Edited version of private advice

Authorisation Number: 1051544789250

Date of advice: 24 July 2019

Ruling

Subject: Commercial Debt Forgiveness

Question

Do the commercial debt forgiveness rules apply to the Loan and Trade Creditor Amounts owing to the Company from the Partnership under Division 245 of Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following period:

Income year ended 30 June 20XX

The scheme commenced on:

During the income year ended 30 June 20XX

Relevant facts and circumstances

The Partnership carried on a land development business.

A dispute arose between the partners of the Partnership (Dispute) and the partners reached an agreement via a 'Deed of Settlement and Release' (Deed).

The parties to the Deed were the partners in the Partnership. The related parties to each of these entities, including the Company, were not party to the Deed.

The Deed provided an agreement to sever the business; dissolve the Partnership; release all claims against each other in respect of the Dispute; and a means to transfer the properties from the Partnership to the partners.

Following the Deed, a further agreement (Agreement) was executed between the partners and other related entities that were not party to the Deed. This Agreement recorded in writing the terms previously reached by the partners when the Partnership dispute was settled under the Deed and specifically released and discharged the Partnership, the other partner and the related entities of the other partner from any claim.

The Company provided a loan to the Partnership (Loan) which was reported in the 2016 financial year records of both the Company and the Partnership. The Loan was used for the purpose of carrying on the business of the Partnership. There was no interest charged on the Loan and there was no fixed repayment term as the director of the Company was expecting the Loan to be repaid once the Partnership had sold the land development lots and all liabilities in the Partnership were repaid. Cash transfers regarding the Loan to the Partnership were made directly from the Company's bank account.

The Company also provided services to the Partnership and issued invoices for these services (Trade Creditor Amounts). These invoices were reported as income in the financial records of the Company and as an expense in the financial records of the Partnership. The Partnership also claimed GST input tax credits in respect of these invoices.

Only a small portion of the Trade Creditors Amounts owed to the Company were paid by the Partnership. The remaining invoices were not paid and the liability of the Partnership to pay them was released under the terms of the Deed and the Collateral Agreement.

The Partnership did not provide any property, or consideration, either monetary or non-monetary to the Company in relation to the Partnership's outstanding Loan and Trade Creditor Amounts.

Any liability the Partnership had to pay the amounts recorded as due to the Company was settled in accordance with the terms of the Deed and the Agreement and the Partnership was effectively dissolved as per the terms of these agreements.

The Partnership therefore had no capacity to repay the debt at the time of forgiveness of the Loan and Trade Creditor Amounts.

During the 20XX financial year, the Company made adjustments to its financial records and reported the Trade Creditor Amounts invoiced to the Partnership as a bad debt on 31 March 20XX following the execution of the Deed. The Loan from the Company to the Partnership was also forgiven in the Company's accounts following the Deed.

The Partnership has not made any adjustments for the Loan liability and the Trade Creditor Amounts due to the parties not being able to agree on the correct tax treatment of the above issues and the 20XX income tax return remains outstanding.

The Company and the Partnership were not trading at arm's length.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 245

Income Tax Assessment Act 1997 section 245-10

Income Tax Assessment Act 1997 section 245-35

Income Tax Assessment Act 1997 section 245-40

Income Tax Assessment Act 1997 paragraph 245-40(b)

Income Tax Assessment Act 1997 section 245-55

Income Tax Assessment Act 1997 subsection 245-55(1)

Income Tax Assessment Act 1997 paragraph 245-55(1)(a)

Income Tax Assessment Act 1997 subsection 245-55(3)

Income Tax Assessment Act 1997 section 245-60

Income Tax Assessment Act 1997 section 245-61

Income Tax Assessment Act 1997 section 245-65

Income Tax Assessment Act 1997 subsection 245-65(1)

Income Tax Assessment Act 1997 paragraph 245-65(2)(b)

Income Tax Assessment Act 1997 section 245-75

Income Tax Assessment Act 1997 section 245-85

Income Tax Assessment Act 1997 section 245-95

Income Tax Assessment Act 1997 section 245-195

Income Tax Assessment Act 1997 section 245-215

Reasons for decision

Summary

The commercial debt forgiveness rules in Division 245 of the ITAA 1997 will apply to the Loan and Trade Creditor Amounts owing to the Company from the Partnership.

Detailed reasoning

Division 245 of the ITAA 1997 applies when a commercial debt (or part of a commercial debt) is forgiven.

Division 245 of the ITAA 1997 was rewritten into the ITAA 1997 commencing 1 July 2010. It applies to debts forgiven from the 2010-11 income year onwards.

Commercial debt

Section 245-10 of the ITAA 1997 stipulates that a debt will be a 'commercial debt' if:

(a)  the whole or any part of interest, or of an amount in the nature of interest, paid or payable by you in respect of the debt has been deducted, or can be deducted, by you; or

(b)  interest, or an amount in the nature of interest, is not payable by you in respect of the debt but, had interest or such an amount been payable, the whole or any part of the interest or amount could have been deducted by you; or

(c)  interest or an amount mentioned in paragraph (a) or (b) could have been deducted by you apart from the operation of a provision of this Act (other than paragraphs 8-1(2)(a), (b) and (c)) of the ITAA 1997 that has the effect of preventing a deduction.

To determine whether a commercial debt exists we have to look at the borrower's purpose and not that of the lender (Federal Commissioner of Taxation v Tasman Group Services Pty Ltd 2009 ATC). If the use of the loan could result in an allowable deduction of interest, were interest to be charged, a commercial debt exists.

In this case, the commercial debt forgiveness rules under Division 245 of the ITAA 1997 need to be considered separately for both the Loan and the Trade Creditor Amounts owing to the Company from the Partnership.

The Loan

In the current circumstances, the Loan was used for the purpose of carrying on the business of the Partnership. Therefore, if interest were charged and was payable on the Loan by the Partnership it could be deducted. Accordingly, the Loan is a commercial debt and falls within the provisions of Division 245 of the ITAA 1997.

The Trade Creditor Amounts

The Company issued invoices for services provided to the Partnership in respect of its business (the Trade Creditor Amounts). The Partnership reported the invoices as an expense but did not pay the Company in respect of these invoices. It is also considered that if interest were charged and was payable by the Partnership on the Trade Creditor Amounts that it could be deducted. Accordingly, the Trade Creditor Amounts are also a commercial debt that fall within the provisions of Division 245 of the ITAA 1997.

Forgiveness of a debt

A debt is forgiven under section 245-35 of the ITAA 1997 when a debtor is released or waived from their obligation to pay the debt or the period within which the creditor is entitled to sue for recovery of the debt ends.

Section 245-35 of the ITAA 1997 states that a debt is forgiven if and when:

(a)  the debtor's obligation to pay the debt is released or waived, or is otherwise extinguished other than by repaying the debt in full; or

(b)  the period within which the creditor is entitled to sue for the recovery of the debt ends, because of the operation of a statute of limitations, without the debt having been paid.

In this case, the Partnership, as debtor, in accordance with the terms of the Deed and the Agreement has been released from its liability to pay the Trade Creditor Amounts and the Loan to the Company and accordingly these debts have been forgiven.

Gross forgiven amount

The amount of forgiveness (called the gross forgiven amount) for the debtor reflects the loss that the creditor makes for tax purposes. It is worked out in 2 steps:

(a)  The value of the debt when it was forgiven is worked out on the basis that the debtor was solvent both then and when the debtor incurred the debt; and

(b)  The value of the debt is then offset by any consideration given for the forgiveness of the debt.

The difference between the value of the debt and the amount offset is the gross forgiven amount.

Value of the debt

Section 245-55 of the ITAA 1997 outlines the general rule for determining the value of a debt. Subsection 245-55(1) of the ITAA 1997 states the value of the debt at the time it is forgiven is the amount that would have been its market value at the forgiveness time, assuming that:

(a) When the debt was incurred, the debtor was able to pay all their debts as and when they fell due; and

(b) The debtor's capacity to pay the debt is the same at the forgiveness time as when the debtor incurred it.

The assumption in paragraph 245-55(1)(a) of the ITAA 1997 however does not apply when calculating the value of the debt if the creditor was an Australian resident at the forgiveness time, the debt was not a moneylending debt and the debtor and the creditor were not dealing with each other at arm's length in respect of incurring the debt (subsection 245-55(3) of the ITAA 1997).

In the current circumstances, although the Partnership and the Company may not have been dealing at arm's length in respect of incurring the debt, based on the facts provided, it was expected, at the time these debts were incurred that the Partnership would have been able to repay its debts (including the Loan and the Trade Creditor Amounts) as and when they fell due. Accordingly, the value of the debt for the purposes of section 245-55 of the ITAA 1997 in this case will be the face value of the debt at the time of forgiveness (i.e. the combined amount of the Loan and Trade Creditor Amounts for the Partnership's liability to the Company).

Amounts offset against the value of the debt

Subsection 245-65(1) of the ITAA 1997 provides a table to explain how to work out the amount (if any) that is offset against the value of a debt when it is forgiven (calculated under sections 245-55, 245-60 or 245-61 of the ITAA 1997) in working out the gross forgiven amount of the debt. In the current circumstances, the applicable item of the table is item 3, which states that if the debt is not a moneylending debt, (and the conditions in subsection (2) are met and none of items 4, 5 and 6 applies), then the amount offset against the value of the debt will be the market value of the debt at the time of the forgiveness.

Items 4, 5 and 6 do not apply as the debt was not assigned and there were no debt for equity swaps.

Subsection 245-65(2) of the ITAA 1997 states the conditions for the purposes of item 3 of the table in subsection (1) which are:

(a) at least one of the following is satisfied:

(i) at the time when the debt was forgiven, the creditor was an Australian resident;

(ii) the forgiveness of the debt was a CGT event involving a CGT asset that was taxable Australian property; and

(b) at least one of the following is satisfied:

(i) there is no amount, and no property, covered by column 2 of item 2 of the table;

(ii) the amount worked out under item 2 of the table is greater or less than the market value of the debt at the time of the forgiveness and the debtor and creditor did not deal with each other at arm ' s length in connection with the forgiveness.

In this case, the Company and the Partnership were not dealing with each other at arm's length, the Company was an Australian resident at the time when the debt was forgiven, and there was no consideration paid by the Partnership for the forgiveness of the debt. Therefore item 3 will apply for the purposes of section 245-65 of the ITAA 1997.

The market value of the debt at the forgiveness time will be nil for the purposes of section 245-65 of the ITAA 1997. Accordingly, there will be no amount to be offset against the value of the debt.

Therefore the gross forgiven amount under section 245-75 of the ITAA 1997, and in turn the net forgiven amount under section 245-85 of the ITAA 1997, will be the amount of the Loan and Trade Creditor Amounts outstanding and forgiven.

Application of net forgiven amounts

Section 245-95 of the ITAA 1997 sets out the order of application of the net forgiven amounts of a debtor and states:

The total of the net forgiven amounts of all your debts forgiven in an income year is applied to reduce 4 classes of amounts that could otherwise reduce your taxable income in the same or later income year. It is applied in the following order:

(a) to your tax losses from previous income years;

(b) to your net capital losses from previous income years;

(c) to the deductions you would otherwise get in the income year, or in a later income year, because of expenditure from a previous year (for example, the capital allowance deductions you would get for expenditure on acquiring a depreciating asset);

(d) to the cost bases of your CGT assets.

The net forgiven amount relating to the Loan and the Trade Creditor Amounts will therefore be applied in accordance with this provision.

It is further noted that if any net forgiven amountremains after reducing the debtor's tax losses, net capital losses, deductible expenditure and CGT asset cost bases, the balance is generally disregarded. However, section 245-195 of the ITAA 1997 relevantly provides an exception to this where the debtor is a partnership.

Section 245-215 of the ITAA 1997 provides that any unapplied total net forgiven amount of a partnership is transferred to partners.

As the debtor is a partnership, section 245-215 of the ITAA 1997 may apply in these circumstances.

Other relevant issues not considered

For the purposes of this ruling, it is noted that the potential application of Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) which, in part, can operate to deem a private company to have paid a dividend where a company forgives a debt to it by a shareholder or an associate of the shareholder, pursuant to section 109F of the ITAA 1936, has not been considered.

In this regard, it is relevant to note in the current circumstances that if the Loan or Trade Creditor Amounts forgiven have been, or will be included in the Partnership's assessable income (including under Division 7A of the ITAA 1936), the exception in paragraph 245-40(b) of the ITAA 1997 may apply and the commercial debt forgiveness rules would not.

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