1 Article published in Issue 13, of The Taxpayer, dated 18 Jan 2010 In a nutshell... Debt forgiveness: Beware unforeseen implications The global financial crisis had one (probably not unexpected) result a huge increase in the number of loans that were written off or compromised in some way. A domino effect from this was felt in the tax consequences that subsequently arose due to commercial debt forgiveness activity. There are provisions in tax law to deal with debt forgiveness, but before these, the forgiveness of such a debt would typically provide the creditor with a capital loss (or in some cases a revenue loss). In other words, the debtor may not have been assessed on any gain, and could continue to claim deductions for accumulated revenue and capital losses, as well as other deductible costs. This was, in effect, a doubling-up of tax losses and available deductions. So the commercial debt forgiveness (CDF) provisions take aim at this duplication by applying the forgiven amount with a view to reducing deductions. There are specific exclusions however, such as where the forgiven debt can be seen to be in respect of employment. In these cases, the benefit of being forgiven a debt will typically constitute a fringe benefit, and be taxed as such. Also if the forgiven amount sees it included in the assessable income of the debtor. This can happen where a private company is deemed to have paid a dividend (under Division 7A) where a debt owed to the company is forgiven. There are even situations where the forgiven debt will give rise to ordinary income. This was the case with one company where the resulting gain (from a released debt) was deemed to be inextricably and directly linked to the trading activities of the company. It is important that taxpayers are conscious of the very broad definitions of forgiveness contained in the CDF tax provisions, to make sure no steps are taken that may inadvertently result in such a debt forgiveness being deemed to have taken place....the full article follows All information provided in this publication is of a general nature only and is not personal financial or investment advice. It does not take into account your particular objectives and circumstances. No person should act on the basis of this information without first obtaining and following the advice of a suitably qualified professional advisor. To the fullest extent permitted by law, no person involved in producing, distributing or providing the information in this publication (including Taxpayers Australia Incorporated, each of its directors, councillors, employees and contractors and the editors or authors of the information) will be liable in any way for any loss or damage suffered by any person through the use of or access to this information. The Copyright is owned exclusively by Taxpayers Australia Inc (ABN ). NOTICE FORBIDDING UNAUTHORISED REPRODUCTION No item in this publication covered by copyright may be reproduced or copied in any form (graphic, electronic or mechanical, or recorded on film or magnetic media) or placed in any computer or information transmission or retrieval system unless permission in writing is obtained from Taxpayers Australia Inc. call or download an application form from
2 The Taxpayer 18 January Issue /2010 The application of the commercial debt forgiveness provisions By Roger Timms and Weiran Wang The global financial crisis has resulted in a significant increase in the number of loans which are written off or compromised in some way. In these circumstances consideration of the commercial debt forgiveness (CDF) provisions is necessary in order to determine the taxation consequences which may arise. In the recent case of Tasman Group Services Pty Ltd v FC T (2009) FCAFC 148, the Full Federal Court (on appeal) considered a number of issues in relation to the CDF provisions. This article provides a detailed explanation of the CDF provisions together with comment regarding the judgment of the Court in the Tasman Group Services case. It is important to be aware that, whilst the Tasman Group Services case involved substantial international transactions, the CDF provisions have the same application to all taxpayers, including the SME market. Background of the CDF provisions The CDF provisions, contained in Schedule 2C of the ITAA36, which have application to certain debt forgiveness which occurs after 27 June Prior to the introduction of the CDF provisions the forgiveness of such a debt would typically provide the creditor with a capital loss (or in some cases a revenue loss) with the possibility of there being no adverse tax implications for the debtor. In other words, the debtor whilst relieved of the liability to repay a debt, may not have been assessed on any gain and could continue to claim deductions for accumulated revenue and capital losses and other undeducted expenditure. This could result in what was, in effect, a duplication of tax losses. The intention of the CDF provisions is to remedy the effective duplication of tax deductions that may otherwise arise from the forgiveness of commercial debts. The application of the CDF provisions results in the forgiven amount being applied to reduce certain amounts which may otherwise be taken into account as deductions in calculating the debtor s taxable income. In order for the CDF provisions to become operative, it is necessary that there be: the existence of a commercial debt the forgiveness of that debt, and a net forgiven amount calculated. What is a debt? The term debt is defined under s245-15(1) ITAA36. Broadly, a debt is described as an amount which is an enforceable obligation imposed by law on a person to pay an amount to another person. In addition, s provides that a debt also includes interest on a debt which has been accrued but not paid. Exclusion from the definition of a debt There are specific exclusions from the definition of debt which are contained in s The exclusions arise in circumstances where the debt forgiveness is dealt with by the following provisions of the tax law which take priority over the CDF provisions: Fringe benefit exclusion s245-15(2) If the obligation to repay a debt is waived, it is necessary to consider whether the benefit arising as a result of the decision to waive the obligation to pay has been provided in respect of employment. If so, the benefit will typically constitute a taxable fringe benefit and a fringe benefit tax (FBT) liability will accrue to the creditor. Assessable income exclusion s245-15(3) An amount is not to be regarded as a debt if the amount has been, or will be, included in the assessable income of any year of income of the person on whom the obligation to repay is imposed. The forgiveness results in an amount being included in the assessable income of the debtor, which may generally arise in the following situations: 1. Division 7A This would typically arise as a result of s109f of Division 7A TAA36 deeming a private company to pay a dividend where all or part of a debt owed to the company is forgiven and the debtor is: a shareholder or associate of a shareholder of the company, or it is reasonable to conclude that the debt was forgiven because the debtor has been a shareholder (or associate) at some time.
3 NOTE: For the purposes of determining whether a debt has been forgiven, s109f(3) adopts the CDF definition of forgiveness in s (subject to the exclusion of the debt parking rules in subsection (4)). Where the provisions of s109f are satisfied (and the limited exceptions in s109g are not available) Division 7A will have application and include the forgiven amount in the assessable income of the debtor the CDF provisions will not apply. This outcome is subject to the existence of sufficient distributable surplus in the company, as the maximum deemed dividend which the Commissioner can assess under Division 7A is the amount of the company s distributable surplus (calculated in accordance with formula contained in s109y). If, for example, the company had a distributable surplus of nil no amount would be included in the assessable income of the debtor and therefore the CDF exclusion contained in s245-15(3) would not be available. In these circumstances the CDF provisions would be operative. 2. Ordinary income In some situations it may be that the act of forgiving a debt may give rise to ordinary income. This occurred in Warner Music Australia Pty Ltd v FCT, 96 ATC 5046, where a liability due to the Commonwealth was released and it was held that the resultant gain represented ordinary income as the released debt was inextricably and directly linked to the trading activities of the company. It would not, however, be a common outcome for an act of debt forgiveness to result in the derivation of ordinary income by the debtor. What is a commercial debt? The existence of a debt is not sufficient to meet the first condition of the CDF provisions. Division 245 requires the debt to be a commercial debt. According to s ITAA36, a debt will be considered to be a commercial debt in the following situations: 1. Where interest is paid or payable in respect of the debt s245-25(2) A debt is a commercial debt if the whole or any part of interest paid or payable (including an amount in the nature of interest) is or would be allowable as a deduction to the debtor, or would be allowable apart from the operation of an exception provision under s245-25(5). 2. Where no interest is payable s245-25(3) A debt is a commercial debt if had interest been payable in respect of the debt, a deduction would have been available apart from the operation of an exception provision under s245-25(5). 3. Where the debt is considered as a non-equity share s245-25(4) A non-equity share issued by a company is taken to be a commercial debt owed by the company to the shareholder. In general, a non-equity share is determined by the debt and equity rules in Division 974 of ITAA97. NOTE: The exception provision under s245-25(5) has the effect of preventing a deduction that would otherwise be allowable, but does not include paragraphs 8-1(2)(a), (b) and (c) of ITAA97. An example of an exception provision would be Division 820 of ITAA97 which contains the thin capitalisation rules. In respect of the deductibility of interest requirement under s245-25(2) and s245-25(3), the legislation is silent as to whether it is required at all times. For instance, if the use to which the funds representing the debt have been put change so that interest would be considered initially deductible but not thereafter, or vice-versa, how should the provision be applied? It would appear that where interest would be deductible at any time, the CDF provisions would have application to a forgiven amount. In some situations this could produce an inequitable outcome. What constitutes forgiveness of a debt? There are five circumstances defined in s pursuant to which a debt might be considered forgiven. 1. The obligation on the debtor to pay is released, waived or extinguished. These words are not defined and therefore take on their ordinary meaning. Forgiveness occurs at the time of the relevant action by the creditor 2. The application of the statute of limitations. These are State laws which generally provide that a debt is deemed to be forgiven if the period within which the creditor may sue for recovery expires by operation of the statute of limitations, without: a) written acknowledgement of the debt by the debtor to the creditor; or b) some repayment having occurred. In most Australian jurisdictions six years is the relevant period for the purposes of the statute of limitations. In the case of VL Finance v Legudi (2003) VSC 57, it was held that, in respect of an at-call loan, the relevant period for the purposes of the statute of limitations in Victoria commences when the loan is first made. 3. An agreement is entered into to relieve the debtor of an obligation to pay at a future time. The agreement may be formal or informal. 4. Debt parking. Section (4) contains a form of forgiveness, The Taxpayer 31 August 2009 Copyright Taxpayers Australia
4 referred to as debt parking, which may not be immediately recognised by many taxpayers and advisors. A debt will be considered forgiven where it is assigned by the creditor to a new creditor and: c) the new creditor is an associate of the debtor, or d) the assignment is pursuant to an arrangement to which the new creditor and the debtor are parties. The rationale for such an arrangement to constitute debt forgiveness is apparently that the new creditor (being an associate of the debtor) may not call up the debt. A simple reorganisation of inter-entity loan accounts amongst related parties may trigger the debt parking provisions. For example: assume that Company A has loaned $50,000 to Trust B ( with both entities being controlled by the Brown family); Company C is incorporated as a financier for the Brown family and in that capacity takes an assignment of the $50,000 loan from Company A. Such an arrangement would result in the debt parking provisions having application and therefore the debt being considered to be forgiven. 5. Debt for equity swap. A debt will be considered forgiven where the creditor subscribes for shares in the debtor company and any part of the subscribed funds are used to repay the debt. Specific exclusions from the definition of forgiveness According to s245-40, the debt forgiveness provisions are not triggered where the forgiveness is: Effected under the Bankruptcy Act - therefore only applicable to individuals Effected by will - a specific term of the deceased s will dealing with the forgiveness For reasons of natural love and affection - it would seem that a company could affect forgiveness for these reasons (refer: ATO ID 2003/589). Calculation of the net forgiven amount Step 1: Working out the notional value of a debt According to s245-55, the notional value of a debt is the lesser of: a. The first applicable amount - the value of the debt (as an asset of the creditor) at the time of the forgiveness assuming that the debtor was solvent at the time the debt was incurred and when it was forgiven, and b. The second applicable amount - the value of the debt in accordance with (a) above adjusted (where relevant) to reflect the impact which changes in interest rates and currency fluctuations have on the value of the debt. NOTE: The assumption that the debtor s solvency at the time the debt was incurred is generally referred to as an assumption of solvency. However, in certain circumstances the notional value of the debt may be calculated without an assumption that the debtor has the necessary capacity to pay, ie. an assumption of solvency. According to s245-55(4), this would occur where: a. (i) the creditor is a resident, or (ii) if a non-resident, the debt is subject to the CGT provisions as taxable Australian property, and b. the creditor and debtor were not dealing at arm s length in respect of the incurring of the debt, and c. the debt is not a money lending debt. When considering this exception to the assumption of solvency, the issue most likely to require analysis is whether the debtor and creditor have dealt at arms-length in the incurring of the debt. This will ultimately be a question of fact. However, where the parties are parent and subsidiary, such as in the Tasman Group Services case, or where they are otherwise related, such as a family company and trust controlled by the same family, there would typically be a presumption that the arms-length standard would not be met, although the parties to the transaction may be able to demonstrate to the contrary. Step 2: Working out the consideration in respect of the forgiveness The consideration is usually the amount of money and/ or property the debtor is required to give in respect of the forgiveness. However, where: there is no consideration in respect of the forgiveness the whole or a part of the consideration in respect of the forgiveness cannot be valued, or the debtor and creditor were not dealing at arm s length in connection with the forgiveness, s245-65(2) requires that the market value of the debt at the time of forgiveness be the amount of deemed consideration. Step 3: Determining the gross forgiven amount of the debt The gross forgiven amount is obtained by deducting the consideration from the notional value of the debt. The determination can be represented as: Gross forgiven amount = Notional value of the debt consideration
5 Step 4: Calculating the net forgiven amount of the debt To arrive at the net forgiven amount the gross forgiven amount must be reduced where the forgiveness results in: (i) any amount being included in the assessable income of the debtor; (ii) any reduction in an amount that would otherwise be an allowable deduction to the debtor; and (iii) any reduction in the cost base of an asset of the debtor. NOTE: The net forgiven amount may be further reduced if the debt is between companies in the same group and the creditor forgoes a capital loss or a deduction for the bad debt. Application of the net forgiven amount The net forgiven amount calculated in accordance with Division 245 is then applied to reduce the tax attributes of the debtor in the order required by s : 1. Deductible revenue losses 2. Deductible capital losses 3. Deductible expenditure such as expenditure deductible under Division 40 (capital allowances) research and development expenditure, borrowing expenses etc 4. Cost base of certain CGT assets (excluding personal use assets, main residence and goodwill). If after applying the net forgiven amount in the required manner some part of the forgiven amount remains, that amount will not constitute assessable income of the debtor, and there are no further tax implications for the debtor. NOTE: Special rules contained in subdivision 245-G apply to groups of companies where the debtor and creditor are companies under common ownership. Where subdivision 245-G applies, the net forgiven amount is applied as follows: if one or more non-debtor companies have deductible revenue losses, the net forgiven amount is allocated to each such company proportionately; if no company in the group has deductible revenue losses, but one or more non-debtor companies have deductible net capital losses, the net forgiven amount is allocated to each such company proportionately; apply the CDF provisions in the normal manner if: - the debtor company is the only company in the group that has deductible revenue losses - no company in the group has deductible revenue losses and the debtor company is the only company in the group that has deductible net capital losses, or - none of the companies in the group have deductible revenue losses or deductible net capital losses. Illustration of the CDF provisions As indicated above, the CDF provisions were recently considered by the Full Federal Court in the Tasman Group Services case. The facts of the case offer an opportunity to illustrate the calculation steps involved in applying the CDF provisions. Facts The cross-appellant, Tasman Group Services Pty Ltd (Tasman), formerly known as SBA Foods Pty Ltd (SBAF), was a wholly owned subsidiary of a Japanese corporation, SBC (up to February 2002). In November 1996, SBAF acquired a meat processing and exporting business that was funded partly by share capital and partly by loans from SBC. The business was not a success and incurred heavy trading losses. This led to SBC advancing further loans totalling over $118m. In February 2002, SBC sold its shares in SBAF to a third party for $17m. None of the loans to SBC were repaid. In fact, under the share sale agreement, SBC agreed to ensure that on the Completion Date (1 March 2002) no amount of Financial Indebtedness exists, ie. the loan funds advanced by the then parent company must no longer be liabilities of the subsidiary company. Before the Full Federal Court, the matters to be considered were: whether the losses owing by SBAF were considered to be debt were such debts commercial debt, and were such debts forgiven and if so, what was the net forgiven amount? Decision The Full Federal Court dismissed Tasman s crossappeals, confirming that the loans were debts within the meaning of s of Division 245 of Schedule 2C to ITAA36. The taxpayer had argued that the loans were not debts as they had been subordinated in favour of external bank loans and therefore took on the character of de-facto equity. The Court concluded that the loans, whilst subordinated, remained enforceable obligations imposed by law even if the time for payment was postponed or deferred. Further, the debt was commercial pursuant to s245-25, an expected outcome given the nature of the loans provided. It was also confirmed that the debt was forgiven under s on the basis that it did not have to be expressly forgiven and was effectively waived by conduct (in this case the act of recording a removal of the debt from the books and records of the company).
6 The Court then considered the appeal by the Commissioner in relation to the calculation of the notional value of the debt. In allowing the appeal, the Full Federal Court held that the statutory assumption of solvency was not excluded because the relevant CGT asset did not have the necessary connection with Australia as it was not used at any time by the Japanese parent company (the creditor) in carrying on a business through a permanent establishment in Australia (refer: s245-55(4)). Accordingly, the notional value of the debt was required to be determined at the time it was forgiven as if SBFA was solvent. Application of the CDF provisions using the case facts The relevant facts can be summarised as follows (noting that the figures below are only approximate amounts extracted from the judgment for the purposes of illustration of the application of the CDF provisions): 1. Loans from parent company to Tasman Group Services $118,000, Amount paid upon forgiveness nil 3. Value of the debt at time of forgiveness assuming: (i) debtor s capacity to pay at the time of forgiveness was the same as at the time the debt was incurred (s245-55(2)(b))... $59,000,000 or (ii) debtor solvency assumed (s245-55(2)(a)) $118,000, Consideration (market value of the debt at time of forgiveness) (s245-65) $17,000,000 Moreover, during the income year that the debt to SBAF was forgiven, the company had: $70.6m of revenue losses $0.76m of capital losses $27.3m of deductible expenditure, and $18m of asset cost base. Based on the decision of the Full Federal Court, the notional value of the debt is required to be determined at the time it was forgiven as if SBFA was still solvent. Therefore, the net forgiven amount is $101,000,000. See table below. The net forgiven amount as calculated would then be applied against the following tax attributes of the debtor: Net forgiven amount $101,000,000 Less: 1. Deductible revenue losses..... ($70,000,000) 2. Deductible capital losses ($760,000) 3. Deductible expenditure ($27,300,000) Balance of the net forgiven amount..... $2,940, Cost base of certain CGT assets.($18,000,000) Balance of the cost base $15,060,000 As a result of the application of the CDF provisions, the debtor would have lost all the deductible revenue losses, deductible capital losses, and deductible expenditure. The balance of the cost base of certain CGT assets would also be reduced from $18,000,000 to $15,060,000. Conclusion It is important that taxpayers are conscious of the very broad definition of forgiveness contained in the CDF provisions to ensure that steps are not taken which inadvertently result in debt forgiveness being deemed to occur. This may be of particular relevance where a reorganisation of a closely held SME group is carried out. Further, before entering into a debt forgiveness arrangement it would be prudent to consider: whether an amount of assessable income may accrue to the debtor the tax adjustments which may result for the debtor, and whether the debtor is a company which is a member of a group which may result in tax adjustments arising for other group companies. No solvency assumption Assumption of solvency DEBTOR Notional value of debt $59,000,000 $118,000,000 Less consideration 17,000,000 17,000,000 Net forgiven amount $42,000,000 $101,000,000 CREDITOR 3 CGT cost base $59,000,000 1 $118,000,000 Less consideration 17,000, ,000,000 Capital loss $42,000,000 $101,000,000 1: Market value: s : Market value: s : Included for illustrative purposes (creditor a non-resident).