SENATE

Explanatory Memorandum

TO THE BILL AS INTRODUCED (Circulated by authority of the Treasurer,the Hon Ralph Willis, MP)

CHAPTER 3 - Bankruptcy and losses

Overview

3.1 Part 3 of Schedule 1 of the Bill will strengthen the provisions of the Income Tax Assessment Act 1936 ('the Act') that deny deductions for losses where taxpayers are released from debts under bankruptcy law (whether as bankrupts or not).

3.2 The Bill will also remove an existing anomaly that taxpayers, although denied revenue losses, are allowed to claim net capital losses incurred before bankruptcy or release from debts under bankruptcy law.

Summary of the amendments

Purpose of the amendments

3.3 The amendments will:

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ensure that the Act denies deductions for losses incurred before bankruptcy notwithstanding that the bankruptcy is later annulled in connection with arrangements under which debts are released;

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prevent net capital losses incurred before bankruptcy or release from debts under bankruptcy law from being taken into account in ascertaining future net capital gains or losses; and

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ensure that a capital loss is taken to have been incurred by a taxpayer who pays an amount in respect of a debt that was taken into account in determining the amount of a net capital loss that, upon bankruptcy or release from debts under bankruptcy law, is prevented from being taken into account in ascertaining future net capital gains or losses.

Date of effect

3.4 The amendments relating to annulment of bankruptcy will apply to annulments occurring after 25 February 1995. The amendments relating to capital losses will apply to taxpayers who become bankrupt or who have been released from debts after 25 February 1995 [item 40] . This accords with the Government's announcement of 26 February 1995.

Background to the legislation

Annulment of bankruptcy

3.5 Subsection 79E(8) of the Act denies deductions for general domestic losses of the post-1989 years of income incurred before bankruptcy or, where the taxpayer has not become a bankrupt, incurred before release from any debts by the operation of an Act relating to bankruptcy. Subsections 79F(8), 80(4), 80AAA(9) and 80AA(6) operate in similar circumstances to deny film losses of post-1989 years of income, general domestic losses of the pre-1990 years of income, film losses of pre-1990 years of income and primary production losses of pre-1990 years of income respectively. The following discussion refers to subsection 79E(8) losses but is equally applicable to these other types of revenue losses.

3.6 There is a technical argument, based partly on the decision of the Federal Court in Oates v FC of T 91 ATC 4060, that subsection 79E(8) might not apply if a release from debts occurred in circumstances where a bankruptcy was annulled. The argument would be that, following Oates , all annulments are excluded from paragraph 79E(8)(a), and that paragraph 79E(8)(b) could not apply because any release in conjunction with an annulment would not be 'by the operation of an Act relating to bankruptcy'.

3.7 The amendments remove the uncertainty. They ensure that deductions for losses are denied where annulment occurs in connection with arrangements under which debts are released. As a result, such a taxpayer will be denied deductions for losses incurred in the pre-bankruptcy period as if the bankruptcy had not been annulled.

Net capital losses

3.8 Although revenue losses incurred before a taxpayer's bankruptcy or release from debts under bankruptcy law are not deductible there is nothing in the existing law that prevents the same taxpayer's net capital losses incurred in the same period from being taken into account. The amendments relating to net capital losses will protect the integrity of the policy behind the provisions denying revenue losses upon bankruptcy or release by extending similar treatment to net capital losses.

Explanation of the amendments

Annulment of bankruptcy

3.9 The Bill will insert new subsections into the Act to provide that where:

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a taxpayer's bankruptcy is annulled under section 74 of the Bankruptcy Act 1966 ; and

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under the composition or scheme of arrangement the taxpayer is required to enter into as a condition for annulment under section 74 of the Bankruptcy Act , the taxpayer has been or can be released from certain debts;

the taxpayer is denied deductions for revenue losses under the provisions of the Act listed in paragraph 3.5 as if the taxpayer was still a bankrupt and the annulment had never occurred.

Types of losses

3.10 The Act generally allows deductions for various types of revenue losses (for example, general domestic losses and film losses). Deductions for those losses are denied, however, when a taxpayer becomes a bankrupt or is released from debts under bankruptcy law. The new provisions will ensure that deductions for the following losses are denied in certain circumstances of annulment of bankruptcy:

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general domestic losses of the post-1989 years of income [item 35 - new subsection 79E(8A)] ;

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film losses of post-1989 years of income [item 35 - new subsection 79F(8A)] ;

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general domestic losses of the pre-1990 years of income [item 36 - new subsection 80(4AA)] ;

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film losses of pre-1990 years of income [item 37 - new subsection 80AAA(9A)] ; and

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primary production losses of pre-1990 years of income [item 38 - new subsection 80AA(6A)].

Reason for annulment

3.11 The new provisions will apply to annulments under subsection 74(5) of the Bankruptcy Act where a bankruptcy is annulled upon the passing of a special resolution at a meeting of creditors of the bankrupt. Upon passing such a resolution, the creditors effectively accept the bankrupt's proposal for a composition or a scheme of arrangement. Such arrangements may provide for the bankrupt to be released from debts either immediately or at some time in the future.

3.12 Section 153A of the Bankruptcy Act provides for the annulment of a bankruptcy where, for example, the trustee in bankruptcy is satisfied that all the bankrupt's debts have been paid in full. The bankruptcy may also be annulled under section 153B of the Bankruptcy Act if the Court is satisfied that a person ought not to have been made a bankrupt - for example because the person is already a bankrupt. Neither of these reasons for annulment, however, will attract the operation of the new provisions as they do not contemplate release from debts.

Arrangements for release

3.13 The new provisions will apply where under the composition or scheme of arrangement required under subsection 74(5) of the Bankruptcy Act , the taxpayer is or can be released from certain debts. This includes, for example, arrangements whereby creditors accept less than the full amount of debts in full satisfaction of the debts due to them. Also included are arrangements whereby the bankrupt is allowed to manage his/her affairs over a period of time with a view to the payment of as much of the debts as possible. Under these circumstances, the new provisions will apply on the basis that there is a possibility that the bankrupt will be released from some part of the debts, say, if such amounts remain unpaid by the end of the agreed period of time. The new provisions will not apply where, for example, creditors agree to accept full payment of the debts due to them by instalments over a fixed period of time.

Types of debt

3.14 The acceptance by creditors of a composition or scheme of arrangement under subsection 74(5) of the Bankruptcy Act does not, except with the consent of the creditor concerned, release the bankrupt from a debt that would not be released by his or her discharge from bankruptcy [paragraph 75(2)(a) of the Bankruptcy Act ]. Accordingly, the new provisions will only apply where arrangements have been made for the release from debts from which the bankrupt would have been released if he or she had instead been discharged from the bankruptcy.

3.15 This is consistent with the policy underlying the existing paragraph 79E(8)(a), which denies deductions for losses on the basis that the taxpayer is expected to be released from debts upon discharge from bankruptcy.

Net capital losses

3.16 The Bill will amend Part IIIA of the Act to ensure that net capital losses incurred in respect of the year of income immediately before the year of income in which the taxpayer becomes a bankrupt or is released from debts under bankruptcy law will not be taken into account in ascertaining whether a net capital gain accrues or a net capital loss is incurred in respect of the latter year of income or any subsequent year of income. [Item 39 - new subsection 160ZC(4A)]

3.17 Subsections 79E(8) and 79F(8) of the Act (the latter applies to film losses) and their predecessors, subsections 80(4), 80AAA(9) and 80AA(6), deny deductions for losses incurred before the day on which a taxpayer became a bankrupt or was released from debts under bankruptcy law. This amendment accords broadly comparable treatment to net capital losses in that net capital losses incurred in respect of the year of income before bankruptcy or release occurs are to be ignored for the purposes of calculating future net capital gains or losses.

3.18 The treatment of the two kinds of losses will differ to an extent, however, in that net capital losses are to be denied in the year of income in which bankruptcy or release occurs whereas subsections 79E(8), etc. first deny revenue losses in the year of income following the year of income in which bankruptcy or release occurs. The reason lies in the fact that a net capital loss is the cumulative net sum of the gains and losses on disposals of assets over consecutive years whereas a revenue loss is incurred in respect of a particular year of income (see subsections 160ZC(3) and (4)).

3.19 The amendment affecting the treatment of net capital losses applies notwithstanding an annulment of bankruptcy in connection with arrangements under which debts are or can be released. Where:

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a taxpayer's bankruptcy is annulled under section 74 of the Bankruptcy Act 1966 ; and

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under the composition or scheme of arrangement the taxpayer is required to enter into as a condition for annulment under section 74 of the Bankruptcy Act , the taxpayer has been or can be released from debts from which the taxpayer would have been released if he or she had instead been discharged from the bankruptcy;

no net capital losses incurred in respect of the year of income immediately before the year of income in which the taxpayer became a bankrupt or was released from debts under bankruptcy law would be taken into account in ascertaining whether a net capital gain accrued or a net capital loss was incurred in respect of the latter year of income or any subsequent year of income. [Item 39 - new subsection 160ZC(4B)]

3.20 The Bill will also insert new provisions into the Act to ensure that a taxpayer who makes a payment in respect of a debt will be taken to have incurred a capital loss in the year of income in which payment is made, where:

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the taxpayer incurred a net capital loss that is not allowed to be taken into account because of the new subsection 160ZC(4A) ('denied net capital loss'); and

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the Commissioner of Taxation is satisfied that the debt was taken into account in working out the amount of the denied net capital loss.

[Item 39 - new subsection 160ZC(4C)

3.21 The amount of the capital loss taken to have been incurred because of the payment of a debt is to be the smallest of the following:

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the amount of the payment;

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so much of the debt as the Commissioner is satisfied was taken into account in calculating the amount of the denied net capital loss; and

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the amount of the denied net capital loss less the sum of capital losses arising from earlier payments in respect of debts taken into account in calculating that denied net capital loss.

[Item 39 - new subsection 160ZC(4D)]