Edited version of private advice

Authorisation Number: 1052000285956

Date of advice: 30 June 2022

Ruling

Subject: Capital loss - debt forgiveness

Question

Will you incur a capital loss under Part 3-1 of the Income Tax Assessment Act 1997 on forgiveness of the loan?

Answer

No.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The debtor purchased the property in 20XX.

You and the debtor were in a committed relationship since 20XX and lived in a de facto relationship since 20XX.

You and the debtor agreed that you would operate a café at the property with XX.

The debtor invested $XX of their own funds into complete building works as required by Council to bring the property to initial code.

From September 20XX to January 20XX, you expended a total of $XXX to convert the property into a working café. $XXX was sourced from your personal superannuation account and $XXX was sourced from your personal bank account.

On numerous occasions the debtor affirmed that his intention was, that should the property ever be sold, that your financial contribution to the property would be honoured and returned to you in full, with a shared entitlement to any capital gain.

In January 20XX you and your sibling commenced operation of the business.

You did not pay any rent to the debtor for the use of the property to run the business.

The business paid for all on going costs, including but not limited to insurances, public liability, rates.

The debtor undertook building maintenance and lawn mowing.

You paid for the building insurance. Which remained in place until the debtor's death in November 20XX when it was transferred to the estate.

In August 20XX XX indicated their intention to relinquish the role as partner in the café and return home overseas.

You and the debtor decided to sell the property, and it was listed in August 20XX.

By February 20XX as there were no offers received on the property.

You independently operated the café from February 20XX until the debtor sustained a life-threatening injury in June 20XX which left the debtor hospitalised until September 20XX.

The debtor was diagnosed with a terminal illness on XX October 20XX and died on XX November 20XX.

The debtor prepared a Will on 5 November 20XX.

Following the signing of the Will, the debtor showed you a copy and indicated they had accidentally instructed the property be left in full, to their adult child.

The debtor indicated that they believed that the $XXX should be repaid to you, recognised as a debt against the debtor for the purposes of probate.

On 10 November 201XX the debtor sent their adult child a personal message on Facebook stating, 'you have to understand when you sell the café that $XXX must go to XX as that is what she invested out of their pocket'.

You advised the debtor the importance of speaking with their solicitor. The debtor's response was it was all too difficult, stating that they didn't have the energy for any hassles and was confident their adult child would abide by their request.

The adult child has advised they will not be honouring the agreement and will not repay the loan from the estate.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 section 102-25

Income Tax Assessment Act 1997 section 104-25

Income Tax Assessment Act 1997 section 108-20

Income Tax Assessment Act 1997 section 116-20

Income Tax Assessment Act 1997 section 116-30

Reasons for decision

A CGT asset is defined as any kind of property, or a legal or equitable right that is not property under subsection 108-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997). Relevantly, to avoid doubt, a part of, or an interest in, an asset referred to in subsection (1), is a CGT asset - subsection 108-5(2) ITAA 1997. Examples of CGT assets include land and buildings; shares in a company and units in a unit trust; options; debts owed to you; a right to enforce a contractual obligation; and foreign currency.

A debt owed to a lender is a CGT asset for the purposes of section 108-5 ITAA 1997 - see CGT Determination Number 2 TD 2 which specifically states that a debt is an asset of the lender. The debt is disposed of when the lender waives or forgives the debt. As such a CGT event will happen to the lender.

The relevant or most specific CGT event is determined depending on the facts and circumstances of the case - subsection 102-25 (1) ITAA 1997.

Relevantly, subsection 104-25(1) ITAA 1997 provides that CGT event C2 happens if your ownership of an intangible CGT asset ends by the asset being released, discharged or satisfied. The time of the event is:

(a)  when you enter into the contract that results in the asset ending; or

(b)  if there is no contract - when the asset ends.

You make a capital gain if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base - subsection 104-25(3) ITAA 1997.

Whether the lender makes a capital gain or capital loss from the CGT event will depend on the consideration (capital proceeds) received for the forgiveness of debt and the appropriate cost base of the asset which is the debt.

Personal use asset

In working out your net capital gain or net capital loss for the income year, any capital loss you make from a personal use asset is disregarded - subsection 108-20(1) ITAA 1997.

A personal use asset is: a debt arising other than: (i) in the course of gaining or producing you assessable income; or (ii) from your carrying on a business - subsection 108-20(2) ITAA 1997

In FC of T v Total Holdings (Australia) Pty Ltd (1979) 43 FLR 183; (1979) 9 ATR 885; (1979) 24 ALR 401; (1979) 79 ATC 4279 ('Total Holdings') the Full Federal Court considered whether a taxpayer who on-lent funds interest free to a subsidiary, made the loan in the course of its income producing activities.

We have considered the definition of personal use asset and find that a personal use asset will not apply to your circumstances as there is a sufficient nexus between the expenditure and your income producing activities.

Market value substitution rule

The capital proceeds from a CGT event are the total of the money you have received, or are entitled to receive, in respect of the event happening; and the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event) - subsection 116-20(1) ITAA 1997.

The market value substitution rules will apply if no capital proceeds are received from a CGT event; and no consideration paid for the acquisition of a CGT asset - subsection 116-30(1) ITAA 1997.

Also, the capital proceeds from a CGT event are replaced with the market value of the CGT asset that is the subject of the event if the capital proceeds are more or less than the market value of the asset and the event is CGT event C2 - subsection 116-30(2) ITAA 1997.

The market value of the debt at the time of the CGT event is worked out as though the forgiveness of debt had not happened and was never proposed to happen - subsection 116-30(3A) ITAA 1997.

The loan you provided to the debtor is a CGT asset to you within the meaning of the term in section 108-5 ITAA 1997. CGT event C2 in section 104-25 ITAA 1997 will apply when you waive or forgive the loan in the amount of $XXX.

For your capital proceeds from CGT event C2, you are taken to have received an amount equal to the market value of the debt at the time of the event, that is when the debt is forgiven, because you receive no consideration from the debtor for the forgiveness of the debt - refer to the market value substitution rule in subsection 116-30(1) ITAA 1997.

The market value of the debt at the time of the event is worked out as though the forgiveness of debt had not happened and was never proposed to happen - subsection 116-30(3A) ITAA 1997.

If the market value of the debt is less than the amount owed to you (face value of the debt) then you will make a capital loss from the forgiveness of debt.

If the market value of the debt equals the face value of the debt, you make no capital gain or capital loss from the forgiveness of debt.

As explained above, the value of the debt will be its market value at the time of the forgiveness.

In your case, the value of the debt to be forgiven is $XXX and that amount is also the market value of the debt at the time of the forgiveness.

Therefore, you make no capital gain or capital loss from the forgiveness of debt.

You as the lender, will not be subject to income tax as a result of the forgiveness of debt.