Q&A: Debt forgiveness

Article from The Taxpayer, published December 2018

For this month’s Q&A, Tax & Super Australia’s Tax Team provides guidance around the tax consequences in the case of debt forgiveness between a company and associated person.


Scenario

A company has a loan liability (with interest charged at the bench mark interest rate) to an associated person (shareholder/director of the company), which it cannot afford to pay back. The company is closing down and, to clear the balance sheet, the shareholder is considering forgiving this debt.

Question

What are the tax consequences: for the company and also for the shareholder?

Guidance

The creditor/lender: Shareholder (the lender)

The shareholder (the lender) is entitled to be repaid by the company. If the shareholder decides to forgive the loan, the “forgiveness” will terminate the obligation of the borrower (the company) to repay the loan. A loan receivable is an asset for CGT purposes and when the loan is forgiven, CGT event C2 happens because ownership of the asset comes to an end (sect 104-25 of ITAA 1997). The debt is considered to be an asset of the lender (sec 108-5 of ITAA 1997), at a cost base equal with the amount of the loan with no consideration to be received by the lender, thus resulting in a capital loss.


However in “CGT Determination Number 2” (TD2) the Commissioner specifies:

  • If the lender does not receive any consideration for the disposal of the debt, the market value substitution rules (s116- 30(2) ITAA 1997) apply and the lender is taken to have received an amount equal to the market value of the debt at the time of the disposal.
  • The market value of the debt at the time of disposal is worked out as though the debt was not waived and was never intended to be waived.
  • Generally the cost base of the loan is the amount of the loan.

As mentioned above, under the market value substitution rules in relation with a CGT event C2, the capital proceeds from a CGT event are replaced with the market value of the asset at the time of the CGT event if no proceeds were received or those capital proceeds are more or less than the market value (sec 116-30). The market value of a CGT asset that is subject to CGT event C2 is worked out as if the event had not occurred and was never proposed to occur (sec 116-30(3A)). Based on these aspects, it is very important to establish the timing of the CGT event. 


In the case of the shareholder (the lender) the event that gave rise to CGT event C2 is when the forgiveness of the loan to the company was formally effected. At the time the event occurred the market value of the loan was NIL as it was clear to the shareholder that the loan was unrecoverable since the company was closing down and unable to pay the debt. Subsection 116-30(3A) says that the market value should not be ascertained by the act of forgiveness. (Please note that if the company had the ability to pay the loan then the market value may be its face value, thus resulting in no capital loss to the shareholder). A capital loss should apply for the shareholder as interest was charged on the loan. If interest was not charged there is a risk that the loan may be a personal use asset. In TD2 the Commissioner specifies that a capital loss is not allowed on the disposal of a non-listed personal use asset (s 108-20 of ITAA 1997). However, consideration should be given to the time when the loan was made and also to the shareholder intention when lending money to their company.


For example, if when the loan was made there was an expectation of deriving dividend income, even though no interest was charged, the loan may not be considered to be a personal use asset held by the shareholder. In FCT V Total (Holdings (Australia) Pty Ltd a deduction was allowed for money that was lent interest free to a subsidiary. Even though the loan made to the subsidiary was interest free, the purpose of the loan was to make the subsidiary more profitable, potentially resulting in dividend payment to the parent company.


On the other side, if the interest free loan made by the shareholder to the company was made at a point in time when the company was unprofitable with no likelihood of the shareholder deriving assessable income as a result of the loan, the reason to make the loan could be more one of financial assistance than to earn future dividends from the company. In this situation the loan may be a personal use asset.


A debt is written off when the debtor absolves the creditor from any obligation to pay back the loan. This will result in a forgiveness of the debt and the debt forgiveness rules may apply if the debt is a “commercial debt”. A debt is an enforceable obligation imposed by law on a person to pay an amount to another person (sec 245-15 ITAA 1936).


A debt is a commercial debt where:

  1. The whole of any part of the interest paid or payable would be an allowable deduction to the debtors (s245-10(a) ITAA 1997) or
  2. If interest is not payable in respect of the debt but if interest had been payable it would have been deductible to the debtor (s 245-10(b) ITAA 1997).


If some provision in the tax legislation denies the deductibility of the interest, this may not prevent the application of Division 245. For example, where the taxpayer pays interest on a overseas loan and withholds tax from the payment of the interest but failed to pay the withholding tax to the ATO then a deduction of the interest will be denied (sec 26-25 ITAA 97). However, this will not preclude the application of Division 245 to the debt.


Also a non-share equity interest can be a commercial debt for the purpose of section 245-15 ITAA 1997. A non-share equity interest could be a loan with no interest that fails to pass the debt test under Division 974 of the ITAA 1997, but Division 245 would still apply if the interest could have been deductible due for the operation of section 245-15 of ITAA 1997 (which relates to non-share distributions and dividends).


The debtor/borrower: The company

Subsection 245 E of ITAA 1997 relates to the commercial debt forgiveness rules and the order that the net amount of a forgiven commercial debt needs to be applied as follows:

  1. Prior income year revenue losses
  2. Net capital losses from earlier years
  3. Deductible expenditure, such as expenditure relating to depreciating assets and capital works
  4. Cost base and reduced cost base of certain CGT assets


The net forgiven amount has to be applied first by the company against the deductible tax losses. The debtor may choose the order and the amount in which tax losses are to be reduced (sec 245.120 ITAA 1997). Losses that do not meet the loss utilisation test (div 165) will not be reducible.


After the company has applied its forgiveness amount against the deductible tax losses, then any remaining balance will be reduced against the net capital losses (sec 245.130 ITAA 1997). Where there are amounts of net capital losses that cannot be taken into account because the company failed the continuity of ownership test, then the amount of net capital loss will not be used to reduce the net forgiven amount.


If any balance of net forgiven amounts remains after these reductions then it will be used to reduce certain categories of deductible expenses included in sec 245-145(1) ITAA 1997. The expenditure can only be reduced if would be deductible in the year in which the forgiveness occurred or future years.


Any balance of net forgiven amount remaining after applying all these reductions will be applied against the cost base of certain CGT assets (sec 245-175-ITAA 1997). However, there are some excluded asset cost bases that will not be reduced by the net forgiven amount (S 245-175(2)). These include assets such as: a pre CGT asset, a personal use asset, a dwelling that was the debtor’s primary place of residence any time before the forgiveness year, goodwill, a member’s rights in relation to a superannuation interest or an interest in an approved deposit fund, etc. 


The net amount that remains after applying it against all the categories mentioned will not be assessable and not carried forward but disregarded (s 245-195-ITAA 1997).


The commercial debt forgiveness rules included in Division 245 do not apply if the debt is forgiven:

  • when the debt is waived and the waiver constitutes a fringe benefit
  • as a result of bankruptcy
  • the debt has been included in the assessable income of the debtor
  • the forgiveness is effected under a will
  • the forgiveness is a result of love and affection or
  • the debt is a tax-related liability

For more information regarding the commercial debt forgiveness rules please check The Tax Summary on page 775.

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