House of Representatives

Explanatory Memorandum

Circulated By the Authority of the Treasurer, the Hon Wayne Swan MP

Chapter 3 - Debt forgiveness rewrite - Schedule 2C

Outline of chapter

3.1 Schedule 2 to this Bill rewrites Schedule 2C to the Income Tax Assessment Act 1936 ( ITAA 1936) into the Income Tax Assessment Act 1997 ( ITAA 1997).

Context of amendments

3.2 Schedule 2C to the ITAA 1936 provides a taxation treatment for the gain made when a taxpayer's debt is forgiven. The gain is not treated as assessable income. Instead, Schedule 2C works out an amount (the 'net forgiven amount'), which reduces the taxpayer's tax losses, net capital losses, capital allowances and the cost bases of capital gains tax (CGT) assets. These are things that would otherwise reduce the taxpayer's future income tax liability.

Detailed explanation of new law

3.3 The rewrite repeals Schedule 2C and reproduces its effect in the ITAA 1997 . [Schedule 2, items 1 and 2, Schedule 2C to the ITAA 1936, Division 245 of the ITAA 1997]

How the rewrite is different

Guide material

3.4 The rewrite contains newly written guide material for the whole Division and for most of its Subdivisions . [Schedule 2, item 2, sections 245-1, 245-5, 245-30, 245-48, 245-80, 245-95 and 245-200]

3.5 The existing diagrams that map Schedule 2C and each of its Subdivisions have not been reproduced because they add little to the reader's understanding of the provisions.

Structural changes

3.6 The rewrite follows the structure of Schedule 2C: it has the same Subdivisions and they appear in the same order.

3.7 The main exception is that Subdivision G is not rewritten. Subdivision G provides special rules for forgiveness of a debt between companies in the same group. As a consequence of enacting provisions for consolidated groups in 2002 (see Part 3-90 of the ITAA 1997), Subdivision G is no longer necessary and is omitted from the rewrite.

3.8 A few provisions have been moved to different Subdivisions or to other places in the ITAA 1997. For example, the definition of 'moneylending debt' that was in Subdivision H has been moved into the Dictionary to the ITAA 1997. These differences are discussed in more detail later.

Differences in Subdivision A - Which debts are covered

3.9 Subdivision A of Schedule 2C explains which debts are subject to the debt forgiveness rules. The rewrite achieves the same outcome but with a slightly different approach.

3.10 Schedule 2C applies to 'commercial debts', a defined term based on another defined term, 'debt'. The ITAA 1997 avoids using terms inconsistently. Since it already uses 'debt' in its ordinary sense, it could not adopt the Schedule 2C definition of 'debt'. Therefore, the rewrite incorporates the content of that definition directly into operative application rules. It was convenient to do the same with the definition of 'commercial debt' . [Schedule 2, item 2, sections 245-10, 245-15 and 245-20]

3.11 One aspect of the definition of 'debt' in Schedule 2C that is not reproduced is the requirement (in subsection 245-15(1) of Schedule 2C) that there be an obligation to pay an amount to another person. The ordinary meaning of 'debt' requires an obligation to do something, so that need not be expressly stated. To the extent that a debt might involve an obligation to do something other than pay an amount, the context (for example, references to 'paying' the debt, rather than to satisfying it) makes it clear that the rewrite is concerned with monetary debts. Therefore, the rewrite does not reproduce the reference to an amount.

3.12 A second aspect of the definition that is not reproduced is the requirement that the obligation be enforceable. There might be some unenforceable obligations that could be described as debts (for example, debts of honour). However, it is unlikely they could satisfy the further requirement that interest on the debt could be deducted. Therefore, the rewrite also does not include that requirement.

3.13 Another aspect of the definition of 'debt' in Schedule 2C that is not included in the rewrite is the rule that treats accrued but unpaid interest on the debt as being part of the principal debt rather than a separate debt (section 245-20 of Schedule 2C). This rule was originally included to reduce compliance costs but in practice has not achieved that result. Further, conflating the time at which the interest accrued and the time at which the original debt was incurred can actually distort the value of the forgiven debt (because, in valuing the debt, the provisions assume the debtor's capacity to pay is the same when it is forgiven as when it was incurred). For those reasons, the rule is not replicated. As a result, each amount of interest that accrues is a separate debt and, if it is forgiven, is subject to the debt forgiveness rules separately from any forgiveness of the principal amount.

3.14 Section 245-26 in Schedule 2C provides for the Schedule to apply to trustees when a trust estate's debt is forgiven. The ITAA 1997 already provides for a trust to be treated as an entity (see section 960-100), so this provision did not need to be rewritten.

3.15 The provisions that stop the rewrite applying to forgivenesses that were in train when Schedule 2C was enacted in 1996 have been moved into the Income Tax (Transitional Provisions) Act 1997 ( IT(TP)A 1997) on the basis that they have only a limited future role . [Schedule 2, item 9, subsection 245-10(1) of the IT(TP)A 1997)]

Differences in Subdivision B - What is debt forgiveness

3.16 Subdivision B of Schedule 2C explains what 'forgiveness' of a debt is. The rewrite does the same thing in much the same way, although it presents the material in separate shorter sections rather than in a single longer section . [Schedule 2, item 2, sections 245-35 to 245-37]

3.17 Some exceptions included in the definitions of 'debt' and 'commercial debt' in Subdivision A of Schedule 2C have been moved into the section that lists the forgivenesses to which the provisions do not apply. This was necessary because the rewrite moves the content of those definitions directly into the operative provisions. Including them in the list of forgivenesses not covered is also more consistent with their true nature as exceptions . [Schedule 2, item 2, paragraphs 245-40(a), (b) and (f)]

Differences in Subdivision C - What is the value of the forgiven debt

3.18 Subdivision C of Schedule 2C works out the gross benefit to the debtor of the debt being forgiven. In general, this is the value of the debt forgiven less what the debtor pays for the forgiveness. The rewrite reproduces the Subdivision in substantially similar terms.

3.19 One exception is the appearance of the provision about how much the value of the debt forgiven is reduced when the debtor provides consideration for the forgiveness. In Schedule 2C, section 245-65 is unusually difficult to understand. The rewrite simplifies the drafting of the provision by presenting the rules in a table. The result it achieves is unchanged . [Schedule 2, item 2, section 245-65]

3.20 The rewrite omits section 245-70. For the purposes of working out the gross forgiven amount of a debt, section 245-70 treats money or property the debtor applies for the benefit of the creditor, or at the creditor's direction, as if it had been paid or given to the creditor. The section is redundant because the calculation of a gross forgiven amount does not depend on the debtor giving money or property to the creditor; it merely asks if the money or property was paid or given in respect of the forgiveness. Therefore, although the rewrite omits the section, it does not change the Subdivision's operation.

3.21 Another exception is that the rewrite splits section 245-75 of Schedule 2C into two sections, reflecting the fact that it deals with two separate ideas . [Schedule 2, item 2, sections 245-75 and 245-77]

3.22 A minor change in outcome occurs because the rewrite adopts the ITAA 1997 definition of 'end user' of property (see section 250-50), while Schedule 2C defines the expression to have the meaning given by section 51AD of the ITAA 1936 (see subsection 245-60(3) of Schedule 2C). The two definitions are substantially the same (they both describe an entity who can use the property or control its use). However, unlike the definition in section 51AD, the ITAA 1997 definition explicitly disregards temporary control of the property for the purpose of ensuring public health or safety, protecting the environment or continuing the supply of an essential service. The rewrite adopts the ITAA 1997 definition because the ITAA 1997 'end user' approach is consistent with the policy behind the section 51AD definition and the minor difference is likely to be relevant so infrequently that adopting the ITAA 1997 definition is not a significant change . [Schedule 2, item 2, paragraph 245-60(1)(c)]

Differences in Subdivision D - Adjustments to the debt's value

3.23 Subdivision D of Schedule 2C reduces the value of a forgiven debt to produce a 'net forgiven amount'. That net forgiven amount is then applied by Subdivision E to reduce the taxpayer's tax losses, CGT cost bases, and so on. Subdivision D reduces the debt's value in two ways. The value of a forgiven debt is reduced first by any part of the value that is otherwise taken into account in working out the taxpayer's taxable income (see section 245-85 of Schedule 2C). That stops double counting. Second, the taxpayer is allowed to transfer some of the tax effect of the forgiveness to the creditor if both are companies with a common ownership (see section 245-90 of Schedule 2C). The rewrite reproduces those provisions . [Schedule 2, item 2, sections 245-85 and 245-90]

3.24 If the companies in that second case do wish to transfer some of the tax effect, Subdivision D requires them to agree in writing and to lodge the agreement with the Commissioner of Taxation (Commissioner) before the first of them lodges its tax return for the year. However, the Commissioner can determine a later day for lodging the agreement. The rewrite clarifies that such a determination must be in writing [Schedule 2, item 2, subparagraph 245-90(4)(b)(ii)]. It also makes explicit the existing position that it is not a legislative instrument (because it does not meet the conditions for being such an instrument - see section 5 of the Legislative Instruments Act 2003) [Schedule 2, item 2, subsection 245-90(5)].

Differences in Subdivision E - Tax consequences of a forgiven debt

3.25 Subdivision E of Schedule 2C contains the provisions that apply the value of a forgiven debt to reduce the taxpayer's tax losses, net capital losses, capital allowances and the cost bases of CGT assets. The rewrite reproduces those provisions . [Schedule 2, item 2, Subdivision 245-E]

3.26 The rewrite removes an ambiguity in the way section 245-155 of Schedule 2C works. That section reduces expenditure for the purposes of working out future deductions that are based on the expenditure and limits the total of those deductions to the amount of the expenditure after that reduction. The rewrite clarifies that the reduction cannot exceed the unused amount of the expenditure . [Schedule 2, item 2, subsection 245-155(2)]

3.27 This Subdivision of Schedule 2C contains some repetition. For example, subsection 245-105(5) says much the same thing as section 245-115. The rewrite makes sure material only appears once . [Schedule 2, item 2, sections 245-115, 245-130 and 245-175 and subsection 245-145(1)]

3.28 Subsection 245-105(2) of Schedule 2C is presented as an operative rule but is in fact only for guidance. In the rewrite it becomes a non-operative note . [Schedule 2, item 2, note to subsection 245-105(1)]

3.29 The rules in Subdivision E of Schedule 2C that allocate the forgiven amount of a debt use a drafting approach that locates much of the operative material in defined terms. For example, section 245-130 allocates the amount to reducing 'deductible net capital losses', which is defined in section 245-125. Where those definitions do not already appear in the ITAA 1997, the rewrite instead moves their content directly into the allocation provisions. That prevents the unnecessary use of definitions . [Schedule 2, item 2, sections 245-115, 245-130, 245-145, 245-175, 245-180, 245-185 and 245-190]

3.30 Some of the material in the definition of 'excluded expenditure' in section 245-140 of Schedule 2C relates to things occurring before the Schedule commenced (see subsections 245-140(3) and (4)). Because of its limited future operation, the rewrite moves that material into the IT(TP)A 1997 . [Schedule 2, item 9, subsection 245-10(2) of the IT(TP)A 1997]

3.31 Section 245-140 of Schedule 2C lists the capital allowance deductions that are subject to being reduced when a debt is forgiven. The rewrite reproduces that list but corrects a defect. Item 22 of the list refers to expenditure on Australian films under section 124ZAF of the ITAA 1936. That section covered expenditure under contracts entered into before 13 January 1983 and had been inoperative for many years before it was repealed in 2006. The equivalent provision for expenditure made under contracts entered into after that date is section 124ZAFA but that section is not listed in section 245-140. The rewrite replaces the reference to section 124ZAF with one to section 124ZAFA . [Schedule 2, item 2, item 22 in the table in subsection 245-145(1)]

Differences in Subdivision F - Partnerships

3.32 Subdivision F of Schedule 2C provides for any part of the net forgiven amount that a partnership cannot use to be divided amongst the partners. It would then reduce the partners' personal tax losses, net capital losses, and so on.

3.33 The rewrite reproduces that result. However, section 245-205 of Schedule 2C is not reproduced. That section provides that the Subdivision's rules about partnerships do not apply to corporate limited partnerships. Since the corporate limited partnership rules in Division 5A of Part III of the ITAA 1936 already provide for that result, section 245-205 is redundant. To reinforce that message, notes are added to the definitions of 'partnership' and 'company' alerting readers that the income tax law treats a corporate limited partnership as a company and not as a partnership . [Schedule 2, items 42 to 45, definitions of 'company' and 'partnership' in subsection 995-1(1)]

3.34 Section 245-210 of Schedule 2C is also not reproduced. That section provides for Subdivisions A to E to apply to partnerships. In the ITAA 1997, section 960-100 ensures that a partnership is an entity so that provisions that apply generally to entities also apply to partnerships. Coupled with the partnership provisions in Division 5 of Part III of the ITAA 1936, that makes section 245-210 unnecessary.

Differences in Subdivision G - Company groups

3.35 Subdivision G of Schedule 2C provides for the value of a company's forgiven debt to reduce the tax losses or net capital losses of other companies in the same group.

3.36 The rewrite does not reproduce Subdivision G. Since Part 3-90 of the ITAA 1997 was enacted in 2002, a consolidated corporate group has been treated as a single entity for tax purposes, so the separate entities within the group do not have their own income tax affairs.

3.37 It is still possible for a group of wholly-owned companies to decide not to consolidate. The policy for the treatment of grouping provisions for a group that chooses not to consolidate was set out by the Review of Business Taxation in its 1999 paper A Platform for Consultation: ^[7]

The availability of a consolidation taxation regime removes the need to retain the current grouping provisions. In particular, the current tax treatment is unsound whereby, on the one hand, each group entity is treated as a separate taxpayer and, on the other, grouping provisions operate to break down that separation in a partial fashion.

3.38 This position led to the recommendation of the Review to repeal grouping provisions. ^[8] That recommendation was implemented when Part 3-90 was enacted. The explanatory memorandum to the New Business Tax System (Consolidation) Bill (No. 1) 2002 restated the policy expressed by the Review of Business Taxation: ^[9]

The intention of the measures contained in this Bill is to allow wholly-owned groups to elect to be taxed in one of two ways - as a single consolidated taxpaying entity or on an individual entity basis for each member of the group. The existing hybrid and less than comprehensive arrangements as represented by the grouping provisions will be replaced by the consolidation regime.

3.39 It follows that removing Subdivision G is broadly consistent with the policy behind the consolidation provisions. The general anti-avoidance rule in Part IVA of the ITAA 1936 is available to counter any schemes that removing the Subdivision might otherwise enable for unconsolidated company groups. Because Subdivision G only applies to companies, Part IVA is already relied on to counter such arrangements entered into by other entities, such as trusts.

Differences in Subdivision H - Definitions, record-keeping and timing

3.40 Subdivision H of Schedule 2C contains a rule about the timing of debts that result from drawing on a line of credit, some rules about keeping records of commercial debts and definitions of some terms used in the Schedule.

3.41 The rule about the time of incurring debts that arise from drawings on a line of credit (section 245-260 in Schedule 2C) is omitted. The current rule provides that the whole debt is taken to have been incurred when the first drawing was made after the most recent time that no amount was owed on the line of credit.

3.42 That rule was originally included to reduce compliance costs but in practice has not achieved that result. Further, merging the times of the drawings, can actually distort the value of the forgiven debt in ways that disadvantage taxpayers. For those reasons, the rule is not replicated.

3.43 Some of the definitions are not rewritten because:

•

they are already defined in the ITAA 1997 (for example, the definition of 'associate' is the same in the ITAA 1997 as in Schedule 2C);

•

the definition simply repeats the term's ordinary meaning (for example, 'pay' is defined to include 'repay' but, as repay simply means to pay back, the ordinary meaning of 'pay' already covers it); or

•

the rewrite builds the content of the definition directly into an operative provision (for example, the definition of 'debt' as including a part of a debt appears in the rewrite as a rule that applies the provisions to parts of debts in the same way as they apply to a whole debt).

3.44 Other definitions are moved into the Dictionary to the ITAA 1997 . [Schedule 2, items 3 to 8, definitions of 'forgiveness', 'forgiveness income year', 'moneylending debt', 'net forgiven amount' and 'total net forgiven amount' in subsection 995-1(1)]

3.45 That leaves the Subdivision only with the rules about record-keeping. Accordingly, the Subdivision's heading is changed from 'General' to 'Record-keeping' . [Schedule 2, item 2, heading to Subdivision 245-G and section 245-265]

3.46 The rewrite reproduces the current record-keeping rules except that it makes failing to keep the required records an offence of strict liability. That means that the offence does not require any fault element (see section 6.1 of the Criminal Code). Under the current law, establishing an offence would require proof of an intention not to keep the records (see subsection 5.6(1) of the Criminal Code). The change recognises the difficulty of proving an intention not to keep records that might not have been kept because of carelessness or oversight. It is also consistent with other record-keeping provisions in tax laws (for example, subsection 262A(5A) of the ITAA 1936 and subsection 382-5(10) of Schedule 1 to the TAA 1953) . [Schedule 2, item 2, subsection 245-265(9)]

3.47 The rewrite also removes the defence of reasonable excuse provided for in Schedule 2C's record-keeping rule (see subsection 245-265(8A)). That defence is open-ended, leaving it unclear what needs to be established to make it out, or to rebut it when raised. It also brings the provision into line with other record-keeping provisions in tax laws, which do not provide any such defence. The Criminal Code does provide defences that are relevant to this provision, such as involuntariness (see section 4.2), mental impairment (see section 7.3) and mistake of fact (see section 9.2).

Application and transitional provisions

Application

3.48 The rewrite applies to debts forgiven in the 2010-11 income year and later income years. For most taxpayers, the 2010-11 income year starts on 1 July 2010. For taxpayers with a substituted accounting period, their 2010-11 income year will start on a different day . [Schedule 2, item 9, subsection 245-5(1) of the IT(TP)A 1997]

Transitional

3.49 Debts forgiven before the rewrite applies (that is, debts forgiven in the 2009-10 income year or in an earlier income year) are still subject to the operation of Schedule 2C, even though it is repealed [Schedule 2, item 9, subsection 245-5(2) of the IT(TP)A 1997]. That does not affect the operation of section 8 of the Acts Interpretation Act 1901 ( which provides for the continuation of rights, obligations and penalties created under repealed provisions, and of legal proceedings relating to those rights, obligations and penalties) [Schedule 2, item 9, subsection 245-5(3) of the IT(TP)A 1997].

3.50 A number of rules in Schedule 2C provide treatments for things that occurred, or were in train, before 27 June 1996, when Schedule 2C commenced (see subsections 245-10(2) and 245-140(3) and (4)). Those provisions are of little ongoing relevance now but the rewrite preserves any residual operation they may have by moving them into the IT(TP)A 1997 . [Schedule 2, item 9, section 245-10 of the IT(TP)A 1997]

Consequential amendments

3.51 References to Schedule 2C are replaced by references to the equivalent provisions in the rewrite. Some of those consequential amendments also change wording, or add asterisks, to reflect the transfer of Schedule 2C defined terms into the ITAA 1997 Dictionary . [Schedule 2, items 10 to 22 and 24 to 41, paragraphs 82KZMA(6)(b) and 82KZMF(2)(b), subsections 73A(1A), 82KZM(2) and 109F(3) and sections 124KAA and 124ZAFAA to the ITAA 1936 and paragraphs 165-115ZA(2)(b), 204-30(2)(c) and 243-75(2)(a) and (b), subsections 25-25(1) (note), 25-35(5) (item 3 in the table), 36-15(7), 36-17(9) (note), 40-90(1), 40-645(3) (note 1), 43-50(7), 104-25(5) (note 2), 243-75(1), 707-140(3), and 707-415(2) (item 1 in the table) and (4), and sections 12-5, 112-97 (item 19 in the table), and 230-470 of the ITAA 1997]

3.52 Note 1 to subsection 40-645(3) is amended to remove the words 'of this Act', which exist to provide a contrast between references to provisions of the ITAA 1997 and references to provisions of Schedule 2C. The contrast is no longer necessary because all references in the note are now to provisions of the ITAA 1997 . [Schedule 2, item 23, subsection 40-645(3) (note 1)]

Legislative history of Schedule 2C

3.53 Schedule 2C to the ITAA 1936 was added by the Taxation Laws Amendment Act (No. 2) 1996 [ Act No. 76 of 1996].

3.54 These Acts have amended Schedule 2C: