Edited version of private advice

Authorisation Number: 1052240815183

Date of advice: 16 April 2024

Ruling

Subject: Single entity rule - commercial debt forgiveness rules

Question 1

Will section 701-1 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to HeadCo, as the head company of the HeadCo tax consolidated group (HeadCo TCG) of which SubCo is a subsidiary member, in relation to the novation of the notes, which are payable to the noteholders, from SubCo to HeadCo (the Novation) such that the intragroup debt between HeadCo and SubCo that arises from the Novation will not result in ordinary or statutory income or a deduction to HeadCo?

Answer

Yes.

Question 2

In respect of the Novation, is the gross forgiven amount calculated under Subdivision 245-C of the ITAA 1997 nil because the market value of the debt at the forgiveness time as worked out under subsection 245-55(1) of the ITAA 1997 would equal the amount offset against the value of the debt as worked out under item 2 of the table in subsection 245-65(1) of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

Income year ended 30 June 20XX

The scheme commenced on:

Income year ended 30 June 20XX

Relevant facts and circumstances

1.         HeadCo is a public company listed on the Australian Stock Exchange (ASX) and is the head company of the HeadCo TCG.

2.         SubCo is a subsidiary member of the HeadCo TCG.

3.         Prior to joining the HeadCo TCG, SubCo issued unsecured notes. The proceeds were to be used to repay existing debt and fund its investment and acquisitions.

4.         A trustee was appointed to hold the notes (the Note Trustee) on trust for the benefit of the noteholders (the Noteholders).

5.         Under the trust deed, SubCo must pay the Note Trustee the face value of the notes and interest until the notes are redeemed, repaid, repurchased or otherwise cancelled.

6.         Just before the expiry of the notes, SubCo extended the maturity date of the notes for another five years and reduced the interest rate.

7.         SubCo was solvent when it issued the notes and remains solvent.

8.         On X [MONTH] 20XX, SubCo, HeadCo and the Note Trustee (the Parties) executed an agreement whereby SubCo's rights and obligations in respect of the notes were novated to HeadCo and HeadCo replaced SubCo as the issuer of the notes (the Novation Deed).

9.         The purpose of the Novation was to simplify the HeadCo group and reduce compliance costs.

10.       HeadCo and the Note Trustee agreed to release SubCo from the future performance and claims of the trust deed and SubCo agreed to release the Note Trustee and HeadCo from future claims in connection with the notes.

11.       The Novation gave rise to an intragroup debt between HeadCo and SubCo for an amount equal to the market value of the notes.

12.       For accounting purposes, SubCo derecognised the liability to the Noteholders for an amount equal to the face value of the notes, recognised the intragroup debt with SNC for an amount equal to the market value of the notes and the difference was recognised as a gain. The gain on sale arises due to interest rates in the market having moved up since the notes were issued.

13.       At all relevant times, all of the dealings between SubCo and the Note Trustee and HeadCo and the Note Trustee have been at arms-length.

Relevant legislative provisions

Income Tax Assessment Act 1997

Subsection 995-1(1)

Section 701-1

Division 245

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise stated.

Reasons for decision

Question 1

Summary

The single entity rule applies to HeadCo, in relation to the Novation, such that the intragroup debt between HeadCo and SubCo that arises from the Novation will not result in ordinary or statutory income or a deduction to HeadCo.

Detailed reasoning

The meaning and legal effect of a novation

Novation is defined in Osborn's Concise Law Dictionary as:

A tripartite agreement whereby a contract between two parties is rescinded in consideration of a new contract being entered into on the same terms between one of the parties and a third party. A common instance is where a creditor at the request of the debtor agrees to take another person as his debtor in the place of the original debtor. It involves the substitution of one party to a contract by another person, and its effect is to release the obligations of the former party and to impose them on the new party, as in the case of a change in the membership of a partnership firm. The creditors of the old firm will usually be deemed to have accepted the new firm as their debtor by continuing to trade with the new firm as if it were identical with the old.

In Olsson v Dyson (1969) 120 CLR 365 at 388-89, Windeyer J considered the legal effect of a "novation" as distinct from an "assignment":

Novation is the making of a new contract between a creditor and his debtor in consideration of the extinguishment of the obligations of the old contract: if the new contract is to be fully effective to give enforceable rights or obligations to a third person he, the third person, must be a party to the novated contract. The assignment of a debt, on the other hand, is not a transaction between the creditor and the debtor. It is a transaction between the creditor and the assignee to which the assent of the debtor is not needed. The debtor is given notice of it; for notice is necessary to complete an assignment pursuant to the statute or in the case of an equitable assignment to preserve priorities. But the debtor's assent is not required. He is not a party to the transaction.

In Scarf v Jardine at p. 351 Lord Selborne said novation "means this-the term being derived from the civil law-that there being a contract in existence, some new contract is substituted for it, either between the same parties (for that might be) or between different parties; the consideration mutually being the discharge of the old contract". In that sense "novation" means simply a new contract standing in the place of the old.

Novation is discussed in Taxation Determination TD 2006/11 Income tax: for the purposes of Division 775 of the Income Tax Assessment Act 1997, does forex realisation event 2 and forex realisation event 4 occur when, on novation, a foreign currency-denominated debt is ended and a new party becomes either the creditor or debtor in the substituted debt?. Paragraphs 13 to15 of TD 2006/11 provide that:

13. Novation is the process whereby with the consent of all parties, including the creditor, a new contract is entered into in substitution for an existing contract. Often one party to the original contract is substituted by another party under the new contract (Olsson v. Dyson (1969) 120 CLR 365 at 388, 389 per Windeyer J).

14. The effect of a novation is to discharge, by agreement, the existing contractual rights and obligations or part of them and create new obligations and rights in substitution (Re United Railways of Havana and Regla Warehouses Limited [1960] 1 Ch 52 at 84, 85 and 88; [1959] 1 All ER 214 at 229 and 233).

15. A novation can effect the substitution of a new debtor for the original debtor, with the intention of releasing the latter. Similarly, a novation can effect the substitution of a new creditor for the original creditor, with the intention of effectively transferring the rights of the latter to the former. In either case, the novation of a debt results in the discharge of the original debt and creation of a new debt.

Application to HeadCo and SubCo

The effect of the Novation Deed entered into by HeadCo, SubCo and the Note Trustee was that:

•         SubCo was released from all of its rights and obligations under the trust deed (the original debt)

•         HeadCo was substituted for and replaced SubCo as the Note Issuer in the trust deed and obtained the rights and assumed the obligations and liabilities of the Note Issuer (the new debt)

That is, the Novation resulted in the discharge of the original debt between SubCo and the Note Trustee, and creation of the new debt between HeadCo and the Note Trustee.

The single entity rule (SER)

The SER in section 701-1 provides:

If an entity is a subsidiary member of a consolidated group for any period, it and any other subsidiary member of the group are taken for the purposes covered by subsections (2) and (3) to be parts of the head company of the group, rather than separate entities, during that period.

Taxation Ruling TR 2004/11 Income tax: consolidation: the meaning and application of the single entity rule in Part 3-90 of the Income Tax Assessment Act 1997 discusses the consequences of the SER.

7. For income tax purposes the SER deems subsidiary members to be parts of the head company rather than separate entities during the period that they are members of the consolidated group.

8. As a consequence, the SER has the effect that:

(a)  the actions and transactions of a subsidiary member are treated as having been undertaken by the head company;

(b)  the assets a subsidiary member of the group owns are taken to be owned by the head company (with the exception of intra-group assets) while the subsidiary remains a member of the consolidated group;

(c)   assets where the rights and obligations are between members of a consolidated group (intra-group assets) are not recognised for income tax purposes during the period they are held within the group whether or not the asset, as a matter of law, was created before or during the period of consolidation (see also paragraph 11 and paragraphs 26-28); and

(d)  dealings that are solely between members of the same consolidated group (intra-group dealings) will not result in ordinary or statutory income or a deduction to the group's head company.

The SER is further explained at paragraphs 34 and 35 of TR 2004/11:

34. ....the intra-group rights and obligations that are derived from the holding of membership interests within a group are [not] recognised. Dealings solely within the consolidated group in respect of these rights and obligations cannot trigger income tax consequences in respect of the head company.

35. In summary, the SER ensures that the income tax laws will apply to a consolidated group on the basis that the group is a single entity with all of the actions and transactions undertaken by the subsidiary members of the group being imputed to the head company. This allows for the proper administration of the income tax laws to the consolidated group. The SER, broadly speaking, allows for parity between the income tax position of a consolidated group, treated as a single entity, and of a company carrying on business in divisions.

The SER has the effect that dealings that occur solely between SubCo and HeadCo, as members of the same income tax consolidated group, will not result in ordinary or statutory income or a deduction to HeadCo, as the head company.

The Novation gave rise to an intragroup debt between HeadCo and SubCo for accounting purposes for an amount equal to the market value of the notes. Under the SER, the intragroup debt is disregarded and will not result in ordinary or statutory income or a deduction to HeadCo.

Further, the SER applies to deem SubCo to be part of the head company, HeadCo, and the actions and transactions of SubCo are treated as having been undertaken by HeadCo.

In the present case, the notes were entered into by SubCo. Under the SER, HeadCo is taken to be the relevant debtor for the purposes of working out HeadCo's liability for income tax as head company of the HeadCo TCG.

Question 2

Summary

There is no gross forgiven amount under Subdivision 245-C as the market value of the debt at the time of the forgiveness is equal to the amount offset worked out under item 2 of the table in subsection 245-65(1).

Detailed reasoning

Commercial debt forgiveness

The commercial debt forgiveness rules set out in former Division 245 of Schedule 2C to the Income Tax Assessment Act 1936(ITAA 1936) were largely reproduced in the current Division 245 of the ITAA 1997 pursuant to the Tax Laws Amendment (Transfer of Provisions) Act 2010, which continues the rewriting of the ITAA 1936, to reflect current drafting styles without changing original ideas and meanings unless expressly provided.

The commercial debt forgiveness rules set out in Division 245 (of the ITAA 1997) applies to any commercial debt (or part of a commercial debt) you owe that is forgiven. (subsection 245-2(1)).

The net forgiven amount of a debt is worked out by reducing the value of your forgiven debt by:

a)    any consideration you provided for the forgiveness, and

b)    any amounts that this Act already brings to account because of the forgiveness.

The net forgiven amounts of all your forgiven debts in an income year are added up. This total net forgiven amount is applied to reduce the following amounts (in the following order):

a)    your tax losses from previous income years

b)    your net capital losses from previous income years

c)    the deductions you would otherwise get in the income year, or in a later year, because of expenditure from a previous year (e.g. the capital allowance deductions you would get for the cost of a depreciating asset)

d)    the cost bases of your CGT assets (subsection 245-2(3))

Any unapplied total net forgiven amount is disregarded (subsection 245-2(4)).

Commercial debts

Section 245-10 provides that a debt constitutes 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 8-1(2)(a), (b) and (c)) that has the effect of preventing a deduction.

SubCo issued the notes to raise funds to repay its existing debt and fund its investment and acquisitions. The interest was deductible under section 8-1. Therefore, the notes are commercial debts to which Subdivisions 245-C to 245-G apply.

Forgiveness of a debt

A debt is forgiven under section 245-35 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.

ATO Interpretative Decision ATO ID 2005/244 Income tax Consolidation: consolidated group - entity leaving with a liability - application of commercial debt forgiveness rules considered whether the former commercial debt forgiveness rules in Division 245 in Schedule 2C of the ITAA 1936 applied to the head company of a consolidated group where an entity exited the consolidated group with a liability that was owed to a non-group member.

ATO ID 2005/244 sets out how the SER applies and concludes that the debt forgiveness rules only applies if the non-member entity (creditor) forgives the obligations arising from the debt instruments.

While the entity that issues the debt instrument remains a member of the consolidated group, its liabilities under the debt instrument are treated as liabilities of the head company of the group for the purposes of determining the income tax liability of the head company, that is, for head company core purposes as provided in subsection 701-1(2) of the Income Tax Assessment Act 1997 (ITAA 1997). This is due to the operation of the single entity rule in section 701-1 of the ITAA 1997.

...

Only the non-member entity, as holder of the rights to have the issuing entity's obligations under the debt instrument met, is in the position to forgive those obligations. Further, the debt forgiveness rules in Division 245 of Schedule 2C of the ITAA 1936 will only apply if the non-member entity forgives the obligations under those debt instruments in accordance with the definition provided in clause 245-35 of Division 245 of Schedule 2C of the ITAA 1936.

In the present case, the notes were issued by SubCo. As set out in the response to Question 1, SubCo's liabilities in respect of the notes are treated under the SER as HeadCo's liabilities and HeadCo is treated as the relevant debtor for the purposes of determining HeadCo's income tax liability as head company of the HeadCo TCG.

Division 245 will apply if the Noteholders forgive the debtor's obligations to pay the debt in accordance with section 245-35. SubCo's obligation to pay to the Note Trustee the face value of the notes and interest (i.e. SubCo's obligation to pay its debt to the Note Trustee) was released or extinguished as a result of the Novation. Accordingly, SubCo's debt was forgiven.

Gross forgiven amount

The amount of forgiveness (called the gross forgiven amount) for the debtor reflects the loss that the creditor makes for tax purposes (section 245-48). It is worked out in 2 steps:

a)    the value of the debt when it was forgiven is worked out on the basis that you were solvent both then (i.e. at the time the debt is forgiven) and when you incurred the debt, and

b)    the value of the debt is then offset by any consideration given for the forgiveness of the debt.

The difference between the value of the debt and the amount offset is the gross forgiven amount.

Value of the debt at the forgiveness time

Subsection 245-55(1) provides that the value of the debt at the time (the forgiveness time) when it is forgiven is the amount that would have been its market value (considered as an asset of the creditor) at the forgiveness time, assuming that:

a)    when the debtor incurred the debt, it was able to pay all its debts (including that one) as and when they fell due, and

b)    the debtor's capacity to pay the debt is the same at the forgiveness time as when it incurred it.

However, the value of the debt is the amount worked out under subsection 245-55(2) if it is less than the amount determined under subsection 245-55(1).

The assumption under paragraph 245-55(1)(a) does not apply when calculating the value of the debt if the creditor was an Australian resident at the forgiveness time, the debt was not a moneylending debt and the debtor and the creditor were not dealing with each other at arm's length in respect of incurring the debt (subsection 245-55(3)). In these circumstances, the basic (market value) rule applies at the time the debt was incurred. The value of the debt depends on its value when the debt was incurred by reference to the financial capacity of the debtor at that time.

The general rule is subject to the special rules for working out the value for a non-recourse debt or of a previously assigned debt (subsection 245-55(4)), neither of which are relevant to this case.

HeadCo and the Note Trustee were dealing at arm's length, so subsection 245-55(3) does not apply. Accordingly, the value of the debt at the forgiveness time will be its market value assuming HeadCo was solvent at all relevant times.

The amount offset against the value of the debt

The rules to determine the amount that can be offset against the value of a debt are set out in section 245-65. In broad terms, the offset amount is the consideration given for the forgiveness of the debt (section 245-48), which reduces the value of the debt (determined under section 245-55) to arrive at the gross forgiven amount of the debt.

Item 2 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) provides that in the case where the debt is not a moneylending debt, and none of items 3, 4, 5 or 6 applies, the amount offset is the sum of:

a)    each amount the debtor has paid, or is required to pay, and

b)    the market value at the time of the forgiveness, of each item of property (other than money) that the debtor has given, or is required to give,

as a result of, or in respect of, the forgiveness of the debt.

Item 1 of the table in subsection 245-65(1) does not apply because the notes are not moneylending debt as that term is defined in subsection 995-1(1).

Item 3 of the table in subsection 245-65(1) does not apply as none of the threshold conditions in paragraph 245-65(2)(b) are met. Relevantly:

•         HeadCo, the relevant debtor, has assumed the obligation to pay the debt owed to the Noteholders. HeadCo is required to pay an amount (i.e. the face value of the notes and interest) as a result of, or in respect of, the forgiveness of the debt (i.e. the old debt between SubCo and the Note Trustee), as covered by column 2 of item 2 of the table (and therefore subparagraph 245-65(2)(b)(i) is not satisfied)

•         HeadCo (the debtor) and the Note Trustee (the creditor) dealt with each other at arm's length (and therefore subparagraph 245-65(2)(b)(ii) is not satisfied)

Items 4 and 5 do not apply because the notes were not assigned in the manner prescribed by section 245-36.

Item 6 does not apply because the notes were not forgiven by subscribing for shares in a company as mentioned in section 245-37.

Therefore, item 2 applies.

As a result of the Novation, HeadCo assumed the legal obligations under the trust deed with the Note Trustee in substitution for SubCo and agreed to enter into an equivalent face value loan which had the same market value as the original loan).

Therefore, the gross forgiven amount is nil under the commercial debt forgiveness rules because the market value of the debt at the forgiveness time as worked out under subsection 245-55(1) is equal or less than the amount offset against the value of the debt as worked out under item 2 of subsection 245-65(1) of the ITAA 1997 (subsection 245-75(2)).