Edited version of your written advice

Authorisation Number: 1051366139054

Date of advice: 30 April 2018

Ruling

Subject: Money lending and bad debts

Question 1

Are you entitled to a deduction under section 25-35 of the ITAA 1997 for the bad debts arising from writing off the principal component of your promissory notes?

Answer

No

Question 2

Is a capital loss available to you when CGT event C2 in section 104-25 of the ITAA 1997 happens to each of the debt when the ownership of the promissory note ends?

Answer

Yes. CGT event C2 does not happen by merely writing off the debts. There must be a legal impediment imposed on the company for the collection of the debts at that time.

This ruling applies for the following periods:

Year ended 30 June 201X

Year ended 30 June 201X

Year ended 30 June 201X

The scheme commences on:

01 July 201X

Relevant facts and circumstances

You are an incorporated company. You provide franchising opportunities and support the franchisees in training, marketing and operations.

Foreign Company X is the sole shareholder of your company.

As part of the franchising arrangement, you would pay franchisees’ development and fit out costs. The payments were recorded in your Balance Sheet in a holding account referred as ‘AR – Franchisee Rebill’. Franchisees were progressively invoiced during the development/fit out process with final invoices issued once works were completed. Four of the store development/fit out projects were repaid fully. Franchisees that could not pay the costs and/or obtain bank finance, would grant a promissory note to you. When a promissory note was granted, the costs were transferred from the ‘AR – Franchisee Rebill’ account to a ‘Promissory Note Balance Sheet’ account.

The promissory notes were granted because financial institutions were not willing to provide finance to your franchisees. In order to secure a loan, your management would recommend relevant franchisee based on a ‘rated to expand’ assumption and the franchisee must provide an equity injection of 30% of the cost of the store expansion project. You would not have been able to expand your business into such stores if you did not accept the promissory notes.

In the 201X and 201X income years, several franchisees provided you with promissory notes to pay for their store development/refurbishment costs.

The promissory notes were issued with a set process followed for each new Note. Generally, the same agreements were put in place and the same interest rates used. Franchisees were subject to credit checks to ensure that they were able to meet the repayments. Details of the loan process were provided in your further information response, which form part of the facts of your ruling.

You commenced offering promissory notes in March 201X. You expected this to continue as part of your normal business operations. The issuing of promissory notes only ceased when the Master Franchise was sold to Company Y in June 201X. You issued 10 promissory notes only (four of them are in process or repaid in full).

The other six promissory notes debts have been outstanding for over three years. The details of these promissory notes were provided in your application, which form part of the facts of the ruling.

Each of the promissory notes was to be repaid over two to five year terms at commercial interest rates (except for one promissory note with the Amortization Schedule showing 0% interest rate for a 24 month term). There was a view to profit in issuing the promissory notes by way of charging interest at the rate of 9%, and 10% thereafter if the promissory note was extended past the maturity date.

The interest charged has been included as your assessable income. The principal portions of promissory note repayments were not recorded as assessable income.

Foreign Company X was responsible for liaising and negotiating with your franchisees for repayment and determining whether those debts should be written off as bad. In several cases, Foreign Company X made accommodations to the terms of the Notes to encourage payment of the outstanding debts. Since the franchise agreements are with the US related entities and each franchisee, you leveraged off that relationship to assist in collection and/or negotiation of the debt.

In 201X and 201X income years the promissory notes were written off in part or full after the franchisees ceased trading. The basis for determining each of the Promissory Notes to be bad was addressed in your application. The six promissory notes schedules were also attached in your application. The information forms part of the facts of the ruling.

There were no waivers or suspension written on these notes. You or Foreign Company X did not commence any legal proceedings to recover these debts, or execute any Deed of Release. You confirmed that you could still bring an action against the franchisees to recover the debt.

Besides the 10 promissory notes you accepted, you did not enter into any other lending arrangements.

Foreign Company X, on the other hand, has a common practice to lend money to its franchisees.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 25-35

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 subsection 108-5(1)

Reasons for decision

Question 1

Summary

Section 25-35 of the Income Tax Assessment Act 1997 (ITAA 1997) provides you can deduct a debt (or part of a debt) that you write off as bad in the income year if it is in respect of money that you lent in the ordinary course of your business of lending money.

In this case, you are not carrying on a business of money lending in respect to the promissory notes. Therefore, you cannot claim a deduction under section 25-35 of the ITAA 1997 when you wrote off the relevant debts as bad.

Detailed reasoning

Subsection 25-35(1) of ITAA 1997 provides 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 lending money.

Bad debts

Paragraph 3 of Taxation Ruling TR 92/18, Income tax: bad debts, provides that the question of whether a debt is bad is a matter of judgment having regard to all the relevant facts. Generally, provided a bona 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.

Guidelines for deciding when a debt is bad are at paragraphs 31-33 of TR 92/18, which include a debt may be considered to have become bad where the debt has become statute barred; where the debtor has become bankrupt or has executed a deed of assignment or scheme of arrangement; where, if the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the debt; and where a taxpayer has taken the appropriate steps in an attempt to recover the debt.

The basis for determining each of the promissory notes to be bad was addressed in your application. The information maintained that Foreign Company X, on behalf of you, has taken appropriate steps in an attempt to recover the debt. Then Foreign Company X determined that each promissory note was bad because there was little or no likelihood of that debt being recovered.

For the purposes of section 25-35 of the ITAA 1997, you did not have to establish that all efforts to recover would be terminated, and/or it gave it up absolutely. Thus, it is accepted that the debts were bad in this case.

Carrying on a business

Whether an entity is ‘carrying on a business’ is a question of fact, depending on the circumstances of the particular case. As noted in the Federal Court decision in Evans v. Federal Commissioner of Taxation 89 ATC 4540; (1989) 20 ATR 922, no single indicator is determinative, rather all of the indicators must be considered. Whether a business is being carried on is based on the overall impression gained after looking at the activity as a whole and the intention of the taxpayer undertaking it.

The common law has identified a number of indicators that are relevant in determining whether a taxpayer's activities constitute the carrying on of a business. Paragraph 13 of Taxation Ruling TR 97/11, Income tax: am I carrying on a business of primary production? also re-iterates the relevant indicators from case law. They include:

● whether the activity has a significant commercial purpose or character;

● whether the taxpayer has more than just an intention to engage in business;

● whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity;

● whether there is repetition and regularity of the activity;

● whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business;

● whether the activity is planned, organised and carried on in a businesslike manner, such that it is directed at making a profit;

● the size, scale and permanency of the activity;

● whether the activity is better described as a hobby, a form of recreation or a sporting activity.

Carrying on a business as a moneylender

It is accepted that your main business activities were providing products to the franchisees and supported them in training, marketing and operations. However, the relevant question is whether you carried on a money-lending business as well.

Federal Commissioner of Taxation v. Marshall and Brougham Pty Ltd 17 FCR 541, 87 ATC 4522, 18 ATR 859 at ATC p. 4528, ATR p. 866 provides some general guidelines on determining whether a taxpayer is a money-lender. It states:

It is generally accepted that in order to be regarded as carrying on a business one must demonstrate continuity and system in one's dealings. In the case of money lending it has been said that a person must hold himself out as willing to lend money generally to all and sundry (subject to credit-worthiness): see Litchfield v. Dreyfus [1906] 1 KB 584. It is not decisive whether the lender is a registered money-lender or not, although this will be a factor to take into account. It should be mentioned that it need not be the only business or the principal business of the taxpayer. It will be insufficient, however, if it is merely ancillary or incidental to the primary business. In the end, it will be a question of fact for the court to decide by looking at all the circumstances involved: see Newton v. Pyke (1908) 25 TLR 127.

Furthermore, as expressed in paragraph 46 of TR 92/18, the Commissioner’s view is 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 is 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.

There were also other relevant cases that considered whether a taxpayer was carrying on a money-lending business.

In Board of Review case 11 CTBR Case 29, the taxpayer was an ice manufacturer which, in accordance with trade practice, lent money to vendors of its products to enable them to purchase runs. One vendor defaulted on a loan and, after realising its security, the taxpayer suffered a loss. It was held that although the money was lent in the course of the company's business, that business was ice manufacturing and it was impossible to conclude that the company carried on a money lending business.

In Board of Review case 11 CTBR Case 26, a timber and builders merchant financed saw-millers in building and equipping mills, with the object of securing supplies of timber. The company was authorised by its Memorandum and Articles of Association to lend money with or without security. It also built houses and financed building operations. The company claimed a deduction for a loan amount made to a particular firm of saw-millers, which it wrote off as a bad debt. The Board of Review concluded that lending money was not a mere adjunct to the company's business in the sense that it was relatively unimportant or easily severable from the other operations. The company's money lending activities were to both suppliers and buyers of timber and were on such an extensive scale that they formed an integral part of its operations. The Board concluded that, on balance, the company was carrying on a money lending business.

Application in this case

On balance, we consider that you did not carry on a business of money lending.

It is not enough that you had an intention to make a profit, or that you were provided promissory notes with remunerative rates of interest. The objective evidence does not support that you lent money to the franchisees in a businesslike manner, and/or that a profit was likely to be made. Moreover, you did not carry out the activity in a similar manner to that of the ordinary trade in that line of business.

The following factors supported the conclusion that you were not carrying on a business of money lending:

Firstly, you only accepted 10 promissory notes from the franchisees. Six of them were considered bad and written off. Other than that, you did not enter into any other lending arrangement (either as a borrower or lender). The evidence does not demonstrate that you had a degree of system, continuity and repetition. Even if Foreign Company X had offered other loan programs, it is a separate entity to you. Money lending did not appear to be an integral part of your operations. Relevantly, you also accepted a promissory note that had a zero interest rate. This debt was provided to fund the refurbishment costs of a store.

Secondly, you only accepted promissory notes when the franchisees were unable to pay their development/fit out costs. Franchisees were progressively invoiced when the development/fit out process was completed. Arguably, the promissory notes were not made in the ordinary course of a business of lending money but were accepted when you had unsettled invoices. Furthermore, you maintained that the promissory notes were necessary in order to enable the expansion of your business. Although money was lent in the course of your business and there was a perceived benefit that was likely to flow from the activity, you were not necessarily carrying on a money lending business.

Lastly, the evidence does not demonstrate that you made your own decisions with respect to borrowing, or you exercised your corporate mind about activities which you might have been expected to be involved in the carrying on of a systematic activity characterised as a business of lending money. Foreign Company X was primarily responsible for the loan application and recovery activities. Foreign Company X provided the interest/repayment schedules at the start. It was also Foreign Company X that was responsible for liaising and negotiating with the franchisees for repayment and determining whether those debts should be written off as bad. Foreign Company X also made accommodations to the terms of the promissory notes to encourage payment of the outstanding debts, including accepting a lesser amount in satisfaction of the debt. Furthermore, you (or Foreign Company X on your behalf) had not commenced any legal proceeding to recover the payment of the debts.

On balance, therefore, we consider that you did not carry on a business of money lending. The requirement in paragraph 25-35(1)(b) of the ITAA 1997 is not satisfied.

Accordingly, you cannot claim a deduction under section 25-35 of the ITAA 1997 for the bad debts arising from writing off the principal component of your promissory notes.

Question 2

Summary

CGT event C2 in section 104-25 of the ITAA 1997 happens to each of the debt when the ownership of the promissory note ends. There must be a legal impediment imposed on you to collect the debts at that time.

You would make a capital loss when the ownership of your promissory note ends.

Detailed reasoning

Subsection 108-5(1) of the ITAA 1997 describes a CGT asset as any kind of property or a legal or equitable right that is not property. Promissory notes are CGT assets.

CGT event C2 happens when a debt owed to you ends. Specifically, subsection 104-25(1) of the ITAA 1997 states that CGT event C2 happens if your ownership of an intangible asset ends by the asset:

(a) being redeemed or cancelled; or

(b) being released, discharged or satisfied; or

(c) expiring; or

(d) being abandoned, surrendered or forfeited; or

(e) if the asset is an option – being exercised; or

(f) if the asset is a convertible interest – being converted.

The time of event is: when you enter into the contract that results in the asset ending (for example, a settlement deed); or if there is no contract, when the asset ends (for example, when it becomes irrecoverable at law).

Your ownership of the debts, which the promissory notes represent, did not end when they were written off as bad. ATOID 2003/215 provides that the mere writing off of a debt by a taxpayer is insufficient to constitute a cancellation, release, discharge, satisfaction, surrender, forfeiture, expiry or abandonment at law or in equity for the purposes of subsection 104-25(1) of the ITAA 1997. It further clarifies that a debt is not extinguished if it is merely forgiven or abandoned without any legal impediment imposed on its collection.

Accordingly, the debts would only cease to exist when the right to enforce payment is restricted. For instance, you extinguished the debts under a deed of release, such that you were legally barred from collecting the debt. In that situation, CGT event C2 would have happened under subsection 104-25(1) of the ITAA 1997.

You would make a capital loss if the capital proceeds are less than the asset’s reduced cost base (subsection 104-25(3) of the ITAA 1997).