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Appendix 4: Commercial debt forgiveness

Last updated 21 December 2020

If a commercial debt owed by a taxpayer is forgiven during the income year, the taxpayer should apply the total 'net forgiven amount' of that debt to reduce, in this order, the taxpayer's:

  • tax losses from previous income years (in the order the taxpayer prefers)
  • net capital losses from previous income years (in the order the taxpayer prefers)
  • certain undeducted expenditure, and
  • cost bases of CGT assets.

Partnerships cannot have tax losses or net capital losses from previous income years.

For CGT purposes, each partner has a separate cost base (and reduced cost base) for the partner’s interest in each CGT asset of the partnership.

What is a commercial debt?

A debt is a commercial debt if any part of, or an amount in the nature of, interest paid or payable on it is or would be an allowable deduction, or could have been deducted if not for some provision in the income tax legislation that has the effect of preventing a deduction (other than the exceptions in subsection 8-1(2) for outgoings of a capital nature, private or domestic outgoings and for outgoings relating to exempt income or non-assessable non-exempt income).

If interest is not payable in respect of the debt, the debt is still a commercial debt if interest would have been deductible had interest been payable.

What constitutes the forgiveness of a debt?

Generally, a debt is forgiven if the partnership’s obligation to pay the debt is released or waived, or is otherwise extinguished other than by repaying the debt in full.

A debt is also forgiven if one or more of the following happen:

  • a creditor assigns the right to receive payment of the debt to an associate of the debtor
  • a creditor subscribes for shares in a debtor company to enable the debtor to repay the debt it owes to the creditor, and the debtor uses any of the money subscribed in towards payment of the debt
  • the right to recover the debt ceases because of the expiry of a limitation period.

Calculation of the net forgiven amount

Calculate the net forgiven amount of a debt as follows:

  1. Determine the value of the debt. This is usually the lesser of    
    • the market value of the debt at the time of forgiveness (assuming the partnership was solvent at the time the debt was incurred and the partnership’s capacity to pay the debt has not changed from the time the debt was incurred), and
    • the sum of the market value of the debt at the time the debt was forgiven (based on the above assumptions and assuming that interest rates and currency exchange rates that affect the market value of the debt remain constant from the time the debt was incurred until the forgiveness time) plus any amounts allowable as deductions because of the forgiveness of the debt that are attributable to changes in those interest rates and currency exchange rates. This might occur because of a decrease in the value of the debt due to market movements. Special rules apply in calculating the value of non-recourse debt and assigned debt – see sections 245-60 and 245-61 of the ITAA 1997.
     
  2. Calculate the gross forgiven amount of the debt by subtracting from the value of the debt certain amounts in respect of the forgiveness – see section 245-65 of the ITAA 1997. This is normally the sum of the amounts of money the partnership has paid, or the market value of the property the partnership has given, in respect of the forgiveness of the debt. Special rules apply in determining the amount subtracted if a debt is forgiven by subscribing for shares in the debtor company or if the debt is assigned.
  3. Reduce the gross forgiven amount of the debt by any amount    
    • which has been, or will be, included in the partnership’s assessable income for any income year as a result of the forgiveness of the debt
    • by which a deduction otherwise allowable to the partnership has been, or will be, reduced as a result of the forgiveness of the debt (except for a reduction under Division 727 of the ITAA 1997 which is about indirect value shifting), and
    • by which the cost base of any CGT assets of the partnership has been, or will be, reduced under Part 3-1 or 3-3 (the CGT provisions) of the ITAA 1997 as a result of the forgiveness of the debt.
     

The amount (if any) remaining is the net forgiven amount of the debt.

  1. The total of the net forgiven amount of each debt that is forgiven during the income year is the “total net forgiven amount” for the income year.

Application of total net forgiven amount

Apply the total net forgiven amount to reduce the amounts the partnership has in the following categories, in order listed:

  • tax losses from previous income years
  • net capital losses from previous income years
  • certain undeducted expenditure, and
  • the cost bases of CGT assets.

Partnerships cannot have tax losses or net capital losses from previous income years.

For CGT purposes, each partner has a separate cost base (and reduced cost base) for the partner’s interest in each CGT asset of the partnership.

The relevant category for a partnership is certain undeducted expenditure. The partnership may choose the item against which the total net forgiven amount is applied, provided it is applied to the maximum extent possible within that category. If any balance remains after applying the amount to the maximum extent possible, special rules apply to partnerships. See Special rules.

Expenditures

Expenditures against which the total net forgiven amount can be applied are limited to those incurred by the partnership before the forgiveness income year which remain undeducted but which would be deductible in that year or future income years. These expenditures are:

  • expenditure deductible under Division 40 of the ITAA 1997 (capital allowances)
  • expenditure incurred in borrowing money to produce assessable income under section 25-25 of the ITAA 1997
  • expenditure on scientific research under subsection 73A(2) of the ITAA 1936
  • R&D expenditure deductible under Division 355 of the ITAA 1997
  • advance revenue expenditure under Subdivision H of Division 3 of Part III of the ITAA 1936
  • expenditure on acquiring a unit of industrial property to produce assessable income under subsection 124M(1) of the ITAA 1936
  • expenditure on Australian films under section 124ZAFA of the ITAA 1936
  • expenditure on assessable income-producing buildings and other capital works under section 43-10 of the ITAA 1997.

There are two principal methods for reducing expenditures:

  • Straight line deduction: If the deduction is calculated as a percentage, fraction or proportion of a base amount (for example, deductions for the decline in value of depreciating assets calculated under the prime cost method), make the reduction to the base amount. The effect is that deductions allowable in the forgiveness income year and later income years are reduced. The total amount of deductions allowable is limited to the reduced base amount. The amount of the reduction is treated as if it had been a deduction when calculating any required balancing adjustment amount.
  • Diminishing balance deduction: If the deduction for a particular expenditure is a percentage, fraction or proportion of an amount worked out after taking into account any previous deductions for the expenditure (for example, deductions for the decline in value of depreciating assets calculated under the diminishing value method), the amount of the reduction is taken to have been allowed as a deduction before the forgiveness income year.

If any deductions are disallowed under the ITAA 1936 or the ITAA 1997 as a result of recouping an amount of expenditure that is subject to reduction as a result of the above debt forgiveness rules, the recouped expenditure against which the total net forgiven amount was previously reduced is included in the assessable income of the partnership in the income year in which it is recouped.

Cost bases of certain CGT assets

The cost base and reduced cost base of certain CGT assets owned by the partnership at the beginning of the forgiveness income year must be reduced by the partnership’s total net forgiven amount remaining after reducing deductible expenditures (see above).

The CGT assets whose cost bases are not subject to reduction include those from which a capital gain or capital loss will not be made or is unlikely to be made if a CGT event happens to them, for example, CGT assets acquired before 20 September 1985, trading stock or a personal use asset within the meaning of section 108-20 of the ITAA 1997. Also excluded are CGT assets whose disposal would result in an amount being assessable to, or deductible for, the partnership, such as depreciating assets.

A taxpayer may choose the CGT assets whose cost bases and reduced cost bases are to be reduced and the extent of that reduction. However, the cost base of CGT assets that constitute investments in associates of the partnership must be reduced last.

If a taxpayer chooses to apply an amount to reduce the cost base and reduced cost base of a CGT asset, then at any time on or after the beginning of the forgiveness income year, the cost base and reduced cost base of each relevant CGT asset is taken to be reduced by that amount.

Ordinarily, the reduction of a CGT asset’s cost base and reduced cost base cannot exceed the amount that would have been the reduced cost base of the asset, calculated as if the asset was disposed of at its market value on the first day of the forgiveness income year. However, a special rule applies (see subsection 245-190(3) of the ITAA 1997) if an event occurred after the beginning of the forgiveness income year that would cause the reduced cost base of the asset to be reduced, in which case the market value on the day on which that event occurred must be used.

The reduction of the cost base and reduced cost base of a CGT asset affects the calculation of the amount of the capital gain or capital loss on a CGT event happening to the relevant CGT asset, because the cost base or reduced cost base that is taken into account in determining the capital gain or capital loss (respectively) must reflect that reduction.

Special rules

Special rules apply if a partnership (other than corporate limited partnership) has a total net forgiven amount which cannot be fully applied in reducing the categories of amounts set out above.

Any part that cannot be applied in that way is allocated to the partners in the proportion they share in the net income of the partnership or the partnership loss. Each partner is taken to have had a debt forgiven during the forgiveness income year, and the amount calculated under the formula is added to the individual partner’s other net forgiven amounts (if any) in calculating the partner’s total net forgiven amount for the forgiveness income year (see subsection 245-215 of the ITAA 1997).

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