Tough Tax Tactics for Tough Times

Transcription

1 Tough Tax Tactics for Tough Times Mark Pizzacalla Managing Partner HLB Mann Judd Level 9, 575 Bourke Street Melbourne VIC Mobile:

2 1 Abstract Overview Strategic Tax Matters Corporate Tax Governance Risk Differentiation Framework ATO Audit Readiness Prudential Tax Audits Director Penalty Regime Key tax issues in current economic times Bad Debts Debt Forgiveness Trading Stock Depreciation Funding issues for hybrid trust structures Compliance tax matters Fixed assets and depreciation Company Tax losses Audit fees Directors fees and Employee Bonuses Superannuation Guarantee and remuneration Accruals versus provisions Amortisation versus depreciation Business Blackhole Expenses Travel To consolidate or not to consolidate About the Author Disclaimer References

3 1 Abstract Tough economic times mean that as a CEO/CFO 1, you are expected to be aware of how you can maximise your company's after tax cash position. Businesses grappling with the current economic tightening can minimise exposures and exploit opportunities if they adopt appropriate tax planning strategies. In doing so, CEOs/CFOs may have to focus on tax provisions seldom used during boom times, identify tax strategies which ameliorate the impact of the downturn, and apply tax concessions which may be potentially available to them. This session is designed to help CEOs /CFOs decide which tax issues should be on the boardroom table during these tough economic times to help reduce the impact of the current business cycle. All references in this paper are to the Income Tax Assessment Act 1936 and Income Tax Assessment Act 1997, unless otherwise stated. 1 For the purpose of this paper, the terms CEO and CFO may be used interchangeably. 3

4 2 Overview The vast majority of CEOs/CFOs that I meet simply want to ensure that they are paying the right (legitimate) amount of tax. This represents a vast difference in taxpayer attitudes and a real cultural shift from the 1980s, and certainly bears no resemblance to taxpayer attitudes of the 1970s. 2 As a result of the Australian Taxation Office s (ATO) increased focus on tax governance, CEOs and CFOs prefer to have peace of mind when it comes to attending to the taxation affairs of the company that they are acting for. This makes good commercial sense as there is no upside for CEOs/CFOs to get involved in any grey tax matters for which they do not have an approved Private Ruling, or a Reasonably Arguable Position (RAP) Paper. However, during times of economic crisis, temptation can creep in, and CEOs and CFOs can take their eye "off the ball", or be a little bit more aggressive than they otherwise would be, in relation to their company's tax affairs. This may not necessarily be a conscious decision on their part, but just part of the commercial pragmatism that may kick in when company revenues are down, profits are being squeezed, and cash flow is under continuous pressure. All of these factors can culminate in a change of behavioural patterns that are aimed at trying to keep businesses in the black. The purpose of this session is to bring to the attention of CEOs/CFOs some of the salient tax considerations and issues that they should be addressing during these tough economic times. Whilst this list is not exhaustive, it does provide a high level view of the nature and types of tax matters that Boards should be focusing on. Tax Strategy Strategies need to be put into place which either makes the business money, saves the business money, or through improvements to processes and systems, will provide the business with significant benefits and synergies over time. Strategies need to be put into place which either makes the business money, saves the business money, or through improvements to processes and systems, will provide the business with significant benefits and synergies over time. With this in mind, this paper comprises three distinct parts. The first part deals with strategic tax matters that should be considered, the second part deals with key tax issues in current economic times, whilst the third part outlines salient tax compliance related matters. 2 Australian Taxation Office, 'Eyes on the commercial ball' (Paper presented at the International CFO Forum, The Mint, Sydney, 20 November 2009). 4

5 3 Strategic Tax Matters 3.1 Corporate Tax Governance At the top of the list is the issue of good corporate governance. From the ATO s perspective, this includes managing tax risk. 3 In the event of an audit, the business must be able to demonstrate to the ATO that it has the capacity to identify errors and mitigate tax risks. 4 It is also important to remember that if you are the CEO/CFO of a $100m turnover company, what is expected of you will be more than if you were responsible for a $10m turnover company (not that you should let this affect your thinking or approach!). Of course, simply because your business may be bigger does not necessarily mean that you are high risk from a tax perspective and vice versa. 5 The ATO expects to see that the company s corporate governance processes in relation to tax are functioning well on two levels: Strategic: at a macro level, what is the company s approach? Operational: what controls does the company have in place to meet its obligations? At a strategic level, 6 some of the governance questions include: Do you know how the ATO categorises your business under the Risk Differentiation Framework? What are the consequences of your risk rating? Do you have processes to present the approach to tax risk for review by the Board? Do you know your advisor s risk stance and does their approach to risk align with that of your business? Are the amounts of tax you are paying in line with your business results? At the operational level, 7 some of the key governance questions include: Are the roles and responsibilities associated with overall tax compliance clearly defined? Does your tax function have adequate resources to manage tax risks effectively and provide reasonable assistance when dealing with us? Can you ensure that tax information used for your internal accounting or provided to the ATO is accurate and reliable? Are you confident that your records and control systems enable you to meet your tax obligations properly? 3 Australian Taxation Office, Large business and tax compliance (2011), 8. 4 Australian Taxation Office, Large business and tax compliance (2011), 8. 5 Michael D Áscenzo, Two to Tango (Speech delivered at the G100, Sydney, Australia, 9 December 2009). 6 Australian Taxation Office, Large business and tax compliance (2011), 8. 7 Australian Taxation Office, Large business and tax compliance (2011), 8. 5

6 Are there material differences between your accounting profit and taxable income and, if so, are you comfortable with the reasons for those differences? A company s approach to these issues is significant, as the ATO has made it clear that the answers to these type of questions will affect how the ATO will engage with you. Mr Mark Konza, Deputy Commissioner (large business & tax compliance), has made it clear that: We differentiate our approach and engagement with taxpayers according to our assessment of their tax risk once we understand you and know how your governance systems work and we rely on them to identify issues we need to resolve, it is clear we have established trust Risk Differentiation Framework In July 2013, the ATO released a new version of its Large Business and tax compliance booklet which was co-designed with large businesses. The release indicates a significant change in the ATO s approach to assessing and managing tax risks and signifies a more proactive approach by the ATO; an approach which is driven by early engagements (between the ATO and large businesses) and enhancing relationships with large businesses. In its booklet, the ATO detailed that the value, volume and complexity of transactions undertaken by large businesses have inherent risks for tax compliance. That the ATO s overall approach is to closely examine significant transactions and business results that show inconsistencies between the tax and economic outcomes. 9 In particular, the compliance risks that the ATO are focusing on are: profit shifting through transfer pricing, thin capitalisation and debt generation; and material transactions such as mergers, acquisitions and business restructure that allows for opportunistic tax planning. The ATO detailed some examples of transactions which could potentially represent a tax risk from the ATO s perspective, as follows: related party cross-border and tax haven dealings where a tax deduction is made in Australia with no corresponding amount of assessable income; complex structures and intra-group transactions associated with generating tax benefits unrelated to the economic substance of your commercial activity; tax benefits from financial and other arrangements that are disproportionately high compared to the limited financial exposure, or where there is a divergence between the real and claimed economic substance of your business activity; using arrangements or products (such as tax rulings) to transfer or create tax benefits in circumstances not contemplated by the law; characterisation of transactions, for tax purposes, that is at odds with their economic substance; distortions and inconsistencies in market valuations; 8 Mr Mark Konza, A world without audits (Speech delivered at the Thomson Reuters Annual User Conference, Sydney, Australia, 17 October 2011). 9 Australian Taxation Office, Large business and tax compliance (2011), 22. 6

7 promotion of tax exploitation schemes; and implementation of a transaction in a materially different way to that described in a product ruling relevant to the transaction. 10 A fundamental change in the ATO s Large Business and tax compliance booklet was the introduction of the Risk Differentiation Framework (RDF). This framework was introduced to aid in the ATO s process of assessing tax risks (in relation to large businesses) and to govern how detailed the ATO s approach should be when responding to the nature and type of tax risk identified. The ATO indicated that their RDF is: based on the premise that our risk management stance will differ based on our perception of your estimated: likelihood of non-compliance (that is, having a tax outcome that we don t agree with), and the consequences (dollars, relativities, reputation, precedent) of that non-compliance. 11 The RDF consists of four broad risk quadrants as detailed below. Large taxpayers will be placed into one of the four quadrants for each tax type (income tax, GST, excise). 10 Australian Taxation Office, Large business and tax compliance (2011), Australian Taxation Office, Large business and tax compliance (2011), 23. 7

8 Quadrant 1 Higher risk taxpayers Taxpayers may be placed into this quadrant because of, for example, their relative size, the nature of the transactions they undertake, their apparent effective tax rate, or their compliance history. The Commissioner noted: 'Certainty for these taxpayers is not in relation to their tax position but rather a certainty that they will be reviewed by us. Such an experience will be fair and professional but may also be quite formal and intense.' 12 Accordingly, the ATO s approach is more likely to involve the use of formal powers of information gathering, and sufficient resources will be allocated to this. Quadrant 2 Key taxpayers Most of Australia's largest businesses fall into this category. That is, taxpayers categorised into this quadrant will be large businesses which have a significant influence on the health of the tax system, and are more likely to have applied for an ATO ruling in relation to contentious tax matters. The ATO s approach to such taxpayers is more likely to involve alternative dispute resolution approaches rather than formal powers of access and questioning. Quadrant 3 Medium risk taxpayers Taxpayer s placed into this quadrant may be involved in specific risk reviews, from time to time, in which the ATO will follow up on specific issues that are of concern. These reviews are likely to be part of a compliance project involving other businesses with similar issues. Quadrant 4 Lower risk taxpayers The ATO s approach in relation to lower risk taxpayers may involve gathering targeted information about specific issues identified in the market, visits to the taxpayer, and monitoring of the taxpayer s tax activities. The ATO notes that taxpayers in this category are less likely to be contacted for additional information or have significant issues of concern requiring follow-up. How is risk assessed? Broadly, the ATO will assess a business twice a year against the businesses previous results and other data (both domestic and international), and place the business in one of the four risk categories using the following risk filter items (this list is not exhaustive): 13 your past compliance behaviour your tax risk management governance your business performance over time compared to your tax outcomes and that of your peers 12 Michael D'Ascenzo, (Speech delivered at the 22nd Australasian Tax Teachers Association Conference 2010, University of New South Wales, 22 January 2010). 13 Australian Taxation Office, The Risk Differentiation Framework, Fact sheet for large business taxpayers. December

9 issues identified by our specialist areas and intelligence gathering, particularly in regard to significant transactions that allow for opportunistic tax planning, such as a material merger, acquisition or disposal intelligence from our industry segments on industry performance and its relationship to tax risks including patterns and trends in tax performance intelligence from overseas tax administrations and from the Joint International Tax Shelter Information Centre (JITSIC) intelligence from other government agencies such as the Australian Securities and Investments Commission (ASIC) and publicly available information risks arising out of the implementation of new tax law your level of international dealings and the tax outcomes derived from such dealings over time and compared to the functions performed, assets used and risks accepted The ATO has previously sent out written correspondence to the CEOs or public officers of large businesses about their risk categorisations. Accordingly, it is important for CEOs/ CFOs to not only consider and plan for their approach to the outcome of their risk ratings on the RDF, but also to implement and monitor internal process and systems so that they may be able to positively influence their risk rating for future years. 3.3 ATO Audit Readiness Therefore, the next question the Board should be asking is whether the company is audit ready? That is, if the ATO knocks on your door tomorrow morning, are you in a position to answer the strategic and operational questions that the ATO may pose. Is the Board aware of its hot spots? Has it done enough ground work and follow-through to mitigate its exposure in these areas? We know that the ATO s primary objective is to achieve high levels of voluntary compliance with Australia s tax and superannuation laws. Australia s tax framework is based on self-assessment, meaning it relies on the community self-regulating. This has been the case since The ATO then uses its compliance model to tailor its strategies. Accordingly, it is important for the Board to understand how the ATO s Compliance Model works and how this impacts the Board and wider organisational structure (refer below for a more detailed discussion). ATO Compliance Model The ATO s compliance program describes the tax and superannuation compliance risks that they are most concerned about and what they are doing to address them. So, you actually know this information up-front before the tax year commences. In this regard, there is, in my view, a high level of transparency by the ATO. The compliance program is then structured around the major market segments as follows: individuals; micro enterprises those with an annual turnover under $2m; small and medium enterprises those with an annual turnover of $2m to $250m; 9

10 large businesses corporate groups with an annual turnover above $250m; non-profit organisations; and government organisations (although this seems to have been excluded as a taxpayer category in the Compliance Program!) The compliance model provides a way for the ATO to better understand what motivates people to comply, or not comply (refer diagram below). It recognises that taxpayers are not a homogenous group, and that their circumstances can change over time. Importantly, it provides insights into factors that influence different compliance behaviours, and assists in deciding what interventions the ATO should make. ATO s Compliance Model The model reflects the different taxpayer attitudes to compliance and the corresponding compliance strategy that best responds to each particular attitude. The model advocates a deeper understanding of taxpayers motivation, circumstances and characteristics so that assistance and enforcement actions can be tailored to promote better compliance. The ultimate aim of the ATO is to influence as many taxpayers as possible to move down the pyramid into the willing to do the right thing zone! With the right responses and interventions (including a mix of alerts, audit, penalties, advice, guidance, education, procedural change, etc), the ATO can influence taxpayer behavior. Tax Office Compliance Program for The Commissioner, in June 2012, launched the Tax Office Compliance Program for Salient highlights from the Compliance Program include: Tax abuse: Focus includes secrecy jurisdictions, refund fraud, serious evasion of GST, organised crime, superannuation, fraudulent phoenix activity and tax avoidance arrangements. Large businesses: Focus includes amendments to taxation of financial arrangements (TOFA), profit shifting transfer pricing and thin capitalization, corporate restructures including mergers and acquisitions, consolidation inappropriate outcomes, research and development claims, 14 Australian Taxation Office, Compliance Program (2012). 10

11 integrity of business systems for GST, financial and GST supplies, taxation of alternative fuels and clean energy measure fuel tax amendments. SMEs: focuses include wealthy individuals in the tax and superannuation systems, use of trusts to inappropriately minimise tax, Division 7A treatment of private company profits, capital gains, non-disclosure and incorrect reporting, employer compliance with fringe benefits tax rules, integrity of business systems for GST and excise obligations, GST and property transactions. Micro enterprises: focus areas include unrecorded and unreported cash transactions, employer obligations, GST refund integrity and GST evasion, ensuring businesses are correctly registered in the tax system, supporting businesses in meeting their lodgment obligations and incorrect fuel tax credit claims following implementation of the clean energy measure. Individuals - priorities will include: incorrect or fraudulent refunds from over-claiming and deliberate fraud, review of work-related expenses for occupations with high levels of claims, people getting caught up in tax avoidance schemes, omitted income, including dividends and interest, capital gains and foreign source income. 3.4 Prudential Tax Audits In the early 1990 s with the introduction of the self-assessment regime, it became common place for corporate groups to undertake a prudential tax audit on the group s tax affairs for, say, the last three years. These exercises were done for a number of reasons, including: making a voluntary disclosure, thus negotiating reduced penalties and interest; know what the tax issues are ( peace of mind factor); and identify tax inefficiencies and introduce new processes and procedures. Having regard to the increased audit activity, over the last few years, we have seen a return to the 1990s approach of companies undertaking tax reviews to determine their exposure, if any, to hidden tax costs. The diagram below provides an example flowchart of how the prudential tax audit process would work in practice. Broadly, this involves: the Board determining the depth and breadth of scope that the prudential audit work should encompass (i.e. specific issues versus more general review); perform initial review to verify initial scope agreed is still appropriate; assessment of preliminary outcomes; preparation of draft report for Board consideration; and finalisation of prudential review and documentation of outcomes, including areas where further work may still be required. 11

12 Determine scoping Provision of relevant financial and group structure information Provide indicative fee estimate Determine Scope of Prudential Review Prudential tax audit process Initial Review Review records and other related documentation Discuss matters with appropriate staff/client accountants Identification of high level issues Prudential Review Process Assess Preliminary Outcomes Finalise Prudential Review Report Discuss potential options Consider restructuring alternatives Finalise Prudential Review Process and Report Prepare Draft Report Material tax issues identified Determine infomation gaps Agree timeline to finalisation Meet with staff/client accountant to discuss findings Issuance of draft Pruential Review Report 3.5 Director Penalty Regime Legislation to enact amendments to the director penalty regime ( DPR ) received Royal Assent on 29 June These amendments generally apply from 30 June 2012, with some transitional provisions, and: extend the DPR to make directors personally liable for their company s unpaid superannuation guarantee charge (SGC) liabilities; ensure that directors cannot discharge their director penalties by placing their company into administration or liquidation when an unpaid PAYG withholding or SGC liability remains unpaid 3 months after its due date; and ensure that directors (and their associates) are liable to PAYG withholding tax where the company has failed to pay amounts withheld to the Commissioner. The provisions apply to all companies (whether small or large, private or listed) and to all directors, regardless of their degree of culpability. The changes significantly increase directors risk of personal liability for the relevant tax liabilities of the company and, accordingly, directors need to exercise caution to ensure that the company is meeting its tax obligations and take prompt action if it appears the company is having difficulty paying these amounts. 12

13 Mistakes about super liability The SGC liability is deemed to arise at the end of the quarter and be payable when the company is required to lodge its superannuation guarantee statement for the quarter, regardless of whether it has been assessed. The legislation provides that a director will not be liable to a director penalty relating to SGC, if the director can establish that the penalty resulted from the company treating the Superannuation Guarantee (Administration) Act 1992 ( SGAA ) as applying to a matter (or identical matters) in a particular way that was reasonably arguable and if the company took reasonable care in connection with applying the SGAA to the matter (or matters). An example may be where a company reasonably thought that a worker was a contractor and not an employee. Director penalty liability and notices The directors are liable for a director penalty ( DP ) if the company has not paid the relevant liability and has not been put into administration or liquidation on or before the day on which the liability is due to be paid to the Commissioner ( due day ). While the DP liability arises on the due day, the Commissioner cannot commence proceedings to recover the penalty until 21 days after he gives the director a DP notice. The notice is deemed to be given when it is posted to, or left at, the director s residential or business address as shown in current ASIC records, regardless of whether or when the director receives it. The commissioner can also now give a copy of the DP notice to the director s registered tax agent, as notified to the Commissioner. Further, there is no time limit for the issuing of a DP notice. Directors can no longer avoid liability by putting the company into administration or liquidation after 3 months have elapsed from the company s due date (or, in the case of new directors, from when they became a director), to the extent that the amount remains unpaid and unreported to the Commissioner at the end of that 3 month period. New directors The legislation includes amendments to ensure that new directors have the time to familiarise themselves with corporate accounts before being held personally liable for corporate debts. The period of grace for new directors has been extended from 14 days to 30 days after their appointment. PAYG withholding non-compliance tax The PAYG withholding non-compliance tax ( PWNCT ) is new and applies to directors and associates of directors. The PWNCT effectively reverses the economic benefit of credits for the director or associate in respect of PAYG amounts withheld from payments by the company to them, where the company has an unpaid PAYG withholding liability in respect of the income year. PWNCT applies to an individual who: was a director of the company on the day by which the company was required to pay the withholding amounts to the Commissioner ( payment day ) and the company did not do so; or became a director of the company after the payment day, if they are still a director (and the company has not paid the amounts) at the end of 30 days after they became a director; or 13

14 was an associate of a director on the payment day; or was an associate of a new director when they became a director and throughout the 30 day period after that time. An associate of a natural person is broadly defined, extending beyond the director s immediate family. It is not necessary for the associate to be actively involved in the company s finances, but PWNCT is only relevant for associates who are employed by (or who receive other relevant entitlements from) the company. Defences The good reason and reasonable steps defences are still available, together with the reasonably arguable position and reasonable care defence mentioned earlier. A new limitation on the availability of the good reason and reasonable steps defences now applies. They can no longer be relied upon (outside court proceedings) unless the director provides all necessary information to the Commissioner within 60 days of receiving a relevant notice from the Commissioner. This places a very high onus on the director in non-court proceedings. Implications for directors Given the potential consequences for them (and possibly their associates) if the company does not comply with its obligations to pay PAYG withholding and SG amounts, the limited defences available and the short time frames allowed, directors will need to be increasingly vigilant to ensure that the company is meeting these obligations. 14

15 4 Key tax issues in current economic times 4.1 Bad Debts Background As the current economic tightening continues, it will be imperative that businesses ensure that they are entitled to fully claim income tax deductions for any bad debts that they are proposing to write off. However, there are a number of practical conditions that must be satisfied before a bad debt deduction can be claimed, as discussed below. Deductibility criteria A deduction is allowed for debts (or parts of debts) that have been written off in an income year. 15 Section 25-35(1) states that a taxpayer can deduct a debt (or part of a debt) that you write off as bad in the income year if: (a) (b) it was included in your assessable income for the income year or for an earlier income year; or it is in respect of money that you lent in the ordinary course of your business of lending money. 16 The above deduction is also subject to the following special rules: 17 a company must satisfy the continuity of ownership or same business test rules in Subdivisions 165-C and 166-C; in the case of certain trusts, the change of control or abnormal trading rules are met (refer Schedule 2F of the ITAA 1936); a company will not be able to deduct a bad debt in various cases that may involve trafficking in bad debts (subdivision 175-C and section 63D); if a debt which has been written off as bad is subsequently recovered, the amount will be assessable (subdivision 20-A); a bad debt deduction may be reduced if some parts of the debt forgiveness rules apply (section ); and special rules apply to tax consolidated groups (Subdivisions 709-D and 709-I). Preliminary conditions A deduction is only allowable under s if all of the following conditions are satisfied: there must be a debt; 15 Section ITAA This paper will not discuss the provisions as they relate to a money lending business. 17 Section 25-35(5). 15

16 the debt must be bad; the debt must have been written off as bad during the year of income in which the deduction is claimed; and the debt must have been brought to account as assessable income. Each of these requirements is separately discussed below. There must be a debt A debt must exist in law at the time of the write-off, and the taxpayer who writes-off the debt and seeks the deduction must have an equitable interest in the debt at that time. Taxation Ruling TR 92/18 provides the Commissioner s view on section Although this ruling considers the application to the predecessor to section of the 1997 Act (being section 63 ITAA 1936), it has not been withdrawn and its principles are still relevant in determining when a debt is a bad debt for the purposes of section The Commissioner of Taxation defines a debt as a sum of money due from one person to another. This is similar to the definition of debt provided by Menzies J in GE Crane Sales Pty Ltd v FC of T (1971) 126 CLR 177 at 186, who held that debt means moneys which the taxpayer is presently entitled to receive. This does not imply there needs to be a physical provision of money from one party to the other to create the debt. Nor does the debt need to be enforceable under a contract or agreement, as an equitable entitlement to a debt will also qualify. The burden of proof is on the taxpayer to prove the existence of a debt. Mere accounting entries recording a debt are not sufficient, if in reality no debt is owed to a taxpayer (refer to Kratzmann v FC of T (1970) 1 ATR 827). The release or compromise of a debt constitutes the extinguishment of that debt. Accordingly there is no debt in existence which can be written off under section Therefore, before a release or compromise is entered into, the debt should be written off. The debt must be bad This is a question of fact which can be difficult to apply in practice. The Commissioner states in Taxation Ruling TR92/18, that the debt does not have to be totally irrecoverable for it to be bad which would only arise where, say, the debtor has died without assets or has become insolvent. However, at the same time, the prospects of recovery must not be merely doubtful. The application of this test, therefore, invariably involves some level of subjectivity. In paragraph 31 of Taxation Ruling TR 92/18, the Commissioner outlines the following situations which suggest that a debt may be bad: the debt has become statute barred; the debtor has disappeared and has no assets; if the debtor is a company, it is in liquidation or receivership and there are insufficient funds to pay the whole debt; and 16

17 on an objective view of all the facts existing at the time, the debt is alleged to have become bad, there is little or no likelihood of the debt being recovered. In paragraph 32 of Taxation Ruling TR 92/18, the Commissioner outlines a number of steps that should be taken before writing off the debt as bad, including: following up the debtor with reminder notices including telephone and mail contact; a reasonable period of time must have elapsed since the original due date for the payment of debt (in which case regard should be given to the taxpayer s specific credit arrangements); taking action to ascertain the debtor s asset position; and issuing recovery proceedings (including service of a demand notice, the issue and service of a summons, any judgement entered against the delinquent debtor, and the execution of any proceeding to enforce judgement). Although the Commissioner acknowledges that a creditor will be limited in its resources to pursue the debt, the practical reality is that the above requirements have been effectively treated by the Commissioner as a checklist that the taxpayer is expected to have ticked off before claiming a bad debt deduction. Tax Strategy The creditor must be able to show positive steps have been taken in trying to recover the debt before it can be treated as being bad. Such steps could include telephone and mail reminders, undertaking title searches to determine the debtor s asset position and issuing recovery proceedings where appropriate. The debt must have been written off as bad during the year of income in which the deduction is claimed As discussed, the debt must be written off before year end. This involves a physical writing off of the debt, although it is not essential that the debt be written off in the creditor s books of account. For example, a company may be entitled to a bad debt deduction where its Board of Directors authorise the writing off of a debt and there is a physical recording of the written particulars of the debt and the Board minutes its decision before year end but the writing off of the debt in the taxpayer's books of account occurs subsequent to year end. Alternatively, a deduction will be written off where there is a written recommendation by a financial controller to write off a debt which is agreed to by management in writing prior to year end followed by a physical writing off of the debt in the books of account subsequent to year end. The consequences of failing to write off the debt before the financial year end can be fatal. In AAT Case 5543 (1989) 21 ATR 3111, a partnership was refused a bad debt deduction where it failed to write off the debt during the year ended 30 June 1976 even though it kept books of account. 17

18 Tax Strategy It will not be sufficient that the write off of a debt is merely provided for in the accounts in order for the debt to be regarded as being a bad debt. Nor will any deduction will be allowed if the debt is written off after year end at the time the books of account are being prepared. The creditor must physically write off the debt before the end of the tax year in which the deduction is claimed. The debt must have been brought to account as assessable income The Commissioner notes that this condition pre-supposes that the creditor is using an accruals basis in recognising income for tax purposes. Taxpayers on a cash basis would not have brought the income to account until it was actually received and, accordingly, are not entitled to claim a deduction for bad debts since the amount of the debt has not previously been included in assessable income. Section 8-1 deductions It should be noted that if a bad debt is not deductible under section 25-35, it may still be deductible as a loss or outgoing under the general deductibility provisions of section 8-1 ITAA It has been held that a bad debt incurred in the course of making loans to employees was a deductible loss incurred in the course of carrying on a business for the purpose of producing assessable income where such loans were a regular part of the taxpayer s business activities (see 14 CTBR(NS)). Similarly, a debt which could not be recovered was held to be deductible under the former section 51(1) of the ITAA (1936). This case involved a building contractor who frequently placed excess cash funds with a finance company on behalf of a group of contractors. The company subsequently lost a $500,000 deposit when the finance company collapsed. The Full Federal Court held that the loss sustained was an allowable deduction under section 51(1) as the periodic investment of monies in the short term money market was an integral part of the whole business carried on by the group. This amount could not have been deducted under section because the amount was not previously returned as assessable income. If a loan has been made in a private capacity (i.e. it is not business related), a bad debt will not be deductible under section 8-1. To qualify for a deduction under section 8-1, a loan must be incurred in gaining or producing assessable income, or in carrying on a business for the purposes of gaining or producing assessable income. In addition, the loss must not be of a capital, private or domestic nature. Such a loan would not be regarded as an ordinary incident of the taxpayer's income earning activities, and would also be excluded from deductibility under the private and capital exclusionary provisions under paragraph 8-1(2)(a) Refer to ATO Interpretative Decision ATO ID 2001/301 for further details. 18

19 Capital loss opportunities Section ITAA 1997 provides that capital losses made from personal use assets are to be disregarded in working out the net capital gain or capital loss of the creditor. Subsection (2) (d) provides that personal use assets include, amongst other things, debts arising other than in the course of gaining or producing assessable income or from carrying on a business. Accordingly, if a debt has arisen other than in the course of gaining or producing the creditor s assessable income or carrying on the creditor s business, the capital loss arising upon cancelation of the debt will not be available to be offset against capital gains. This would also include, for instance, interest-free loans made for private or domestic purposes. It could also cover interest-free loans made to business or investment holding entities where the lender will not be receiving a dividend or distribution. In addition, due to the non-business nature of such loans, they can never be, by definition, capital expenditure incurred in relation to a past, current or future business, as required by subsection (2) ITAA 1997 and, therefore, cannot be amortised as black hole expenditure. Conversely, business related loans can be taken into account in working out the amount of a capital loss. This also automatically precludes the operation of section for any business related bad debt, on the basis that you cannot deduct anything under Section (i.e. the Blackhole provisions) for an amount of expenditure incurred to the extent that it could be taken into account in working out the amount of a capital loss. 4.2 Debt Forgiveness Background Prior to the introduction of the commercial debt forgiveness rules, 19 there was a lack of symmetry between the tax implications arising in relation to a debt forgiveness for a debtor and creditor respectively. In most cases, a debt forgiveness would have no tax consequences for the debtor as it merely relieved the debtor of a liability which would not be assessable income according to ordinary concepts. Conversely, the creditor could typically claim a deduction or capital loss in relation to the forgiveness of the debt. Broadly, the commercial debt forgiveness provisions in Division 245 of Schedule 2C ITAA 1936 were introduced to address this lack of symmetry. These provisions aim to tax the economic benefit of the debt forgiven. In these circumstances, the debtor will typically book an accounting entry debiting the debt liability and crediting the profit and loss account. Instead of treating such a book profit as assessable, the above provisions progressively strip the debtor of various tax attributes by reducing, in order, the debtor s prior year revenue losses, carried forward capital losses, various undeducted expenditures and the cost base of certain CGT assets. The end result is that tax will eventually be borne by the debtor as there will be less deductions and asset cost bases to reduce future assessable income or capital gains the debtor may derive. 19 The commercial debt forgiveness rules were introduced effective 27 June

20 To compound matters these provisions are also extremely complex, and are often inadvertently triggered by taxpayers especially small to medium sized entities. It is therefore crucial to identify their potential application, and any strategies which minimise their impact. Debt A debt is defined to be an enforceable obligation imposed by law on a person to pay an amount to another person, and expressly includes any accrued interest. Prima facie the definition is very wide and would apply to any scenario where a person is obligated to repay an amount. However, it does not apply to an amount which would be regarded as a debt waiver benefit under section 14 of the Fringe Benefits Tax Assessment Act Nor will it apply where the amount payable under the debt is included in the debtor s assessable income. Hence, any amount lent by a private company to a shareholder or an associate of a shareholder which is an assessable deemed dividend under section 109D of Division 7A ITAA1936 will not be treated as a debt under these provisions. Assuming neither exclusion applies, it is then necessary to determine whether the debt constitutes a commercial debt. Commercial Debt A debt is a commercial debt if any interest paid or payable on that debt would have been allowable under the general deductibility provisions of section 8-1 ITAA Moreover, interest free debt will also be regarded as being commercial debt if such interest would have been deductible had it been charged. In applying this test any other provision denying interest deductibility is ignored including, amongst others, the thin capitalisation and capital protected loan provisions. The above rules also apply to amounts in the nature of interest such as discounts on commercial bills, and to amounts paid on non equity shares such as a cumulative redeemable preference shares. However, commercial debt excludes private loans. Where an individual borrows funds to finance the purchase of a holiday home, there will not be a debt forgiveness if that private loan is subsequently forgiven as no interest charged on the loan would have been deductible. Similarly, borrowings which have been applied to generate exempt income or non-assessable non-exempt income will not be treated as commercial debt since any loan interest paid or payable would not be allowable. Where the commercial debt test has been met it will be necessary to determine whether there has been a debt forgiveness. Tax Strategy An UPE owed by a trust to a beneficiary will not be a debt where the amount is not a returnable amount under Taxation Ruling TR 2005/12, being an amount to repay trust capital or a beneficiary loan, or an amount that has been used by the trust to finance its income producing activities. 20

21 4.2.1 Debt forgiveness A debt will be forgiven if it is released, waived or extinguished. This will typically occur under a deed or agreement. However, Heerey J held in the recent Federal Court decision of Tasman Group Services Pty Ltd v FCT (2008) FTC 23, that a debt waiver can also be inferred from the creditor s conduct. Accordingly, a creditor may abandon a right of recovery where they act inconsistently with that right. Thus, if a debtor unilaterally books a debt forgiveness in its accounts and the creditor does not seek to collect that amount, then such conduct may constitute a debt waiver. A debt forgiveness may also occur where: the debt is irrecoverable due to the operation of a statute of limitations as a forgiveness will arise when the creditor s right of recovery expires at the end of the relevant period. The period of time over which such a debt may become statute barred is typically 6 years but can be as low as 3 years in certain jurisdictions; the debtor and creditor agree that the obligation to repay a debt will cease at a future time without the debtor incurring any financial obligation (other than for a token payment) in which case the debt is forgiven when the agreement is entered into and any later forgiveness is ignored; a creditor assigns its rights to receive repayment to a new creditor who is an associate of the debtor, or the debt is assigned under an agreement to which the new creditor and the debtor are both parties. In either case, the debt will be taken to have been forgiven at the time the debt was assigned except where the debt was acquired by the new creditor in the ordinary course of trading on the securities market; and a person subscribes for shares in a company to enable that company to repay a debt it owes to that person. The amount paid from the share capital subscribed will be taken to be the amount forgiven at the time it is so applied. Thus, a creditor cannot pump in additional capital to a related debtor company so that it can repay its debt and avoid the application of these provisions. However, there will not be a forgiveness if the wavier of the debt is effected under a will or a bankruptcy law, or occurs for reasons of natural love and affection. In practice, the latter exemption has been narrowly interpreted by the Commissioner of Taxation. Whilst ATO Interpretative Decision ATO ID 2003/589 found that a company can forgive a debt for reasons of the natural love and affection a director feels towards the debtor, it is not likely that it will be applied by the Commissioner other than in extraordinary circumstances (especially given the limited facts set out in the Interpretative Decision). Calculation of net forgiven amount The next step in applying the provisions is to calculate the net forgiven amount (if any) of the debt. Notional value The start point is to determine the debt s notional value. This will usually be the debt s face value at the time of the forgiveness assuming the debtor was able to pay its debts at the time the debt was both incurred and forgiven. This is because the provisions ordinarily assume the debtor was solvent at the time the debt was incurred and continues to be solvent at the forgiveness time. 21

22 However, where the parties are not acting at arms length when the debt is incurred there will be no assumption of solvency in which case the value may be for a lesser amount. Hence, if a loan is made to a wholly owned insolvent unit trust it will have a notional (and market) value which will likely be much less than its face value. This market value substitution rule dovetails with the CGT cost base provisions in section ITAA 1997, which give the creditor a market value cost base in the debt where the parties have not acted at arm s length. The rationale for this treatment is that it should apply where the creditor has a cost base in its asset (being the debt) that has been reduced under the market value substitution rules, as the creditor will commensurately realise a lower capital loss. Tax Strategy Check whether the debtor and creditor were dealing with each other at arm s length when the debt was incurred. If they were not and if the debtor was not solvent when the debt was incurred, then the notional value of the debt could be limited, which will limit the application of the debt forgiveness rules. Consideration The debt s notional value will then be reduced by any consideration provided by the debtor at the time of the debt forgiveness being any cash paid and/or the market value of any property provided. It may also be reduced by deemed consideration equal to the debt s market value where there is no consideration in respect of the forgiveness, the consideration cannot be valued, or it is greater or less than its market value and the parties are not acting at arms length. In practical terms this means that where there is a non arms length forgiveness involving related parties (e.g. as between family businesses), the notional value may be reduced or extinguished under this deeming rule if the debt has significant market value. In order to ensure symmetry, section TAA 1997 contains a corresponding market value substitution rule which deems the creditor to have received market value consideration in each of the above three scenarios thereby reducing the creditor s capital loss. The market value substitution rule under the debt forgiveness provisions only applies where the creditor was a resident or the debt is taxable Australian property. Tax Strategy Check if the debtor and creditor were dealing at arm s length when the debt was forgiven. If they were not dealing at arm s length at the time of forgiveness, then the consideration could be deemed to be the market value of the debt. If the debtor was solvent at the time of forgiveness, this market value could be close to the face value of the debt, in which case the debt forgiveness rules will have limited application. 22

23 Finally, where the debt forgiveness has arisen due to a debt for equity swap involving a company, the consideration will be the market value of the shares subscribed for under the swap. After applying actual or deemed consideration against the debt s notional value the resulting balance in known as the gross forgiven amount of the debt. This in turn is reduced by any amount that is included in the debtor s assessable income or which reduces a deduction or the cost base of a CGT asset as a result of the debt forgiveness. For example, the forgiveness of a debt owed by a shareholder to a private company may result in the shareholder deriving an assessable deemed dividend under section 109F ITAA 1936, which will be applied to reduce the debt s gross forgiven amount. This gross amount will also be reduced where an intra group election is made between debtor and creditor group companies under common ownership, who agree that the creditor who will forego a capital loss or deduction in exchange for the gross value of the debt forgiveness being reduced by a corresponding amount. The agreement must be in writing and signed by the public officer of each company. It must be made by the earlier of the date of lodgement of the creditor or debtor s tax return for the year of forgiveness. Net Forgiven Amount After applying all the above steps, any remaining balance will be treated as the net forgiven amount of the debt which must be applied against the debtor s tax attributes. Application of the net forgiven amount After applying all the above steps any remaining balance will be treated as the net forgiven amount of the debt which must be applied against the debtor s tax attributes. Reduction of Tax Attributes A debtor must progressively offset the total net forgiven amount against the following tax attributes at the commencement of the income year in which the forgiveness takes place: prior year revenue losses; carried forward net capital losses; deductible expenditures including the opening adjustable value of depreciating assets, the balance of unclaimed borrowing costs, unclaimed prepaid expenditure and certain unclaimed expenditure on Australian films and research and development expenditure; and the cost base of certain CGT assets excluding pre CGT acquired assets, assets disposed of prior to 27 June 1996, personal use assets, main residence, trading stock, CGT assets which are subject to the deductible expenditure rules, rights relating to a superannuation fund or an approved deposit fund and goodwill. 20 Each category of tax attribute must be fully exhausted before the net forgiven amount is applied against a subsequent category of tax attribute. If there is a balance after applying the net forgiven amount against all of the above attributes, that amount expires and is not otherwise assessable. Debtors can also choose what items are reduced within each set of tax attributes. For example, debtors may choose which revenue losses are offset against the net forgiven amount and thus can 20 Section to ITAA