Edited version of your written advice

Authorisation Number: 1051466410814

Date of advice: 13 December 2018

Ruling

Subject: Commercial debt forgiveness

Questions and Answers

1. Does the gift of shares in the company to you amount to a commercial debt forgiveness by you, within the meaning of Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No

2. Will Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) result in any taxable dividends pursuant to the transaction?

No

3. Will you be deemed to have received any assessable dividends from the company in the course of winding it up?

Yes

This ruling applies for the following periods

1 January 2018 to 30 June 2019

The scheme commences on

1 January 2018

Relevant facts and circumstances

Person A and Person B are the directors of Company C.

The shareholders of Company C are:

Shareholder	Class	Number
Person A	A Class	X
Person A	B Class	X
Person A	C Class	X
Person D	D Class	X
Person A	E Class	XX

The A class shares were acquired by Person A and the D class shares were acquire by Person D after 20 September 1985, all other shares were acquired before 1985.

The D class shares are non-equity shares.

Company C owns “Property E”, which was acquired before 1985.

“Property E” consists of a number of lots, some of the lots are owned by Company C and others by Person A.

An independent valuer prepared market valuation reports for “Property E”. The interest valued was the unencumbered fee simple of the subject rural property. The total value of “Property E” was $X with the portion owned by Company C valued at $Y.

“Property E” is subject to a mortgage.

Company C purported to enter into a contract to sell “Property E” to Person B for $X.

The Contract was executed by Person A and Person B as directors of Company C.

Company C was placed into voluntary liquidation by the members of Company C and a Liquidator was appointed.

The proposal – Step 1

Prior to the transfer, the summarised balance sheet for Company C looks like this:

The Asset Revaluation reserve, the Capital Reserve and the Special Reserve are treated as a revaluation reserve in relation to “Property E”.

After the sale to Person B the adjusted balance sheet for Company C will look like this:

The proposal – Step 2

Company C and Person B will execute an agreement for the debt of $X that complies with section 109N of the ITAA 1936.

The proposal – Step 3

After the transfer to Person B has been registered, Person A and Person D will transfer their shares in Company C to Person B as a gift. All individuals are related.

After all the shares have been transferred, and the reserves allocated to Person B as the sole shareholder, the balance sheet will be like this:

In the final liquidation Person B’s obligation to pay the debt of $X to the company will be offset against the company’s obligation to pay Person B that amount as the sole shareholder. This will be done by an appropriate book entry.

After the scheme the property will continue to be used for the same purpose.

The land and buildings are used in conjunction with the business.

Relevant legislative provisions

Income Tax Assessment Act 1997

Section 245-10

Section 245-15

Section 245-35

Subsection 974-75(1)

Subsection 995-1(1)

Income Tax Assessment Act 1936

Subsection 6(1)

Section 44

Subsection 44(1)

Section 47

Subsection 47(1)

Subsection 47(1A)

Paragraph 47(1A)(b))

Subsection 47(2A)

Subsection 47(2B)

Division 7A

Section 109C,

Section 109D

Section 109F

Section 109NA

Subsection 109D(1A)

Reasons for decision

Does the gift of shares in the company to you amount to a commercial debt forgiveness, within the meaning of Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Division 245 of the ITAA 1997 relates to the forgiveness of commercial debts.

Section 245-10 of the ITAA 1997 stipulates that a debt will be a ‘commercial debt’ if:

(a) the whole or any part of interest, or of 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

(b) 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

(c) 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 8-12(a), (b) and (c)) that has the effect of preventing a deduction.

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). If the use of the loan could result in an allowable deduction of interest were interest to be charged, a commercial debt exists.

Further, where only part of the interest that is paid or assumed to be paid in respect of a debt is deductible, the debt is a commercial debt.

Section 245-15 states that Division 245 of the ITAA 1997 also applies:

... to a *non-equity share issued by a company as if it were a debt to which section 245-10 applies that is owed by the company to the relevant shareholder.

Subsection 995-1(1) of the ITAA 1997 defines the following terms:

Equity interest in an entity has the meaning given by:

(a) In the case of a company – Subdivision 974-C; and

(b) In the case of a trust or partnership – section 820-930.

Non-equity share means a *share that is not an *equity interest in the company.

Share

(a) in a company means a share in the capital of the company, and includes stock; and......

Item 1 in the table in subsection 974-75(1) of the ITAA 1997 provides that an equity interest will be:

An interest in the company as a member or stockholder of the company.

Therefore, the shares that Person A holds in Company C will be equity interests. Accordingly, the gifting of these shares will not be covered by the commercial debt forgiveness provisions in Division 245 of the ITAA 1997.

As stated above, commercial debt also includes non-equity shares issued by a company as if they were a debt owed by the company to the Person D. It is therefore necessary to consider the operation of Division 245 of the ITAA 1997 to the gifting of the D class shares by Person D.

A debt is forgiven in the following circumstances:

● if the debtor's obligation to pay is released or waived or is otherwise extinguished otherwise than by repaying the debt in full (subsection 245-35(a) of the ITAA 1997)

● the action for recovery of the debt is barred by a statute of limitations (s 245-35(b))

● the debt is assumed by an associate of the debtor (section 245-36 of the ITAA 1997)

● if an entity subscribes for shares in a company to enable the company to make payment towards discharge of the debt, the debt is forgiven when the company applies the subscribed money towards payment of the debt (section 245-37 of the ITAA 1997).

Forgiveness of debts in the following circumstances will not trigger the operation of Division 245 of the ITAA 1997:

● forgiveness as a result of bankruptcy, will or reasons of natural love and affection

● if the debt is a tax-related liability or civil penalty under Division 290 in Schedule 1 to the Taxation Administration Act 1953

● the amount of the debt has or will be included in the assessable income of the debtor in any year of income.

Under section 245-36 of the ITAA 1997, a debt is forgiven if and when the creditor assigns the right to receive payment of the debt to another entity (the new creditor) and the following conditions are met:

a. either the new creditor is the debtor's associate or the assignment occurred under an arrangement to which the new creditor and debtor were parties;

b. the right to receive payment of the debt was not acquired by the new creditor in the ordinary course of trading on a market, exchange or other place on which, or facility by means of which, offers to sell, buy or exchange securities (within the meaning of Division 16E of Part III of the Income Tax Assessment Act 1936 (ITAA 1936)) are made or accepted.

An associate of a natural person includes a relative, which includes the siblings of their spouse. Therefore Person D and Person B are associates. As the gifting of the shares by Person D to Person B were not made on a market the transfer of Person Ds non-equity shares to Person B may constitute commercial debt forgiveness.

Under section 245-35 of the ITAA 1997 a debt is forgiven if and when:

a. the debtor's obligation to pay the debt is released or waived, or is otherwise extinguished other than by repaying the debt in full; or

b. the period within which the creditor is entitled to sue for the recovery of the debt ends, because of the operation of a statute of limitations, without the debt having been paid.

As the sole shareholder, Person B owns the non-equity share and as stated above section 245-10 of the ITAA 1997 applies as if it were a debt.

As Person B’s obligation to pay the debt to the company will be offset against the company’s obligation to pay Person B that amount as the sole shareholder, including the non-equity shares. Accordingly, debt owed in relation to the non-equity shares will be repaid in full and none of the debt will be forgiven.

Will Division 7A of the ITAA 1936 result in any taxable dividends pursuant to the transaction?

Generally, Division 7A of the ITAA 1936 applies where a private company has made a payment or loan to, or forgiven the debt of, an entity in an income year and in that income year either:

● The entity was a shareholder or shareholder’s associate of the private company at the time the payment, loan or debt forgiveness was made; or

● A reasonable person would conclude that the loan, payment or debt forgiveness was made because the entity had been a shareholder or shareholder’s associate at the time.

An entity includes an individual and an associate includes a relative of an entity.

The general rule is that a private company is taken to pay a dividend to an entity at the end of the income year in which the payment or loan is made or the debt is forgiven (refer to section 109C, section 109D and section 109F of the ITAA 1936). Such dividends are included in the assessable income of the shareholder or associate under section 44 of the ITAA 1936.

Section 109D of the ITAA 1936 provides that a private company is taken to have paid a dividend to an entity if:

a. A private company makes a loan to the entity during the current year; and

b. The loan is not fully repaid before the lodgment day for the current year; and

c. Subdivision D does not prevent the private company from being taken to pay a dividend because of the loan at the end of the current year; and

d. Either:

i. The entity is a shareholder in the private company, or an associate of such a shareholder, when the loan is made; or

ii. A reasonable person would conclude (having regard to all the circumstances) that the loan is made because the entity has been such a shareholder or associate at some time.

Section 109NA of the ITAA 1936 ensures that certain liquidator’s distributions and loans are not treated as dividends. In particular a private company is not taken under section 109C or subsection 109D(1) to pay a dividend because of a distribution or loan made in the course of the winding-up of the company by a liquidator. However, if such a loan is not fully paid by the end of the following year of income, the company will be taken to have paid a dividend under subsection 109D(1A) of the ITAA 1936.

In this case, the loan was repaid and therefore the distribution is not treated as a dividend.

Will you be deemed to have received any assessable dividends from the company in the course of winding it up?

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 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 (other than a net capital gain) that is included in the company’s assessable income for the year, or

b. A net capital gain that would be included in the company’s assessable income for a year of income if the Income Tax Assessment Act 1997 required a net capital gain to be worked out as follows:

Subsection 47(2A) of the ITAA 1936 applies where there is an informal winding up of a company and provides, where:

a. the business of a company has been, or is in the course of being, discontinued otherwise than in the course of a winding up of the company under any law relating to companies;

b. in connexion with the discontinuance, any moneys of the company have been or other property of the company has been, on or after 19 October 1967, distributed, otherwise than by the company, to shareholders of the company; and

c. the moneys or other property so distributed are not, for the purposes of this Act, dividends;

the distribution shall, subject to subsection (2B), be deemed to be, for the purposes of this section, a distribution to the shareholders by a liquidator in the course of winding up the company.

Subsection 47(2B) of the ITAA 1936 provides that where subsection 47(2A) of the ITAA 1936 would otherwise apply in relation to distributions but the company does not cease to exist within three years after the distribution (or such further period as the Commissioner allows), subsection 47(2A) of the ITAA 1936 does not apply to the distribution. In such a case, the distribution is treated as a dividend paid by the company to the shareholders out of profits derived by it and is treated accordingly for the purposes of assessment to tax.

Subsection 44(1) of the ITAA 1936 includes in a shareholder’s assessable income any dividends paid to the shareholder out of profits derived by the company from any source if the shareholder is a resident of Australia.

Section 44(1) of the ITAA 1936 does not apply to a dividend to the extent to which it is either assessable or exempt under another provision of the ITAA.

The term ‘dividend’ in subsection 6(1) of the ITAA 1936 includes:

a. any distribution made by a company to any of its shareholders, whether in money or other property, or

b. any amount credited by a company to any of its shareholders as shareholders.

However, paragraph (d) specifically excludes a distribution from the definition of ‘dividend’ if the amount of the distribution is debited against an amount standing to the credit of the share capital account of the company.

At the conclusion of the proposed transactions Company C is to be deregistered, there will be an ‘informal’ winding up of the company.

The amount owed to Company C by Person B will be offset against her entitlement as a shareholder. Thus in effect, Person B will be receiving payment from three sources: the share premium reserve, the retained profits and capital profits reserve.

The capital profits reserve consists of the capital gain made by Company C on the sale of the property to Person B. As the property was purchased by Company C prior to 20 September 1985, the gain made on its disposal is disregarded (subsection 104-10(5) of the ITAA 1997).

Therefore, provided Company C is deregistered within three years of Step 4 occurring, a distribution to Person B of the amount in the capital profits reserve will be excluded (as a result of paragraph 47(1A)(b)) from being a deemed dividend under section 47 of the ITAA 1936.

The distribution of paid up capital is not a distribution of income and therefore will not be assessable as a deemed dividend under section 47 of the ITAA 1936.

However, at least part of this payment will come from the company’s retained profits account. Section 47 of the ITAA 1936 deems such a distribution to be a dividend in the hands of the shareholder. Therefore, this part of the distribution will be included in your assessable income under section 44 of the ITAA 1936.

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

Will the Commissioner apply Part IVA to any part of the proposal?

Your application for a private ruling has been declined because the Commissioner is not prepared to base a ruling based on assumptions.

We are declining to give you a private ruling on this matter because we consider that making the ruling may prejudice or restrict our administration of the law.

Reasons for decision

The gifting of the shares is clearly a cause for concern in relation to a wider scheme involving Person A and Person D. We have no details on their motivation for gifting the shares to Person B and are not in a position to ask about those motivations because they are not relevant to any narrower scheme involving Person B.

Part IVA is a consideration of the broader legal, financial and taxation impact to not only the rulee, but to entities associated with the rulee. As not all relevant entities involved in the transaction are party to the ruling we are unable to properly and fully consider the application of Part IVA.

Review rights when we have declined to make a ruling

We have declined to make your private ruling, and have given you the reasons. This decision may be reviewable under the Administrative Decisions (Judicial Review) Act 1977 (ADJR).

The ADJR provides you with two main rights.

1. You can send a written notice to the Commissioner requiring him to provide a written statement of:

● the findings of material questions of fact

● the evidence these findings were based upon, and

● the reasons for his decision.

2. You can apply to the Federal Court of Australia or the Federal Circuit Court for a review of the decision.

If you decide to apply to the Federal Court or the Federal Circuit Court for a review of the decision, we suggest you seek professional advice on how to progress. In addition, the Court will be able to provide you with some direction and assistance about the process.

An application must be lodged within 28 days of the issue date on your Notice of private ruling.

You may lodge your application for review at the Federal Court or Federal Circuit Court in the State or Territory in which you ordinarily reside, or the State or Territory listed in the address for the ATO shown on your Notice of private ruling.

You can find more information on the Federal Court website fedcourt.gov.au, or the Federal Circuit Court fedcircuitcourt.gov.au