no specific rules relating to debt forgiveness, with the result that, in general, there are no taxation consequences to the debtor while the creditor usually is entitled to a tax deduction or capital loss for the amount of debt forgiven.

Paragraph 6.2 of the EM to the Taxation Laws Amendment Act (No. 2) 1996 then goes on to provide the following guidance on how the gain received by the debtor is to be treated for taxation purposes:

The amendments will not treat the debtor as having received a taxable gain, but will apply the forgiven amount in reduction of certain amounts otherwise taken into account in calculating the debtor's taxable income.

There are a number of exclusions in section 245-40 of the ITAA 1997 that could result in a gain arising from a commercial debt forgiveness being treated as a taxable gain for the debtor. The exclusions are as follows:

(a) the debt is waived and the waiver constitutes a fringe benefit; or

(b) the amount of the debt has been, or will be, included in the assessable income of the debtor in any income year; or

(c) the forgiveness is effected under an Act relating to bankruptcy; or

(d) the forgiveness is effected by will; or

(e) the forgiveness is for reasons of natural love and affection; or

(f) the debt is a tax-related liability or a civil penalty under Division 290 in Schedule 1 to the Taxation Administration Act 1953 (about penalties for promoters and implementers of tax avoidance schemes).

Application to this case

In this case, the forgiveness of the loans provided to Company X falls within the commercial debt forgiveness rules contained in Division 245 of the ITAA 1997.

The only exclusion in section 245-40 of the ITAA 1997 that may be relevant to this case is paragraph (b). In this regard, paragraph 6.10 of the EM to the Taxation Laws Amendment Act (No. 2) 1996 provides an example as to when a gain from a debt may be included in a debtor's assessable income, this being where an advance or a loan is made to a private company shareholder and is to be included in the shareholder's assessable income as a dividend. This case does not involve a loan from a company to a shareholder. In addition, no portion of the debt has been or will be assessable income of the debtor in any income year under another provision of the ITAA 1936 or ITAA 1997. Accordingly, it is considered that the exclusion in paragraph 245-40(b) of the ITAA 1997 will not apply.

As the loans provided to Company X did fall within the commercial debt forgiveness rules in Division 245 of the ITAA 1997, and as none of the exclusions in section 245-40 of the ITAA 1997 are applicable, the gain received by Company X as a result of the commercial debt forgiveness will not be treated as a taxable gain.

Therefore, any distribution of the gain received by Company X as a result of the commercial debt forgiveness to shareholders at a future date, in the course of liquidating Company X, will not represent 'income derived by the company' for the purposes of subsection 47(1) of the ITAA 1936. As a result, the distribution of the gain will not be a deemed dividend under subsection 47(1) of the ITAA 1936.