Edited version of your written advice

Authorisation Number: 1051431507846

Date of advice: 24 September 2018

Ruling

Subject: Debt forgiveness

Question 1

Will the debt forgiveness result in a capital gains tax event for you upon the release of the debt payable by you to the beneficiaries?

Answer

No

Question 2

Will the commercial debt forgiveness provisions contained within Division 245 of the Income Tax Assessment Act 1997 apply to you upon the forgiveness of the debt payable by you to the beneficiaries?

Answer

Yes

Question 3

Will you be subject to income tax as a result of the release of the debt payable to the beneficiaries?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 2019

Year ended 30 June 2020

Year ended 30 June 2021

Year ended 30 June 2022

The scheme commences on:

1 July 2018

Relevant facts and circumstances

You obtained a loan from a banking institution to purchase the business

The loan was secured against the trustees’ primary residence

The trustees are also among the beneficiaries of the trust

After an extended period of poor trading, the decision was made to pay out the banking loan from the personal funds of a number of the beneficiaries, to remove the risk of losing the home

The same beneficiaries also loaned you additional amounts from ongoing injections of funds over a number of years. These additional amounts were funded by them from a personal line of credit

The trust’s financial accounts show a loan amount from the beneficiaries

You used the additional funds to maintain liquidity, i.e. pay wages, suppliers and fund the ongoing losses

There was never a loan agreement in place, interest paid, an expectation of interest to be paid or an expectation that the amounts would be repaid or recovered in the future between you and the beneficiaries

You want to classify the amount recorded as a loan on the balance sheet as a capital investment

You are not currently going to be wound up as there are leases in place

The debt is irrecoverable

You are not dealing at arm’s length with the lenders

You are not in the business of money lending

The beneficiaries are not in the business of money lending

The entire debt will be forgiven

No consideration will be given for the forgiveness of the debt owed by you

You was solvent at the time the loans were made

The trustees are residents of Australia for taxation purposes.

Relevant legislative provisions

Section 6-1 of the Income Tax Assessment Act 1997

Section 6-5 of the Income Tax Assessment Act 1997

Section 8-1 of the Income Tax Assessment Act 1997

Section 104-25 of the Income Tax Assessment Act 1997

Division 245 of the Income Tax Assessment Act 1997

Section 245-10 of the Income Tax Assessment Act 1997

Section 245-40 of the Income Tax Assessment Act 1997

Section 245-35 of the Income Tax Assessment Act 1997

Section 245-55 of the Income Tax Assessment Act 1997

Paragraph 245-55(1)(a) of the Income Tax Assessment Act 1997

Paragraph 245-55(3)(a) of the Income Tax Assessment Act 1997

Section 245-75 of the Income Tax Assessment Act 1997

Subsection 245-85(1) of the Income Tax Assessment Act 1997

Subsection 245-105(2) of the Income Tax Assessment Act 1997

Sections 245-115 to 245-195 of the Income Tax Assessment Act 1997

Subsection 245-175(2) of the Income Tax Assessment Act 1997

Reasons for decision

Question 1

Summary

The waiving of the debt will not result in a capital gains tax event for you as the borrower is not considered to have an asset.

Detailed reasoning

Section 104-25 of the Income Tax Assessment Act 1997 (ITAA 1997) refers to a capital gains tax (CGT) event C2 happening if an intangible asset ends because it is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered, forfeited or expired.

CGT Determination Number 3, TD 3; What are the CGT consequences for the borrower (debtor) when a debt is waived? states, in part;

1. For CGT purposes, the borrower is not considered to have an asset. Accordingly, when the lender waives the debt, the borrower does not dispose of an asset and therefore makes no capital gain or loss.

2. No other CGT provisions apply to cause a capital gain or loss to the borrower when the lender waives the debt.

Application to your circumstances

You (the borrower) owe the lenders an amount of money. The beneficiaries will forgive the debt owed by you.

As the borrower is not considered to have an asset for CGT purposes, there is no asset disposed of when the lender waives the debt. Therefore there will be no CGT consequences for you when the lenders forgive the debt.

Question 2

Summary

The debt was incurred for the purpose of repaying the original loan to purchase the business and to fund the ongoing business expenses. The trust financial accounts for the year ended show a loan amount from the beneficiaries. The loans are commercial debts and Division 245 of the ITAA 1997 applies. The gross forgiven amount will be the market value at the time of the forgiveness less the offset amount being the market value of the debt at the time of the forgiveness.

Detailed reasoning

Commercial debt

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.

Division 245 was rewritten into the ITAA 1997 commencing 1 July 2010. It applies to debts forgiven from the 2010-11 income year onwards.

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.

To determine whether a commercial debt exists we have to look at the borrower's purpose and not that of the lender (Federal Commissioner of Taxation v. Tasman Group Services Pty Ltd 2009 ATC (Tasman)). In Tasman the taxpayer did not succeed with their argument that various loans received from its overseas parent company were not commercial debt but instead were equity. They argued that although the loans had been made to fund its acquisition of a business, it later become clear to both parties that there was no intention for the loans to be repaid and as a result they became equivalent to an equity investment. The taxpayer also argued that the characterisation of the lending did not solely turn on the use to which the borrowed funds were put. The Full Federal Court in Tasman found that it was the taxpayer’s use of the loans (the borrower), rather than the lender’s purpose of making the loans which was determinative of whether the loans were commercial debts. The loans were commercial debts despite the financial difficulties that the taxpayer was experiencing and the motives of the parent company in assisting the taxpayer to continue trading.

Whether interest has been incurred in the course of gaining or producing assessable income generally depends on the purpose of the borrowing and the use to which the borrowed funds are put. Where a borrowing is used to acquire an assessable income producing asset, or relates to expenses of an assessable income producing activity, the interest on this borrowing is considered to be incurred in the course of gaining or producing assessable income and is therefore deductible under section 8-1 of the ITAA 1997: Taxation Ruling TR 95/25 Income tax: deductions for interest under section 8-1 of the Income Tax assessment Act 1997 following FC of T v. Roberts; FC of T v. Smith (TR 95/25) - which outlines the implications for individuals, partnerships and companies. The principles for determining whether a trust is entitled to a deduction in respect of interest on borrowings are generally the same as for other taxpayers.

Application to your situation – is there a commercial debt?

In your situation, while no interest was payable by you in respect of the loan from the beneficiaries, the debt may still constitute a commercial debt where, should interest have been payable, it would be deductible to you.

To determine whether a commercial debt exists we have to look at the borrower's purpose and not that of the lender. As the debt was used by you to refinance the original loan in relation to the purchase of the business and to fund the ongoing business expenses, the loans are commercial debts. You would be entitled to a deduction for interest incurred on the debt had it been payable, as it would have been incurred in the production of assessable income.

Commercial debt forgiveness

A debt is forgiven under section 245-35 of the ITAA 1997 when a debtor is released or waived from their obligation to pay the debt or the period within which the creditor is entitled to sue for recovery of the debt ends (section 245-35 of the ITAA 1997).

In the following circumstances, the forgiveness of a debt is not caught by Division 245 of the ITAA 1997 because of section 245-40:

i) a forgiveness of a debt that is a fringe benefit

ii) a debt that has been or will be included in the debtor's assessable income (e.g. a loan that is a deemed dividend)

iii) a forgiveness effected under an Act relating to bankruptcy

iv) a forgiveness effected by will

v) a forgiveness for reasons of natural love and affection, and

vi) a debt that is a tax related liability or civil penalty.

A forgiveness effected under an Act relating to bankruptcy is excluded from the application of Division 245 of the ITAA 1997. At present there is only one Act relating to bankruptcy, i.e. the Bankruptcy Act 1966 and therefore this exclusion is only applicable to individuals.

Application to your situation – commercial debt forgiveness reason

As the reason the debt cannot be paid back is because the debtor does not have the funds to pay the loan back, the exclusions under section 245-40 of the ITAA 1997 do not apply. The forgiveness will be due to an inability to repay. Therefore section 245-40 of the ITAA 1997 will not exclude the forgiveness of the debt from the commercial debt forgiveness rules contained in Division 245 (ATO ID 2003-590 Income tax: Commercial debt forgiveness – debt forgiven because of inability to repay and reasons of love and affection).

Forgiven amount and application

Division 245 of the ITAA 1997 provides that an amount equal to the tax benefit obtained known as the net forgiven amount is applied to reduce the taxpayer's tax losses, net capital losses, some expenditures and CGT cost bases which are otherwise available to reduce the taxpayer's assessable income.

Before the net forgiven amount can be determined, the gross forgiven amount must be determined which is the value of the debt when the debt is forgiven less any consideration given in respect of the forgiveness.

Generally, the value of the debt is its market value at the time of the forgiveness assuming the debtor is solvent when the debt is incurred as well as when the debt is forgiven (section 245-55 of the ITAA 1997). If the creditor was an Australian resident at the forgiveness time and you and the creditor were not dealing with each other at arm’s length in respect of you incurring the debt and the debt was not a moneylending debt the solvency provision under paragraph 245-55(1)(a) does not apply to the debt per subsection 245-55(3)(a).

An amount can be offset against the value of the debt under section 245-65. Item 3 in column 1 of the table in subsection 245-65(1) (which explains how to work out the amount that is offset against the value of a debt when it is forgiven) says in the case where the debt is not a moneylending debt, and the conditions in subsection(2) are met and none of the items at 4, 5 and 6 apply then the amount offset is the market value of the debt at the time of the forgiveness.

Under section 245-75 of the ITAA 1997 the following applies;

(1) The gross forgiven amount of a debt is:

(a) if section 245- 65 does not apply to the debt--the value of the debt when it was * forgiven (worked out under section 245- 55, 245-60 or 245- 61); or

(b) if the value of the debt when it was forgiven exceeds the amount offset under section 245- 65 in relation to the debt--the excess.

(2) If the value of the debt when it was forgiven is equal to or less than the amount offset:

(a) there is no gross forgiven amount in respect of the debt; and

(b) Subdivisions 245-D to 245-F (about how to work out the net forgiven amount of a debt and how to treat it) do not apply in respect of the debt.

To then reach the net forgiven amount of the debt the gross forgiven amount is reduced by any amount already taken into account (because of the forgiveness) in determining the debtor's taxable income.

If any net forgiven amount remains after reducing a debtor's tax losses, net capital losses, undeducted expenditure and CGT asset cost bases, the balance is disregarded in all instances except where the debtor is a partnership in terms of section 245-195 of the ITAA 1997.

Application to your situation – forgiven amount

The value of the debt will be its market value at the time of the forgiveness.

The debt is not a money lending debt. The creditor will be an Australian resident at the time of the forgiveness. There is no amount that the debtor has paid or will be required to pay nor are there items of property given or required to be given as a result of the forgiveness. The debt is not assigned nor is it forgiven by subscribing for shares in a company. Therefore the amount offset against the value of the debt would be as per item 3 in column 2 in subsection 245-65(1), being the market value of the debt at the time of the forgiveness.

As per paragraph 245-75(2)(a) if the market value of the debt, at the time of the forgiveness, is equal to or less than the amount offset there is no gross forgiven amount in respect of the debt.

Question 3

Summary

The forgiveness of the debt by the beneficiaries will not give rise to ordinary income.

Detailed

Under section 6-1 of the ITAA 1997 the assessable income of a taxpayer consists of ordinary income and statutory income.

Section 6-5 of the ITAA 1997 states that, if you are an Australian resident, your assessable income includes the ordinary income you derive directly or indirectly from all sources, both in and out of Australia.

A gain resulting from debt forgiveness can be treated as ordinary income of the debtor where the debt forgiven is inextricably linked to the ordinary business of the debtor (Warner Music Australia Pty Ltd v FC of T 96 ATC 5046).

Application to your circumstances

The beneficiaries will forgive a debt owed by you. The forgiveness of the debt by the beneficiaries will not arise out of business operations.

You are not in the business of money lending and did not borrow with the intention of making a profit.

Accordingly, the forgiveness of the debt by the beneficiaries will not give rise to ordinary income in the hands of the trust.

Matters we have not ruled on

We have not ruled on all of your questions. Here, we list each question that we have not been able to rule on, and explain why.

Question 4

You would like to treat the cash injection into the trust, by the beneficiaries, to be treated as capital and not a loan.

We can only make rulings on the laws that the Commissioner of Taxation administers. Your application asks for a ruling about the accounting treatment. We cannot rule on this matter.

Provisions that are relevant for rulings are provisions about certain laws administered by the Commissioner. The Commissioner cannot provide a ruling about this matter.

A private ruling is a written expression of the Commissioner’s opinion of the way in which a relevant provision applies, or would apply, to the entity whose tax affairs are the subject of the ruling, in relation to the specified scheme.