House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon John Dawkins, M.P.)

Bad Debts

Summary of proposed amendments

4.1. The Income Tax Assessment Act 1936 (the Act) will be amended so that taxpayers who are owed a debt are entitled to a deduction when only a portion, rather than the whole, of the debt is bad and is written off. This change puts beyond doubt the application of the present law in relation to partial debt write-offs.

4.2. Other amendments will give deductions for losses incurred where a debt is extinguished on or after 27 February 1992 as part of a debt/equity swap. A debt/equity swap occurs when a taxpayer discharges, releases or otherwise extinguishes a debt in return for equity in the form of shares or units in the debtor. The deductible loss will be the difference between the book value of the debt extinguished and the value of the equity received in return for extinguishing the debt. The value of the equity will be the market value, or the value recorded in the books of the creditor, whichever is greater. The loss deduction will be reduced to the extent that it has previously been allowed as a deduction under the Act.

4.3. Profits or losses subsequently realised on the disposal, cancellation or redemption of the equity will be included as assessable income or allowed as deductions, as the case requires.

Background to the legislation

4.4. Section 63 of the Act allows a deduction for bad debts written off in relation to interest, trade debts and other charges, which have been brought to account as assessable income. For taxpayers who carry on a business of money lending, the writing-off of bad debts on loans made in the ordinary course of business is deductible whether or not the amounts written off have been included in assessable income.

Partial debt write-offs

4.5. A partial bad debt is not just a debt that is merely doubtful. It is a portion of a debt that may be written off as bad on the basis that that portion is not collectable even if there is still some reasonable expectation that the remaining part of the debt may be recovered.

4.6. The amendment will make it clear that the bad debt rules apply to partial bad debt write-offs.

Debt/equity swaps

4.7. A debt/equity swap occurs when a creditor agrees with a debtor to swap a debt for equity in the debtor. Debt/equity swaps take place more commonly in respect of borrowings although it is possible for trade creditors and debtors to enter into such arrangements.

4.8. The mechanics of a debt/equity swap are that the creditor releases the debtor from the debt (or part of a debt) in exchange for the debtor issuing equity (usually shares) to the creditor. The equity is not mere security for the debt; the creditor acquires ownership of the equity and the debt is discharged. The debt is thus 'swapped' into equity. The creditor is most likely to enter into such an arrangement where, if the debt remained on foot, the debtor would be technically insolvent and required to cease trading and liquidate assets. In generally depressed economic conditions, it may be a better option for the creditor to participate in equity than to foreclose against the debtor. The judgment may be that the only real prospect of recovering the amount owed is by way of equity participation in the debtor's business over a longer period.

4.9. To ascertain the deductible loss from a debt/equity swap, it is necessary to determine the value of the equity received in exchange for debt; the loss deductible is the extent to which the value of the equity falls short of the value of the debt. For that purpose, the greater of the market value of the equity or the value recorded in the books of the creditor at the time it is issued is to be adopted as the value of the equity.

4.10. In debt/equity swaps, a debtor may enter into a swap arrangement under which a debt is forgiven or otherwise discharged even though the debt may not at that time be bad. Where the relevant conditions are satisfied, a deduction will be allowable in respect of a loss incurred under a debt/equity swap notwithstanding that the debt, or the part of the debt, technically is not a bad debt.

Explanation of proposed amendments

Partial debt write-offs

4.11. New subsection 63(4) has the effect that the writing-off of a bad portion of a debt is an allowable deduction where the existing conditions for deduction under section 63 ( i.e. that a debt has become bad and is written off) are satisfied. In effect, existing section 63 is to apply, where only part of a debt is bad, as if the bad portion is an entire debt. This is consistent with the dicta of the High Court implicit in G.E. Crane Sales Pty. Ltd. v. Federal Commissioner of Taxation (1971)
126 CLR 177 ;
71 ATC 4268 . [Subclause 22(b)]

Debt/equity swaps

4.12. There are two elements to these amendments.

4.13. First, a loss incurred under a debt/equity swap is an allowable deduction where the relevant debt is extinguished on or after 27 February 1992* . The swap loss under section 63E is not limited to the bad part, if there is one, of the debt swapped. So these amendments give deductions that would not have been available under section 63. [Clause 27]

4.14. Second, profits realised or losses incurred on subsequent disposal, cancellation or redemption of the equity are included in assessable income or allowed as deductions as the case requires. The equity was received in exchange for a revenue item, and so dealing with that equity is a revenue matter. [Clause 27]

Swap loss deductions

4.15. Subsection 63E(3) authorises deductions for losses incurred under debt/equity swaps. The deduction is allowable in the year of income in which shares or units are issued in return for the debt being extinguished. [Paragraph 63E(3)(a)]

4.16. Where a deduction is allowable under section 63E, the debt or partial debt extinguished may not be treated as a bad debt deduction allowable under section 51 or 63. This prevents double deductions from being claimed. [Paragraph 63E(3)(b)]

4.17. When a taxpayer receives shares or units under a debt/equity swap and the taxpayer is required to include an amount in assessable income under subsection 63(3) to recoup section 51 or 63 deductions being previously allowed in relation to the debt, the amount to be assessed under subsection 63(3) is equal to the equity value as defined in paragraph 63E(2)(a). [Paragraph 63E(3)(c)]

4.18. The following conditions need to be satisfied for a debt/equity swap to occur: [Subsection 63E(1)]

(a)

there is an agreement under which the taxpayer extinguishes a debt or part of a debt owed to the taxpayer in return for the debtor issuing shares (other than redeemable preference shares) or units in the debtor;

(b)

the extinguishment of the debt occurs at or about the same time as the issue of the shares or units. That is, these two events should occur contemporaneously;

(c)

the debtor in question is a company, a trading trust (within the meaning of section 102N) or a public unit trust (within the meaning of section 102P). These are treated as companies for tax purposes; and

(d)

either the debt has been included in the taxpayer's assessable income or is in respect of money lent by the taxpayer in the ordinary course of a money lending business. Where a creditor, other than a money lender, extinguishes a debt which includes a part relating to an amount that has previously been included in the assessable income (e.g. accumulated interest) and the other part relating to a non-assessable principal, the part of the debt that has been included in the assessable income is a debt subject to section 63E. The rest of the debt is not a debt subject to section 63E.

Meaning of 'equity value' and 'swap loss'

4.19. The term 'equity value' is a necessary component in calculating the amount of a deductible loss incurred under a debt/equity swap. Simply, the equity value for that purpose is the greater of the market value of the shares or units acquired under the swap and their value shown in the taxpayer's accounts at the time they are issued to the taxpayer. [Paragraph 63E(2)(a)]

4.20. If the amount of debt that is extinguished is greater than the equity value, the difference is a deductible 'swap loss'. [Paragraph 63E(2)(b)]

4.21. This is the loss that becomes definite on the swap even if there was no bad debt beforehand. It is not too indefinite or uncertain to be allowed; for the creditor and debtor have now fixed a definite loss by the terms of the swap arrangement.

4.22. An allowable swap loss deduction under section 63E is subject to the limit determined under section 63F. Explanations on section 63F will follow under the heading of 'Limit on swap loss deductions' .

Disposal of equity

4.23. Under subsection 63E(4), profits or losses realised on a subsequent disposal, cancellation or redemption of equity acquired in a debt/equity swap should be recognised as assessable income or allowable deductions, as the case requires.

4.24. Where that occurs, such profits or losses are not affected by the operation of other provisions of the Act (e.g. capital gains tax). [Paragraph 63E(4)(a)]

4.25. If the consideration received or receivable is more than the equity value (as defined in paragraph 63E(2)(a)), the excess is a profit which is to be included in the assessable income of the taxpayer in the year the shares or units are disposed of, cancelled or redeemed. [Subparagraph 63E(4)(b)(i)]

4.26. If the consideration received or receivable is less than the equity value, the difference is a deductible loss. [Subparagraph 63E(4)(b)(ii)]

4.27. No consideration is treated as a consideration of a nil value. [Subsection 63E(5)]

Example

1,000 shares in a debtor company are issued to a creditor in exchange for the creditor extinguishing a debt. The shares have an equity value of $100.

The creditor later sells 600 shares for $40. At that time, the creditor incurs a loss of $20, which is an allowable deduction.

Some time later, the debtor company's business has recovered and the creditor sells the remaining 400 shares for $430. The resultant profit of $390 is included in the assessable income of the creditor.

The amount of the original swap loss does not limit this profit. Any net profit is still a return that should be treated as having a revenue character, like the debt swapped.

Equity value of 1,000 shares =	$100
Equity value of each share =	10 cents
Equity value of 600 shares	$ 60
Sold for	$ 40
Net deductible loss is	$ 20
Equity value of 400 shares	$ 40
Sold for	$430
Net assessable profit is	$390

Limit on swap loss deductions

4.28. The swap loss under section 63E is limited by section 63F. The purpose of section 63F is to reduce an allowable swap loss deduction to the extent that it has been previously allowed under other provisions of the Act (namely, under section 51 or section 63) or under section 63E itself. [Clause 27]

4.29. Effectively, what is attempted under section 63F is that at the end of discharging the whole debt (either through one single debt/equity swap, or a combination of debt/equity swaps, partial debt write-offs and repayments, etc.), the net deduction allowed (i.e. the total amount of deductions allowed under section 51, 63 or 63E less any amount recovered and assessed under subsection 63(3) or section 25* should be equal to the initial amount of debt owing less the total sum of equity value or any other payments received in discharging the debt.

4.30. This is illustrated below:

Sum of Net Deduction = (Initial Amount of Debt Owing - (Sum of Equity Value plus Any Other Payments))
Sum of Net Deduction = Sum of all deductions allowed under section 51, 63 or 63E less Sum of all recovery assessed under subsection 63(3) or section 25


4.31. Subsection 63F(1) limits current deductions to the extent that they do not exceed the limit worked out under subsection 63F(2). The current deductions refer to bad debts allowable under section 51 or 63 as well as allowable swap losses under paragraph 63E(3). [Paragraph 63F(1)(a)]

4.32. Section 63F applies if: [Subsection 63F(1)]

(a)

there is a deduction (current deduction) that is allowable under section 51, 63 or 63E for the whole or part of a debt;

(b)

there has been a deduction (previous deduction) previously allowed or allowable under section 51, 63 for the whole or part of a debt, or under section 63E for a part of a debt [the 'whole' cannot have been swapped if (a) applies]; and

(c)

the current deduction allowable or at least one previous deduction allowed relates to swap loss deductions under section 63E.

4.33. Subsection 63F(2) illustrates a step by step procedure to determine the limit. In effect, the limit is reduced by deductions already given and by repayments or other reductions in the debt.

4.34. These steps are applied in the following detailed examples, which contain two representative scenarios of debt/equity swaps. The examples will also show the combined operation of subsection 63(3), sections 63E and 63F.

4.35. The original debt was $1,000. $400 has been paid off to date when the first debt/equity swap is entered into. The amount of debt owing at that time, therefore, is $600.

4.36. Based on the above facts, two examples will be looked at:

Example A

Example A is a straight forward debt/equity swap for the whole debt outstanding.

Example B

Example B illustrates more complex and unusual circumstances, combining an initial swap of only part of the debt, a further debt repayment, a write-off of the bad part of the remaining debt, and a swap of the balance of the debt remaining.

4.37. Each example has 3 different situations:

In Situation 1, no previous bad debt deduction has been allowed under section 51 or 63 before the first debt/equity swap.

Situations 2 and 2A examine cases where a part of the debt has been written off and allowed as bad debt deductions under section 51 or 63 before the first debt/equity swap.

In Situation 3, the whole debt has been written off as bad and the full deduction has been allowed under section 51 or 63 before the first debt/equity swap.

Example A

Situation 1	Situation 2	Situation 2A	Situation 3
D/E Swap for the Whole Debt (A)	600	600	600	600
Equity Value (B)	200	200	200	200
Bad Debt Ded Allowed	Nil	200	350	600
s.63(3) Income	Nil	200	200	200
Swap Loss (A)-(B)	400	400	400	400
s.63F(2) Limit	n/a	400	250	Nil
s.63E(3) Deduction	400	400	250	Nil
[D/E = Debt/Equity; n/a = not applicable; Ded = deduction]

Situation 1

Situation 1 of this Example is where the limit under subsection 63F(2) does not apply as no previous deduction has been allowed before this debt/equity swap. [Paragraph 63F(1)(b)]

The swap loss calculated under paragraph 63E(2)(b) for the purpose of subsection 63E(3) will never exceed the debt owing when entering into the debt/equity swap. The swap loss of $400 is fully allowable under subsection 63E(3).

The equity value of $200 is not assessed under subsection 63(3) because no deductions for bad debts have been allowed previously.

Situations 2 and 2A

In Situation 2 and 2A, partial debts of $200 and $350 have been written off before the swap. When the equity value of $200 is received under a debt/equity swap, the equity value is clawed back under subsection 63(3) in both cases. At the same time, the swap loss is calculated as $400.

The limit under subsection 63F(2) is the amount of debt owing (i.e. $600) less any previous deduction ($200 in Situation 2 and $350 in Situation 2A). The limit, therefore, is $400 for Situation 2 and $250 for Situation 2A. The relevant swap loss allowable under subsection 63E(3) is $400 for Situation 2. However, the allowable swap loss in Situation 2A is limited to $250.

Situation 3

Situation 3 is where all of the debt owing has been allowed as bad debt deductions before the swap. In that situation, the limit under subsection 63F(2) is nil and no swap loss is allowable under subsection 63E(3). [Subsection 63F(1)]

The equity value of $200 is assessable under subsection 63(3).

Example B

Situation 1	Situation 2	Situation 2A	Situation3
1st D/E Swap for Part of Debt	300	300	300	300
Equity Value	100	100	100	100
Bad Debt Ded Allowed	Nil	200	350	600
s.63(3) Income	Nil	100	100	100
Swap Loss	200	200	200	200
s.63F(2) Limit	n/a	400	250	Nil
s.63E(3) Deduction	200	200	200	Nil
Net Bad Debt Ded Allowed	Nil	100	250	500
Balance of s.63F(2) Limit	300	200	50	Nil
Balance of Debt Owing	300	300	300	300
Repayment of Debt	100	100	100	100
Bad Debt Ded Allowed	Nil	100	250	500
s.63(3) Income	Nil	100	100	100
Net Bad Debt Ded Allowed	Nil	Nil	150	400
Balance of s.63F(2) Limit	200	200	50	Nil
Balance of Debt Owing	200	200	200	200
Bad Debt Write-off for Part of Debt	100	100	100	n/a
s. 63F(2) Limit	200	200	50	n/a
s. 51(1)/s.63(1) Deduction	100	100	50	n/a
Net Bad Debt Ded Allowed	100	100	200	400
Balance of s.63F(2) Limit	100	100	Nil	Nil
Balance of Debt Owing	200	200	200	200
2nd D/E Swap for Remaining Debt	200	200	200	200
Equity Value	50	50	50	50
Bad Debt Ded Allowed	100	100	200	400
s. 63(3) Income	50	50	50	50
Swap Loss	150	150	150	150
s. 63F(2) Limit	100	100	Nil	Nil
s. 63E(3) Deduction	100	100	Nil	Nil
Net Bad Debt Ded Allowed	50	50	200	350
Balance of s. 63F(2) Limit	Nil	Nil	Nil	Nil
Balance of Debt Owing	Nil	Nil	Nil	Nil
[D/E = Debt/Equity; n/a = not applicable; Ded = deduction]

Situation 1

The position of 1st D/E swap in this Situation is similar to that of Situation 1 in Example A except that a partial debt, rather than the whole, is swapped in this scenario.

After the first swap, the balance of the limit under subsection 63F(2) is $300, not $400. The steps in arriving at that amount are as follows: [Subsection 63F(2)]

Step 1 - the amount is $600;

Step 2 - $600 is reduced by the previous swap loss of $200 (=$400);

Step 3 - the debt owing after the first swap is $300. Since the amount of debt owing is less than the amount ascertained in Step 2, the limit is reduced to the amount of debt owing (i.e. $300).

The next event is the repayment of $100. Again no income is assessable under subsection 63(3). The repayment of the debt has, however, an effect on the amount of the limit under subsection 63F(2). Since the amount of debt owing is now reduced to $200 after repayment, so is the limit reduced to $200. [Step 3]

The next event is a partial debt write-off under section 51 or 63. This event does not reduce the balance of the debt owing. However, it entitles the taxpayer to the deduction and that deduction increases the net bad debt deductions allowed to $100 from nil. It also reduces the limit under subsection 63F(2) to $100 from $200 for the following event. [Step 3]

The final event is the second swap for the remaining debt of $200. Because there has now been a bad debt deduction allowed under section 51 or 63 (i.e. $100) in the previous event, the equity value of $50 must be assessed under subsection 63(3). The swap loss is $150, however, due to subsection 63F(2) limit of $100, only $100 is deductible under subsection 63E(3).

Situation 2

In the first swap, because a partial bad debt deduction of $200 has been allowed before, the equity value of $100 is assessed under subsection 63(3) leaving the net bad debt deductions allowed as $100. The swap loss is $200, and since the limit under subsection 63F(2) is $400 the full swap loss is allowable under subsection 63E(3). As a result of this swap the balance of debt owing now is $300, and the limit is reduced to $200 (i.e. previous limit of $400 less the swap loss allowed of $200). As the limit is less than the debt owing, the limit remains as $200.

The remaining events run in similar steps as in Situation 1 except that any equity value or repayment received is assessed under subsection 63(3) to the extent of the 'net bad debt deductions allowed'.

Situation 2A

Situation 2A runs in the same way as in Situation 2. However, when a partial bad debt of $100 is written off after repayment, a deduction allowable under section 51 or 63 is limited to $50 only instead of $100. The reason for this is that a partial debt deduction under section 51 or 63 is also subject to subsection 63F(2) limit because the writing-off event in this Situation satisfies paragraphs (a) to (c) of subsection 63F(1). As a result, where there has been a previous debt/equity swap, subsequent bad debt deductions under section 51 or 63 are only allowable to the extent that they do not exceed the subsection 63F(2) limit. [Subsection 63F(1)]

Once the subsection 63F(2) limit becomes nil, no further deduction is allowable in respect of the debt. Any equity value or repayment received is assessed under subsection 63(3).

Situation 3

As in Example A, the full amount of debt owing has been allowed as bad debt deductions before in Situation 3. Consequently, no deductions under section 51, 63 or 63E are available during the whole course of events. Instead, all equity value and repayments received are assessable under subsection 63(3).

Consequential amendments

4.38. Subsection 63(3) is amended to include a reference to section 51 to ensure that any bad debts recovered in relation to debts previously allowed under section 51 is assessed under this subsection [subclause 22(a)] . The purpose of this amendment is to maintain consistency in the operation of this subsection and new section 63E. This ensures that where a bad debt or bad part of a debt for which a deduction has been given under section 51 or 63 is recovered, the deduction is recouped as assessable income under subsection 63(3). The recoupment is the lesser of the deduction previously allowed as reduced by any amount previously included under this subsection (i.e. the 'net bad debt deductions allowed' in Example B above), or the amount recovered on the debt for which a deduction has been allowed.

4.39. Sections 50B, 63A-63D, 80F, 82KH and 399A are amended to reflect explicitly the principle clarified in new subsection 63(4), where part of a debt is bad and is written off, a deduction for that part is allowable under section 51 or 63 on the same basis as a whole debt that is written off. [Clauses 21, 23-26, 28-30]

4.40. Sections 50B, 63A-63D, 80F, 82KH and 399A operate to limit bad debt deductions allowable under section 51 or 63 in certain circumstances. These sections are also amended to insert relevant subsections to ensure that limits under the sections apply also to allowable losses available under section 63E. [Clauses 21, 23-26, 28-30]

Commencement date

Partial debt write-offs

4.41. Amendments being made to sections 50B, 63 to 63D, 80F, 82KH and 399A to facilitate deductions for bad part of debts are expressed to apply to write-offs that occur after 26 February 1992. In practice, though, the amendments confirm the existing law.

Debt/equity swap arrangements

4.42. Amendments giving effect to deductions for losses etc. under debt/equity swaps will apply where the relevant debt is extinguished after 26 February 1992.

Clauses involved in proposed amendments

Clause 21: inserts new subsections 50B(13) and 50B(14).

•

subsection 50B(13) ensures that for the purposes of Subdivision B of Division 2A a part of a debt is treated as if it were an entire debt.

•

subsection 50B(14) ensures that the limit under Subdivision B applies to a swap loss deduction allowable under section 63E also.

Clause 22: amends section 63.

Subclause 22(a): amends subsection 63(3) to add a reference to section 51.

Subclause 22(b): inserts a new subsection 63(4) to confirm that a partial bad debt write-off is an allowable deduction under section 63.

Clause 23: inserts new subsections 63A(13) and 63A(14).

•

subsection 63A(13) ensures that for the purposes of section 63A a part of a debt is treated as if it were an entire debt.

•

subsection 63A(14) ensures that the limit under section 63A also applies to an allowable deduction under section 63E.

Clause 24: inserts new subsections 63B(10) and 63B(11).

•

subsection 63B(10) ensures that for the purposes of section 63B a part of a debt is treated as if it were an entire debt.

•

subsection 63B(11) ensures that the limit under section 63B also applies to an allowable deduction under section 63E.

Clause 25: inserts new subsections 63C(3) and 63C(4).

•

subsection 63C(3) ensures that for the purposes of section 63C a part of a debt is treated as if it were an entire debt.

•

subsection 63C(4) ensures that the limit under section 63C also applies to an allowable deduction under section 63E.

Clause 26: amends section 63D.

Subclause 26(a): amends subsection 63D(1) to ensure that the limit under section 63D applies also to allowable deduction under section 63E.

Subclause 26(b): amends subsection 63D(2) to add a reference to a debt/equity swap within the meaning of section 63E.

Subclause 26(c): inserts subsection 63D(3) to ensure that for the purposes of section 63D, a part of a debt is treated as if it were an entire debt.

Clause 27: inserts section 63E that will deal with debt/equity swaps and allow swap losses as a deduction. Section 63E will also include as assessable income or allowable deduction any profits or losses realised from the future sale, redemption or cancellation of the equity taken in exchange for the debt. This clause also inserts section 63F which limits a deduction allowable under section 63E.

Clause 28: inserts new subsections 80F(2) and 80F(3).

•

subsection80F(2) ensures for the purposes of section 80F that a part of a debt is treated as if it were an entire debt.

•

subsection 80F(3) ensures that the limit under section 80F also applies to an allowable deduction under section 63E.

Clause 29: amends section 82KH

Subclause 29(a): amends subsection 82KH(1AA) to include a partial debt.

Subclause 29(b): inserts a new subsection 82KH(ABA) to ensure that the limit imposed under section 82KH applies also to deductions allowable under section 63E.

Clause 30: inserts new subsections 399A(4) and 399A(5)

•

subsection 399A(4) ensures that for the purposes of section 399A a part of a debt is treated as if it were an entire debt.

•

subsection 399A(5) ensures that the limit under section 399A also applies to an allowable deduction under section 63E.

Clause 31: provides that the amendments made by sections 50B, 63 to 63D, 80F, 82KH and 399A regarding partial debt write-off deductions apply after 26 February 1992. It also provides that the amendments made by section 63E apply where the debt swapped is extinguished after 26 February 1992.