Commercial Debt Forgiveness

Commercial Debt Forgiveness

A debt is forgiven if the debtor’s obligations to pay the debt is released or waived or otherwise extinguished. (Section 245-35, Schedule 2C Income Tax Assessment Act 1936, (the 1936 Act)).

Under Section 245-15, a debt is an enforceable obligation by law on a person to pay an amount to another person. It includes the obligation to pay interest and excludes loans caught under Div 7A

What is a Commercial Debt

Before the commercial debt forgiveness rules apply, there must be a commercial debt.

Section 245-25 of Schedule 2C of the 1936 Act covers the situation where interest is payable, and also where the loan is interest free. Basically, a debt is a commercial debt if the borrower would have been able to claim a tax deduction in respect of the interest on the debt. The definition covers not only interest but amounts that are “in the nature of interest”.

There is no definition of “in the nature of interest”. However, it is generally accepted that it is intended to cover, for example, the discount on a discounted bill.

Subsection 245-25(2) takes into account the possibility that the interest might not be deductible say for example, where it is used to derive exempt income.

Hence, if the interest is incurred to produce exempt income, and interest is payable, it is arguable that the debt is not commercial debt and hence, the debt forgiveness rules would not apply. An example would be borrowings incurred to capitalise a controlled foreign Company. Under Section 23AJ, where dividends are received from a controlled foreign Company by an Australian resident Company, the dividends are exempt.

The fact that interest might not be payable under a loan does not prevent the debt from being commercial debt. Under Subsection 245-25(3), the debt would still be commercial debt if, had interest been payable, the interest would have been deductible or would have been deductible apart from the operation of an exception provision.

What Needs to Happen for a Debt to be Forgiven?

With all tax matters, there is the accounting and there is the legal aspect of a forgiveness.

Lawyers have a common habit of forgetting to look at the accounting entries to work out why they happened. The accounting entries should be traced to make sure that the transaction that lead to the entry is fully understood before concluding that there is or is not a tax issue.

Forgiveness

Section 245-35 Schedule 2C of the 1936 Act reflects what legally must happen for an amount to be forgiven.

Basically, the obligation to pay the debt must be released, waived or otherwise extinguished. The provision elaborates further.

In addition, if the period within which the Creditor is entitled to sue for the recovery of the debt ends because the operation of the Statute of Limitations without the debt having been paid, that is taken to be a forgiveness.

Subsection 245-35(3) states that a debt is taken to be forgiven if there is an Agreement and the obligation to pay by the Debtor (i.e. the Borrower) to the Creditor (i.e. the Lender) is to cease at a particular future time.

The section applies whether or not the Agreement is enforceable by legal proceedings but only if the cessation of the obligation is to occur without the Borrower incurring any financial or other obligation. If the Agreement or arrangement has been entered into, the forgiveness is taken to occur when the Agreement or arrangement is entered into. The timing of the forgiveness is set irrespective of whether the debt is to be forgiven under the agreement or by arrangement at a future time.

Debt Parking

Debt parking is the one area of debt forgiveness that is least understood. Forgiveness is taken to include “debt parking”

Basically, debt parking is where the Lender assigns the right to receive payment from the Borrower to another person who is an associate of the Borrower.

It does not apply where the debt was acquired by the other party in the ordinary course of trading on the securities market. Where the assignment has taken place, the Borrower is taken to have been forgiven a debt equal to the amount of the assigned debt.

Debt Converted to Equity

Debt parking includes the situation where the debt is exchanged for shares in the Company that has borrowed the money. The time of the forgiveness is the time the debt is applied towards the payment of shares.

Exclusions

A forgiveness will not arise if the debt is forgiven under an Act relating to bankruptcy (not liquidation), the forgiveness is effected by Will or the debt is forgiven for reasons of natural love and affection (see Section 245-40 of Schedule 2C of the 1936 Act).

Mechanically, to achieve any of the latter two, some form of legal Agreement or legal documentation needs to be executed. At the very least, a Deed Under Seal.

In ATO ID 2003/90, there was a commercial debt that was forgiven between two individuals. The Borrower could only repay part of the debt. The Lender forgave the balance for reasons of natural love and affection. The ATO considered that the natural love and affection exclusion to the debt forgiveness rules did not apply because there were two reasons for the forgiveness. The first was the natural love and affection reason. The second reason was the Borrower’s inability to repay the debt. According to the ATO, the natural love and affection aspect of the forgiveness only applied in relation to the part of the debt that the Borrower could repay.

ATO ID 2003/582 is in respect of a Trust forgiving a debt for reason of natural love and affection. The ATO consider that a Trustee of a Trust can forgive a debt for reasons of natural love and affection. However, the facts of that case were that the Borrower could actually repay the debt at the time of the forgiveness. In interpreting the phrase “for reasons of natural love and affection”, the provision does not require the Lender to feel love or affection towards the Borrower. Only that the debt was forgiven for reasons of natural love and affection.

ATO ID 2003/589 deals with a Company forgiving a debt for reason of natural love and affection. The facts of the ATO ID are that the Directors of the Company passed a resolution allowing the forgiveness of the debt by reason of the Director’s natural love and affection for the Borrower. The ATO ID states that the exception to the debt forgiveness rules would apply. However, the facts of that ID also state that the Borrower was able to repay the debt at the time of the forgiveness.

The conclusion that can be drawn from these IDs is that the ATO are sceptical about applying the natural love and affection exclusion where the Debtor cannot repay the debt. This, to an extent, defeats the purpose of actually having the exception there in the first place. Hence, it is an academic exercise to grant   the natural love and affection exception.

Application of the Net Forgiven Amount

If the debt that is forgiven is worthless, the broad answer is that the Lender claims a loss and there is an adjustment to the tax position of the Borrower as follows.

The Net Forgiven Amount is applied firstly to:

1. The opening balance of carried forward revenue losses, then
2. The opening balance of carried forward capital losses, then
3. The tax value of depreciating assets, then
4. If there is any loss left over, the Capital Gains Tax cost base of assets is reduced by the remaining amount that is forgiven.