Edited version of private advice

Authorisation Number: 1052112631537

Date of advice: 15 May 2023

Ruling

Subject: Commercial debt forgiveness

Question 1

Will the forgiveness of the loan owed by Company A to Indivual B (its director) be a forgiveness of a commercial debt under Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

Question 2

Will the forgiveness of the loan owed by Company A to Indivual B give rise to a deduction under section 8-1 of the ITAA 1997 for the lender?

Answer

No.

Question 3

Will the forgiveness of the loan owed by Company A to Indivual B be a CGT event for the lender?

Answer

Yes, the debt forgiveness will result in CGT event C2.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commenced on:

1 November 20XX

Relevant facts and circumstances

Company A was registered with ASIC on a specified date.

The 20XX Financial Statements for Company A reported

•         Plant & Equipment less Accumulated Depreciation & Impairment of $XXX

•         Loans from Directors of $XXX

The 2016 income tax return of Company A reported carry forward tax losses of $XXX.

As at X November 20XX the sole director and sole shareholder of Company A was Individual B who was the sole director and shareholder of Company A since its start until the 20XX year.

Individual B was working as an employee up to the 20XX year for another employer.

As Company A incurred losses several years, Individual B had contributed their own income in the company (in the form of a director's loan to the company), to enable Company A to meet its expenses and to continue its business.

On X November 20XX Company A and Individual B executed a Deed of Forgiveness of Debt. The Deed forgave a debt of $XXX owed by Company A to Individual B.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 8-1

Income Tax Assessment Act 1997 subsection 104-25(1)

Income Tax Assessment Act 1997 subsection 104-25(3)

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

Income Tax Assessment Act 1997 subsection 116-20(1)

Income Tax Assessment Act 1997 subsection 116-30(1)

Income Tax Assessment Act 1997 subsection 116-30(3A)

Income Tax Assessment Act 1997 subsection 245-10(b)

Income Tax Assessment Act 1997 subsection 245-25(a)

Income Tax Assessment Act 1997 subsection 245-55(1)

Income Tax Assessment Act 1997 subsection 245-55(3)

Income Tax Assessment Act 1997 section 245-115

Income Tax Assessment Act 1997 section 245-145

Income Tax Assessment Act 1997 section 245-195

Reasons for decision

Question 1

Will the forgiveness of the loan owed by Company A to Individula B be a forgiveness of a commercial debt under Division 245 of the Income Tax Assessment Act 1997?

Summary

The forgiveness of the loan will be commercial debt forgiveness under Division 245. The amount forgiven under Division 245 will be the market value of the loan at the time of forgiveness. The forgiven amount will be offset against any tax losses and depreciating items and any amount remaining after this will be disregarded.

Detailed reasoning

Commercial debt

Division 245 of the ITAA 1997 applies when a commercial debt (or part of a commercial debt) is forgiven.

Subsection 245-10(b) provides that a debt is a commercial debt if 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.

Company A used the loan provided by its director to meet its expenses, to enable it to continue its business. If interest was payable on the loan by the company, the whole or any part of the interest would be deductible by the company. Consequently, in accordance with the definition of a commercial debt in section 245-10 of the ITAA 1997 the loan is considered a commercial debt.

Forgiveness of a debt

Under subsection 245-35(a) a debt is forgiven when the debtor's obligation to pay the debt is released or waived, or is otherwise extinguished other than by repaying the debt in full.

In this case, Company A and Individual B, as debtor, executed a Deed of Forgiveness of Debt, under which, the debt owed by Company A to Individual B has been forgiven.

Value of the debt

Under subsection 245-55(1) the value of your debt at the time when it is forgiven is the amount that would have been its market value at the forgiveness time, assuming that:

a.    When you incurred the debt, you were able to pay all your debts as and when they fell due; and

b.    Your capacity to pay the debt is the same at the forgiveness time as when you incurred it.

However, subsection 245-55(3) states the assumption in paragraph 245-55(1)(a) does not apply to the debt if the creditor was an Australian resident at the time of the forgiveness and the debtor and creditor were not dealing with each other at arms-length in respect of the incurring of the debt and the debt was not a moneylending debt (money lent in the ordinary course of a money lending business).

Application of net forgiven amounts

Subdivision 245-E of the IT 1997 sets out how the forgiven amount is applied. The forgiven amount is applied against the following categories, in the order listed:

•         tax losses (section 245-115)

•         net capital losses (section 245-130)

•         certain expenditures (section 245-145), and

•         cost bases of certain assets (section 245-175).

Of relevance to Company A's circumstances are sections 245-115 and 245-145.

Under section 245-115 the forgiven amount is first applied to the maximum extent possible to reduce Company A's tax losses of any income year. In this case the forgiven amount would first be offset against the tax losses reported of $XXX.

Under section 245-145 any of the forgiven amount remaining after being applied under sections 245-115 and 245-130 is then applied against a wide range of deductible expenditure, such as expenditure relating to depreciable assets, deductible under Division 40, whether in the forgiveness income year or a later income year. In this case any remaining forgiven amount would be offset against the depreciable items under plant and equipment under plant and equipment of $XXX.

If the remaining amount exceeded $XXX this would also mean the written down value of plant and equipment would be reduced to $XXX and no deductions for depreciation, in 2017 or later years, would be available for the items that made up plant and equipment.

Any forgiven amount remaining after this is then disregarded under section 245-195.

The reduction in losses and depreciating items in the 20XX income year will impact your tax calculations for the 20XX income year as well as the subsequent income years.

Question 2

Will the forgiveness of the loan owed by Compnay A to Individual B give rise to a deduction under section 8-1 of the Income Tax Assessment Act 1997 for the lender?

Summary

The loan was not advanced in the ordinary course of business and no income was generated from the loan. As such there is no deduction under section 8-1 for the forgiveness of the loan.

Detailed reasoning

Under section 8-1 of the ITAA 1997 you can deduct from your assessable income any loss or outgoing to the extent it is incurred in gaining or producing your assessable income or it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income and it is not capital or private in nature.

No interest was charged nor received on the loan and the loan was not provided in the ordinary course of business of lending money. Additionally, a loan is a capital asset. Neither positive limb under section 8-1 is satisfied and the negative limb, being a loss or outgoing of capital, or of a capital nature, which in any case denies an immediate deduction has been met.

As such no deduction is available under section 8-1 of the ITAA 1997.

Question 3

Will the forgiveness of the loan owed by Company A to Individual B be a CGT event for the lender?

Summary

The forgiveness of the loan will be CGT event C2. If the market value of the debt is less than the face value of the loan there will be a capital loss. If the market value of the debt is the same as the face value of the loan there will be no capital gain and no capital loss.

Detailed reasoning

A capital gains tax (CGT) asset is defined as any kind of property, or a legal or equitable right that is not property - subsection 108-5(1). 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 - see CGT Determination Number 2 TD 2 Capital Gains: What are the CGT consequences for the lender (Creditor) when a debt is waived?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.

Relevantly, subsection 104-25(1) 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.

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

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).

If no capital proceeds are received from a CGT event you are taken to have received the market value, at the time of the event, of the CGT asset - subsection 116-30(1).

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).

The loan Individual B provided to Company A is a CGT asset within the meaning of the term in section 108-5. CGT event C2 happened when Individual B forgave the loan.

For capital proceeds from CGT event C2, Individual B as the lender is taken to have received an amount equal to the market value of the debt at the time of the event, i.e., when the debt is forgiven, because Individual B received no consideration from Company A for the forgiveness of the debt.

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.

Broadly, the cost base and reduced cost base of an asset is the money paid to acquire or create the asset plus any expenditure and/ or incidental costs relating to the asset. For Individual B as the lender, that will be the amount of their loan to the company.

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

If the market value of the debt equals the face value of the debt, Individual B makes no capital gain or capital loss from the forgiveness of debt. The Deed of Forgiveness stated the debt was $XXX. If the market value of the debt was $XXX then the amount taken to be received would equal the face value of the debt and the capital gain or capital loss from the CGT event would be $XXX.