The debt forgiveness provisions are an incredibly complex web that aren't easily explained. Mark Morris unravels some of the tendrils.
Tax forgiveness
It's a cruel world. There's no forgiving and forgetting where the commercial debt forgiveness provisions are concerned, as recent tax cases attest (see INTHEBLACK, Taxing Times, May edition). These provisions, set out under Schedule 2C of the Income Tax Assessment Act 1936, aim to 'tax' the economic benefit a debtor derives from a creditor by forgiving certain debts.
In these circumstances the debtor will typically book an accounting entry, debiting a debt liability and crediting the profit and loss account.
Instead of treating 'profit' as assessable, these provisions progressively strip the debtor of various 'tax attributes' by reducing, in order: the debtor's prior year revenue losses, accumulated capital losses, various undeducted expenditures, and the cost base of certain capital gains tax assets. The end result is that the debtor will be taxed, as there will be less deductions and asset cost bases to reduce future assessable income or capital gains the debtor may derive.
To compound matters, these provisions are also extremely complex, and are often inadvertently triggered by taxpayers, especially small to medium sized entities. It's crucial to identify their potential application, and any strategies which can minimise their impact.
Application criteria
The provisions only apply where a 'commercial debt' loaned after 27 June 1996 has been 'forgiven'. The pivotal concepts of debt, commercial debt and forgiveness need to be clearly understood.
Debt in a nutshell
Debt is defined as 'an enforceable obligation imposed by law on a person to pay an amount to another person', and expressly includes any accrued interest.
The definition is very wide and would apply to any scenario where a person is obliged to repay a loan. However, it does not apply to a loan that would be regarded as a 'debt waiver benefit' under the Fringe Benefits Tax Assessment Act 1986. Nor does it apply where the amount payable under the debt is included in the debtor's assessable income. Therefore, any amount lent by a private company to a shareholder that is an assessable deemed dividend under section 109D of Division 7A will not also later be treated as 'debt' under these provisions. Assuming neither exclusion applies, it is then necessary to determine whether the debt is a 'commercial debt'.
Commercial debt
A debt is a 'commercial debt' if any interest paid or payable on that debt would have been allowable under the general deductibility provisions of section 8-1 of the Income Tax Assessment Act 1997. Moreover, interest-free debt will also be regarded as commercial debt if such interest would have been deductible had it been charged.
In applying this test, any other provision denying interest deductibility is ignored including, among others, the thin capitalisation and capital protected loan provisions.
The above rules also apply to amounts in the nature of interest such as discounts on commercial bills, and to amounts paid on 'non-equity shares' such as a cumulative redeemable preference shares.
Where an individual borrows funds to finance the purchase of a holiday home, the debt forgiveness provisions will not kick in if that private loan is subsequently forgiven, as no interest charged on the loan would have been deductible.
Similarly, borrowings which have been applied to generate exempt income or non-assessable non-exempt income will not be treated as commercial debt since any loan interest paid or payable would not be allowable.
Where the commercial debt test has been met it will be necessary to determine whether a debt has been forgiven.
Forgiveness
A debt will be forgiven if it is released, waived or extinguished.
This will typically occur under a deed or agreement. However, Justice Heerey held in the recent Federal Court decision of Tasman Group Services Pty Ltd v FCT (2008) FTC 23 that a debt waiver can also be inferred from the creditor's conduct. Accordingly, a creditor may abandon a right of recovery where they act inconsistently with that right. Thus, if a debtor unilaterally books a debt forgiveness in its accounts and the creditor does not seek to collect that amount, then that conduct may constitute a debt waiver.
Debt forgiveness may also occur where:
The debt is irrecoverable due to the operation of a statute of limitations.
A forgiveness will arise when the creditor's right of recovery expires at the end of the relevant period.
The debtor and creditor agree that the obligation to repay a debt will cease at a future time without the debtor incurring any financial obligation (other than for a token payment). In this case the debt is forgiven when the agreement is entered into and any later forgiveness is ignored.
A creditor assigns its rights to receive repayment to a new creditor, who is an associate of the debtor, or the debt is assigned under an agreement to which the new creditor and the debtor are both parties. In either case the debt will be taken to have been forgiven at the time the debt was assigned, except where the debt was acquired by the new creditor in the ordinary course of trading on the securities market.
A person subscribes for shares in a company to enable that company to repay a debt it owes to that person. The amount paid from the share capital subscribed will be taken to be the amount forgiven at the time it is so applied. Thus, a creditor cannot pump in additional capital to a related debtor company so that it can repay its debt and avoid these provisions.
However, there will not be a forgiveness if the waiver of the debt is effected under a will or a bankruptcy law, or occurs for reasons of natural love and affection. In practice, the latter exemption has been narrowly interpreted by the tax commissioner.
Calculation of net forgiven amount
The next step in applying the provisions is to calculate the 'net forgiven amount' (if any) of the debt.
Notional value
The start point is to determine the debt's 'notional value'. This will usually be the debt's face value at the time of the forgiveness, assuming the debtor was able to pay its debts at the time. However, where the parties are not acting at arm's length when the debt is incurred there will be no assumption of solvency in which case the value may be for a lesser amount.
Hence, if a loan is made to a wholly owned insolvent unit trust it will have a notional value which will likely be much less than its face value.
Consideration
The debt's notional value will then be reduced by any consideration provided by the debtor at the time of the debt forgiveness being any cash paid and/or the market value of any property provided.
It may also be reduced by deemed consideration equal to the debt's market value where there is no consideration in respect of the forgiveness, the consideration cannot be valued, or it is greater or lesser than its market value and the parties are not acting at arms-length.
In practical terms this means that where there is no arm's length forgiveness involving related parties (e.g. family businesses) the notional value may be reduced or extinguished under this deeming rule if the debt has significant market value.
Gross forgiven amount
After applying actual or deemed consideration against the debt's notional value the resulting balance is known as the 'gross forgiven amount' of the debt.
This, in turn, is reduced by any amount that is included in the debtor's assessable income, or that reduces a deduction or the cost base of a CGT asset as a result of the debt forgiveness.
For example, the forgiveness of a debt owed by a shareholder to a private company may result in the shareholder deriving an assessable deemed dividend under section 109F of Division 7, which will be applied to reduce the debt's gross forgiven amount.
This gross amount will also be reduced where an election is made between debtor and creditor group companies under 'common ownership' who agree that the creditor, who will forgo a capital loss or deduction, will do so in exchange for the gross value of the debt forgiveness being reduced by a corresponding amount.
Net forgiven amount
After applying all the above steps, any remaining balance will be treated as the net forgiven amount of the debt, which must be applied against the debtor's tax attributes.
Reduction of tax attributes
A debtor must progressively offset the total net forgiven amount against the following tax attributes at the commencement of the income year in which the forgiveness takes place:
Prior year revenue losses.
Carried forward net capital losses.
Deductible expenditures including the opening adjustable value of depreciating assets, the balance of unclaimed borrowing costs, unclaimed prepaid expenditure and certain unclaimed expenditure on Australian films and research and development expenditure.
The cost base of CGT assets, excluding pre-CGT acquired assets, personal use assets, main residence, assets disposed of prior to 27 June 1996, trading stock, CGT assets that are subject to the deductible expenditure rules, rights relating to a superannuation fund or an approved deposit fund and goodwill. Investments in associated entities may be reduced but only as a matter of last resort.
Each category of tax attribute must be fully exhausted before the net forgiven amount is applied against a subsequent category of tax attribute. If there is a balance after applying the net forgiven amount against all the above attributes, that amount expires and is not otherwise assessable.
Debtors can also choose what items are reduced within each set of tax attributes. For example, debtors may choose which revenue losses are offset against the net forgiven amount, and thus, can select items which may have less value than others.
Similarly, taxpayers may choose which items of deductible expenditures are reduced and can therefore select items which have the slowest write-off period.
Tax planning is also required in reducing the cost base of CGT assets as the debtor will not want to wipe out the cost base of an asset that is likely to be disposed of in the near future and accelerate a capital gain. Thus, it may be preferable to reduce the value of assets which may diminish in value over time rather than debts that will soon be realised.
Very broadly, special rules apply where the debtor company is a member of a wholly owned group of companies in that the net forgiven amount may be applied against the revenue or capital losses of both the debtor and related group companies on a pro rata basis. There are also special rules which apply to debtor partnerships which are released from debts.
The commercial debt forgiveness provisions can be unexpectedly expensive. Debtors should, therefore, tread carefully before they agree to such a forgiveness, as the outcome may be potentially disastrous for trading entities.
