The commercial debt forgiveness rules are contained in Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997).
The rules do not treat the debtor as having received a gain when a commercial debt is forgiven. Instead, they apply the forgiven amount in reduction of certain amounts otherwise taken into account in calculating the debtor’s taxable income (e.g. carried forward losses).
Commercial debt forgiveness rules
| GENERAL RULE | EXCEPTION TO THE RULE |
| The rules require that net amounts of debts forgiven in a year of income be applied:
| Exceptions to the rules apply if the forgiveness is:
|
For the commercial debt forgiveness rules to apply, there must be:
- a debt
- which is a commercial debt; and
- it must be forgiven
There must be a debt
Debt is a legally enforceable obligation on a person (i.e. the debtor) to pay an amount to another person (ie. the creditor). The rules in Division 245 treat interest payable on debt as being a separate debt if the interest has accrued but has not been paid.
It must be a commercial debt
Debt is a commercial debt if the whole or any part of the interest payable on the debt is or would be an allowable deduction to the debtor.
The fact that interest is not payable on a debt does not prevent the debt from being a commercial debt. A debt will be a commercial debt if the interest on the debt, had it been charged, would have been an allowable deduction to the debtor.
A debt will be a commercial debt if it satisfies the conditions of section 8-1 notwithstanding that a specific provision of the Act would have the effect of precluding a deduction for the interest.
Forgiveness of commercial debt
A debt is forgiven if the debtor’s obligation to pay the debt is:
- released
- waived
- otherwise extinguished; or
- if the right to sue for recovery is lost due to the operation of the Statute of Limitations
but not if it is fully paid in cash.
Reference to a debt includes part of a debt
There is no formal requirement for a release or waiver to be in writing. However, there must be some form of acknowledgement that the debt is no longer payable.
Under some arrangements, the debtor’s obligation to pay the debt may not cease immediately but in the future. Nevertheless, the debt will be treated as forgiven at the time the arrangement is entered into.
Where creditors assign their rights to a debt to a third party, the rules may also apply.
Debt for equity swaps is caught by the rules. They occur when a creditor releases a debt or part of a debt in return for the issue of shares or units to the debtor. Section 245-37 will treat the debt as being forgiven when, and to the extent that, the company applies any of the money subscribed in or towards payment of the debt.
Example
Broke Co owes WealthyCo $100,000 but cannot pay. WealthyCo subscribes for $100,000 fully paid $1 Broke Co shares so that Broke Co can pay WealthyCo $100,000 from its subscription money. Forgiveness is taken to have occurred when Broke Co uses the subscription money to pay WealthyCo.
The net forgiven amount
It is the “net forgiven amount” that is applied in reduction of the carried forward losses etc. Generally, this is the amount forgiven less any consideration given for the forgiveness. The amount is also reduced by:
- any amount which has been or will be included in the debtor’s assessable income
- any amount by which a deduction that would otherwise be allowable has been or will be decreased
- the amount by which the cost base of any asset of the debtor is decreased
This amount is then applied to reduce amounts in the following categories:
- tax losses from previous income years;
- net capital losses from previous income years;
- deductions the debtor would otherwise get in the income year, or a later income year, because of expenditure from a previous year (for example, the capital allowance deductions the debtor would get for expenditure on acquiring a depreciating asset);
- the cost bases of the debtor’s CGT assets.
A debtor is required to reduce these amounts in the order in which they are listed above.
Within each class, the debtor may choose the relevant loss, item of expenditure or asset against which the total net forgiven amount is to be applied, subject to the proviso that it must be applied to the maximum extent possible within that class.
Any part of the net forgiven amount which remains after being successively applied against any available reducible amounts is disregarded, except where the debtor is a partnership, in which case the residual amount flows through for application against the reducible amounts of the partners.
Commercial debt forgiveness deductions
There are three types of deductions in a commercial debt forgiveness scenario.
Deductible revenue losses
The total net forgiven amount is applied first, to the maximum extent possible, in reduction of tax losses (if any) for any income years, if the tax losses could, if the debtor had enough assessable income, be deducted in:
- the forgiveness income year; or
- a later income year.
Deductible net capital losses
These are net capital losses incurred before the forgiveness year which could be applied in working out the net capital gain for the forgiveness income year if the debtor had enough capital gains.
The table of deductible expenditures set out in sections 245-145 sets out the category of deductible expenditures against which the net forgiven amount is to be applied.
Deductible expenditure must be expenditure incurred before the forgiveness year which would be deductible in the forgiveness or later years.
Deductible expenditures include the following:
- expenditure deductible under Div. 40 ITAA 1997 – capital allowances;
- borrowing expenses under Sec. 25-25 ITAA 1997;
- research and development;
- income-producing buildings and other capital works (sec 43-10 ITAA 1997).
The debtor may choose the order in which the deductible expenditures are reduced and the amount of reduction of each.
The cost basis of reducible assets
The final category of amounts that may be reduced by a debtor’s total net forgiven amount is the cost base of CGT assets owned by the debtor at the beginning of the forgiveness year of income.
Assets acquired during the forgiveness year of income are not included in this category.
The following CGT assets are also excluded from the application of the rules:
- pre-CGT assets;
- a dwelling that was the debtor’s main residence at any time before the forgiveness year of income;
- personal use assets;
- goodwill;
- an asset that was trading stock of the debtor throughout the period before the forgiveness year of income when it was owned by the debtor.
The debtor may choose the CGT assets whose cost base is to be reduced and the extent of the reduction.
Record keeping
Section 245-265 provides that records must be kept that enable the following information to be readily ascertained:
- the date on which the debt was incurred
- the identity of the creditor
- the amount of the debt
- the terms of repayment of the debt
- at the time the debt was incurred, the debtor’s capacity to pay the debt when it falls due (if the parties are not acting at arm’s length)
- if the debtor’s obligation to pay the debt is forgiven, the date of forgiveness and the consideration in respect of forgiveness.
When a debt is forgiven, those records are required to be kept until the end of 5 years after the debt is forgiven.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.