Debt forgiveness by private companies

A private company may be taken to pay a dividend to an entity at the end of the company's income year if it forgives a debt owed by the entity during the year either:

• when the entity is a shareholder or an associate of a shareholder of the company, or
• after the entity ceases to be a shareholder or an associate of a shareholder, and a reasonable person would conclude that the payment was made because the entity was a shareholder or an associate of a shareholder at some time.

The total of all dividends a private company is taken to pay under Division 7A is limited to its distributable surplus for that income year.

A forgiveness of debt by a private company in respect of a debt owed by a shareholder or an associate of a shareholder may be treated as a dividend under Division 7A, even if:

• the shareholder or their associate owed the debt in their capacity as an employee or an associate of an employee, or
• the forgiveness occurs in respect of the employment of an employee.

Fringe benefits tax does not apply because forgiven debts treated as dividends paid to a shareholder or their associates are excluded from the definition of a fringe benefit.

For more information, see:

• Division 7A - distributable surplus
• Meaning of 'associate'
• Division 7A and Fringe Benefits Tax

Debts forgiven by other entities

Division 7A also applies to certain debts forgiven by trustees to a shareholder or an associate of a shareholder of a private company, where the company is presently entitled to an amount from the net income of the trust estate and the whole of that amount has not been paid by a specified date.

For more information, see Division 7A - trust amounts treated as dividends - debt forgiveness

Forgiving a debt

A debt or part of a debt is forgiven under the following circumstances:

• the shareholder's or their associate's obligation to pay the debt (or part of the debt) is released, waived or otherwise extinguished (other than as a result of fully paying the debt in cash or in property, with a value at least equal to the amount of the debt)
• the private company loses its right to sue for recovery of the debt due to the operation of a statute of limitations. The limitation period is 6 years (except for the Northern Territory where it is 3 years) from the date that the right to sue to recover commences but can be extended if the shareholder or their associate acknowledges the debt, or makes a part payment of the debt.
• the shareholder or their associate enters into an arrangement with the private company, where their obligation to pay the debt will end at a future time without having to pay anything (other than a token amount). The arrangement does not have to be legally enforceable and the debt may still remain in the private company's accounting records
• the shareholder or their associate enters into a 'debt parking' arrangement. This is where:
  • the private company assigns its right to receive payment of the debt to a new creditor, who is either an associate or a party to an arrangement with the shareholder or their associate about the assignment
  • it is reasonable to expect that the new creditor will not require the shareholder or their associate to repay the debt.
• it is reasonable to expect that the private company will not insist or rely on the shareholder or their associate repaying the debt. Examples of this may include:  
  • the shareholder or their associate losing the capacity to repay the debt
  • the private company never requiring the shareholder or their associate to make a repayment
  • the private company not treating the debt as a genuine liability (for example, the debt is not included in financial statements prepared for third parties)
  • the shareholder or their associate subscribes for shares in the private company to enable the company to make a payment in discharge of the debt, and the company applies all or any of the subscription money towards the debt. The amount taken to be forgiven is the subscription money applied by the private company. The time of forgiveness is when the money is applied.

Division 7A applies to all debts forgiven on or after 4 December 1997, regardless of when the debt arose.

Same debt is forgiven at different times

If the same debt is forgiven at different times, only the first forgiveness is treated as a dividend.

When a forgiven debt is not a dividend

The debt is treated as forgiven at the time the debt parking arrangement is entered into in the 2005-06 income year. The debt is also forgiven when recovery subsequently becomes statute barred. Only the first debt forgiveness is treated as a dividend.

Debt forgiveness is not treated as a dividend where:

• a private company forgives a debt owed to it by another company, unless the other company owed the debt in its capacity as trustee
• the debt is forgiven because the shareholder or their associate became bankrupt or because of Part X of the Bankruptcy Act 1996
• the debt that has been forgiven results from a loan from a private company that has been treated as a dividend under Division 7A (or section 108 of the Income Tax Assessment Act 1936) in the current year or a previous year
• the Commissioner of Taxation exercises his discretion not to treat the debt forgiveness as a dividend.

To exercise his discretion, the Commissioner must be satisfied that:

• the debt was forgiven by the private company because repayment of the debt would have caused the shareholder or their associate undue hardship
• the shareholder or their associate had the capacity to repay the debt at the time it was incurred
• the shareholder or their associate lost the ability to repay the debt as a result of circumstances beyond their control.

To establish undue hardship, evidence is required of exceptional circumstances that would result from the enforcement of the debtor’s obligation to pay so as to make that enforcement excessive, or too great, or not fitting or right, or unjustified. Difficulty or inability to pay other debts as they become due does not constitute undue hardship.

It's possible for the conditions for the exercise of the discretion to be satisfied by a debtor that has incurred the debt as a trustee, although this would not be common. The debtor must establish that they would suffer undue hardship if the debt were not forgiven. Among the factors to consider are the trustee’s rights of indemnity and exoneration for trust liabilities and, in the case of a corporate trustee, the limited liability nature of a company.

Failure to make the required minimum yearly repayment on an amalgamated loan in the year of forgiveness

If the debt forgiven was an amalgamated loan, and in the income year the forgiveness occurred the amount paid to the private company was less than the required minimum yearly repayment, the forgiveness of the debt is treated as a dividend. The amount of the dividend is:

• the amount of the amalgamated loan that has not been repaid at the time of the forgiveness

less

• any amount treated as a dividend in an earlier income year for the loan, due to a failure to make the required minimum yearly repayment in that year. Note: this reduction could only occur from the 2007-08 year because the 2006-07 year is the first year in which a shortfall in a minimum yearly repayment may be treated as a dividend.

In either case, the amount treated as a dividend is also limited by the private company's distributable surplus in the relevant income year.

For more information, see Division 7A - loans by private companies.

Interaction with commercial debt forgiveness provisions

The commercial debt forgiveness provisions in Schedule 2C of the Income Tax Assessment Act 1936 do not apply to a debt forgiveness treated as a dividend under Division 7A to the extent it is included in a shareholder's or their associate's assessable income.

If not all of the debt forgiven is included in a shareholder's or their associate's assessable income because the amount treated as a dividend is reduced by the private company's distributable surplus, the commercial debt forgiveness provisions may apply to the amount of the debt forgiven that was not included in their assessable income.

The amount treated as a dividend

The amount treated as a dividend is the amount of the debt forgiven, subject to the private company's distributable surplus.

Amounts treated as dividends under Division 7A are generally not frankable, even though they are taken to be paid out of the private company's profits. However, there are some exceptions.

Where a deemed dividend arises because of an honest mistake or inadvertent omission, the Commissioner has the discretion to disregard the deemed dividend, subject to conditions being complied with. He may also allow the private company taken to pay the dividend to choose to frank this dividend.

For more information, see:

• Division 7A - franking implications
• Division 7A - the Commissioner's discretion under section 109RB
• Contact us about Division 7A