Forgiveness. Ceasing of Rights to Sue. Agreements to Forgive with Effect from a Future Time. Debt Parking. Share Subscription to Enable Repayment

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1 !"## Refer to ID 2003/27 for full details of the decision. In addition, an overview of the commercial debt forgiveness provisions is provided below. The Forgiveness of Commercial Debt provisions apply to debts forgiven after 27 June 1996, subject to transitional rules in relation to debts forgiven under an agreement or arrangement entered into before that date and evidenced in writing. $%& # The provisions aim to tax over a period of time, an economic benefit derived by a debtor on forgiveness of a commercial debt. This is achieved by reducing, in order, the following tax attributes of the debtor: prior year revenue losses; accumulated capital losses; various undeducted expenditure; and capital gains tax (CGT) asset cost bases. The policy justification for the debt forgiveness rules is based on an assumption that both the debtor and creditor have typically had the benefit of capital losses or tax deductions in relation to the same amounts. Where debts between companies under common ownership are forgiven, the companies may elect to reduce any debt forgiveness exposure if the creditor forgoes a capital loss or income tax deduction. '%!"##( # Fairly obviously, the Forgiveness of Commercial Debts provisions will only apply where there is a commercial debt that has been forgiven. The concepts of commercial debt and forgiveness are therefore fundamental. Debt is defined as an enforceable obligation imposed by law on a person to pay an amount to another person. Broadly, a debt will be a commercial debt if any interest paid or payable is deductible. An interest-free debt will also be a commercial debt if a deduction would have been allowed, had interest been charged. The concept of commercial debt has the effect of excluding the forgiveness of private debt. Where an individual borrows money for private purposes, for example, to acquire a home or non-income producing asset, the provisions will not apply on any forgiveness of that debt.

2 Forgiveness The debt forgiveness rules provide that a debt is forgiven if the debtor s obligation to pay the debt is released or waived, or is otherwise extinguished. Extinguished is defined as not including a full payment in cash. Any other termination of debt, even between arms-length parties and on arms-length terms, is potentially a debt forgiveness if a debt is settled otherwise than fully in cash. As the net forgiven amount (to which the provisions apply), is reduced by consideration, the provision of non-cash consideration having a market value equal to the debt, will nonetheless eliminate any debt forgiveness exposure. This is discussed further below. Ceasing of Rights to Sue A debt is also taken to be forgiven if the period within which the creditor may sue for recovery, ends due to the operation of a statute of limitations. As a result, where a creditor can no longer sue for recovery, a debt forgiveness is taken to occur. Agreements to Forgive with Effect from a Future Time Where the debtor and creditor agree that the debtor s obligations to pay the debt will cease at a particular future time without the debtor incurring further obligations (other than to a nominal or insignificant extent), the debt is taken to be forgiven when the agreement is entered into. Any subsequent forgiveness is ignored. The explanatory memorandum (EM) of Act No , refers to situations where a debtor is effectively released from the obligation to pay the debt notwithstanding the existence of arrangements which imply that the debt remains on foot. The EM also refers to parties not acting at arms-length and agreements that the debtor will not pay, or will pay only a token amount. Debt Parking Debt parking deals with a situation in which a creditor assigns its right to receive repayment to another person where: the new creditor is an associate of the debtor; or the assignment occurred under an agreement or an arrangement to which the debtor and new creditor were parties. In either case, the creditor is taken to have forgiven the debt. Share Subscription to Enable Repayment A deemed forgiveness also occurs where a person subscribes for shares in a company to enable the company to repay a debt. The amount of the debt paid out of the share capital subscribed is taken to be forgiven. Exclusions The legislation provides for a number of situations in which the rules will not apply, including where: the forgiveness is effected under an Act relating to bankruptcy (the corporate equivalent of liquidation is not covered) ; the forgiveness is effected by a will; or the debt is forgiven for reasons of natural love and affection.

3 %)!"$ The net forgiven amount is a threshold concept. It is the amount by which the tax attributes (prior year losses etc.) of the debtor are reduced as a result of the forgiveness. What could be a straightforward concept is grossly over complicated in the legislation. Essentially, the net forgiven amount is determined as follows: the notional value of the debt is determined; any consideration given for the forgiveness is subtracted to arrive at the gross forgiven amount; the gross forgiven amount is reduced by any assessable income, or reduction in allowable deductions or CGT cost bases otherwise resulting under ordinary provisions; and the remaining debt is reduced if the debtor and creditor are related companies (intra-group debt) and the creditor elects to forgo a capital loss. Notional Value Broadly, the notional value of a debt is the value of the debt at the forgiveness time, assuming that the debtor is able to pay their debts as and when they fell due. Put simply, the notional value is typically the face value of the debt. There are, however, adjustments that will apply in some cases where the value is affected by market variables, including changes in interest and foreign currency rates. There is also a deemed market value provision that applies where the debtor and creditor were not dealing at arm s-length when the debt was incurred. In such cases, the assumption that the debtor was able to pay all their debts is removed, which may reduce the notional value of a debt. That is, where a loan is made on nonarm s terms to a company that is insolvent, the notional value of the debt may be its market value (below face value). As a result, the potential debt forgiveness exposure is reduced. The justification for the above approach is that the lender (creditor) would also be denied a capital loss under capital gains tax rules due to the non-arm s length transaction. The policy is that (to the same extent) the debt forgiveness provisions will not apply to the debtor. Special rules apply when in calculating the notional value of non-recourse debt and debt that has been subject to debt parking provisions. Deemed Market Value The deemed market value rules which, in the author s view, will affect many clients apply as follows. If there is no consideration in respect of a debt forgiveness, the consideration cannot be valued, or is greater or less than market value, and the parties have not dealt at arm s length, there is deemed consideration equal to the market value of the debt. What this means is, for non-arm s length parties, such as related entities or family members, the potential debt forgiveness exposure may be reduced in many cases, even where there is a forgiveness for no consideration if the debt has a significant market value (the debtor has capacity to repay). For example, there should be no debt forgiveness exposure if a loan exists between parties A and B, and, despite B s capacity to repay, the debt is forgiven. If B had no capacity to repay, the debt forgiveness provisions would apply, as deemed consideration is limited to the market value of the debt. This treatment is again consistent with CGT deemed market value rules, which would typically prevent a capital loss to the creditor. It is also consistent with the intra-group election discussed in E. Grouping Issues.

4 * %$()!"$ # The legislation provides for the reduction of tax attributes by the total net forgiven amount for a particular year. Broadly the net forgiven amount is to be offset against tax attributes in the following order: revenue losses; net capital losses; undeducted expenditure; and CGT cost bases of certain assets. Each category of tax attributes must be fully exhausted before reduction of the next. If the net forgiven amount exceeds all tax attributes of the debtor, any balance expires without tax implications, subject to debt forgiveness grouping rules discussed below. Revenue Losses The types of revenue losses that may be impacted by the debt forgiveness rules are, broadly, general domestic, film, primary production and foreign losses. The debtor has the ability to choose the order in which various categories of losses are reduced, and the amount of such reduction. If the debtor fails to make a choice, the Commissioner will choose. An obvious planning opportunity arises. Taxpayers with a variety of losses would be advised to offset the net forgiven amount against losses that are quarantined (and therefore less readily available) such as film and foreign losses. Net Capital Losses In relation to net capital losses, only ordinary capital losses and listed personal use asset losses will be impacted by the debt forgiveness provisions. Non-listed personal use asset losses are not affected. Again, the taxpayer can choose the order and extent of adjustments. One would advise clients to forgo netlisted personal use asset losses (if any) first, due to the similar quarantining. Deductible Expenditure Deductible expenditure refers to a broad range of amounts incurred in prior years and carried forward. Most notably, depreciation, borrowing expenses, building write-off deductions, certain pre-paid amounts, capital costs of acquiring intellectual property and a variety of other items including certain primary production and film amounts. Again, taxpayer choice in reducing tax attributes provides planning opportunities. Taxpayers should offset the carry forward expenditure that is least likely to be recouped or has the slowest write-off period. Net forgiven amounts, which are offset, are treated as amounts allowed as a deduction in prior years. As a result there may be implications on future asset disposals (e.g. depreciation balancing charges). Diminishing value method depreciation calculations will also be affected. CGT Cost Bases Any remaining balance is offset against the CGT cost bases of certain assets. Again, there is taxpayer choice, so one would choose assets that are least likely to be disposed of, or least likely to result in gains. Conceivably, this can give rise to both timing and permanent CGT differences. There are various excluded assets that will not be affected (CGT cost bases cannot be reduced), for example, pre-cgt assets, sole or principle residences, goodwill, trading stock and certain other items.

5 + Where a taxpayer s CGT reducible assets include investments in associated entities, those cost bases may only be reduced as a matter of last resort. The maximum reduction in relation to each asset will be its reduced (not indexed) cost base. %,!-## # The debt forgiveness rules allow companies under common ownership, to make an election to reduce the net forgiven amount, where the creditor is prepared to forgo a capital or revenue loss otherwise incurred on the forgiveness. Secondly, where a debt is forgiven, and the debtor is a member of a group under common ownership, the forgiveness can impact group companies (other than the debtor) that have deductible revenue or capital losses. In such cases, the impact of the debt forgiveness is allocated (prorata) among the loss companies, and tax adjustments then apply to each company in the usual way..!# &,!# Further details are available at the following link: ((/##-0$#1.23## The Full Court of the Federal Court in FCT v. Mochkin [2003] FCAFC 15 considered some important aspects of personal exertion income and structuring issues. The taxpayer entered into a sharebroking arrangement with a stockbroking firm, Bridges Son & Shepard Ltd (Bridges). Bridges demanded indemnity from the taxpayer for losses arising from defaults with Bridges made by some of his clients. Bridges sued Mochkin, which resulted in Mr Mochkin making various payments to compromise the matter and release him from liability. Shortly thereafter, the taxpayer entered into another arrangement with another stockbroking firm. This time he put in place a different structure, namely, his family trust would have the arrangement with the stockbroking firm. Very soon that family trust business was quite successful and had significant assets. As a result, and in order to protect those assets, a second family trust was set up to take over the carrying on of the business in agreement with the stockbroking firm. The taxpayer refused to personally guarantee the obligations of the family trust under the new arrangement. This was an important factor. Agreements between the family trust and stockbroking firms were terminated and new agreements were entered into. Each time the same set of factors was present, namely the arrangement was with the family trust and the taxpayer did not provide any personal guarantees. The family trust returned its earnings from the stockbroking business in its net income and distributed that income to the taxpayer and other beneficiaries, including charities. The Commissioner assessed the taxpayer on the whole of the brokerage income in each year. The Commissioner argued that the income was personal income or alternatively that Part IVA applied. The Commissioner identified the scheme to cover the use of the family trust to receive the payment from each stockbroking firm for personal services of the taxpayer. The case also dealt with the receipt of commissions for a placement of Great Central Mines shares. Given that this placement was conducted solely by the taxpayer and that the commission related specifically to the placement, the Courts held that the commission was properly derived by the taxpayer. The Court at first instance found that the income was derived by the family trust and not by the taxpayer. The findings of fact showed that the operations of the family trust were more than a one person business and therefore the income was not wholly due to the personal exertion of an individual. The Court held that the legal source of the income was by contract and thus was derived by the family trust.

6 4 As to the Part IVA issue, the Full Court agreed with the earlier Court that the dominant purpose was to avoid personal liability and not to divert personal income to the trust. The Court noted that the case was not one where a taxpayer simply substituted a corporate entity to derive income from the provision of his own services. The Court noted that there were tax benefits of the structure, however the prevailing or most influential purpose was to avoid the possibility of personal liability. Accordingly the Court held for the taxpayer in relation to the major issue being the business conducted through the family trust. The decision was that the income was trust income (not personal income of Mr Mochkin) and that Part IVA did not apply. The Court did, however, hold for the Commissioner that the payments of commission for brokerage of the Great Central Mines shares were properly assessable to the taxpayer as personal income, and accordingly Part IVA applied to that arrangement.,&!&. 5 0 # Tax Office audits have revealed a general lack of understanding of the requirements involved when using the margin scheme to sell properties. In some cases, the Tax Office has identified genuine misunderstandings of the approach required and mistakes have been made in the valuation process. Other taxpayers have not followed any of the required approaches and simply estimated the value of the property, often without any supporting documentation. Not surprisingly, many of these casual estimations have resulted in a nil margin and nil GST payable. 0 6 Following a consultation process with professional associations, the Commissioner announced that businesses that had elected to use the margin scheme, but had not used a valid valuation, would now be given the choice of: substituting another existing valuation if one is available (e.g. an existing ratings value of the property); obtaining a new valuation (e.g. by engaging the services of a professional valuer); or defaulting to calculating the margin as the difference between the selling price and the original purchase price. The Commissioner also stated that, under this approach, no penalty will apply in cases of genuine misunderstandings or honest mistakes. It is also understood that the Tax Office will conduct an education campaign for businesses on its new approach, including the development of a public ruling in the form of a fact sheet. The Commissioner said that because this issue may continue to arise in the future, the Tax Office is not imposing any time limits on the application of this approach. However, he warned that Tax Office audits have also identified cases in which taxpayers have sought to retrospectively substitute higher valuations in order to reduce the margin on which GST is payable and generate GST credits. Where a valid valuation has been used to establish the original margin on which GST has been paid, the ATO will not accept later revisions of that valuation in any circumstances, the Commissioner said.

7 7,8)# Please refer to case [2003] AATA 342 for full details. 3# ($!# Refer to AAT Case [2003] AATA 265, Re Fraser and Secretary, Dept of Family and Community Services < Refer to < 9 /2 : Subscribers are invited to submit topics for articles for future publication. Information should be sent to: Publisher The Report Thomson Legal & Regulatory Limited ABN trading as CPD (Centre for Professional Development) 35 Cotham Road, Kew Vic 3101 Tel: (Free Call) or (03) Fax: (03) cpd@thomson.com.au Web site: