3 | Commercial Debt Forgiveness

[Music] You are listening to Australia's Tax News podcast. Tax talks. The podcast for Australian Tax Professionals. [Music] Welcome to episode three of Tax Talks. This is Heidi Robson. How to treat forgiving a commercial debt for tax purposes? I ask Robert Campbell who is a tax advisor and also a lecturer at the Tax Institute in Sydney. Here's his answer. Well for the borrower, generally speaking, the forgiveness is not accessible, which is good because if someone is being released from a debt, then it probably means they're in a rather perilous financial position and burdening them with some sort of accessible profit will probably give them a tax bill that they cannot pay. However, the tax laws doesn't mean that they get off the hook-scot-free. There is a tax consequence that will ultimately lead to more tax being paid as a result of the debt forgiveness, but just not at the present point in time. Laws in question are contained within Division 245 of the 1997. And they start by requiring that we have some type of debt, which is a commercial debt. And that is a debt where there is deductible interest, payable on that debt, or if the debt is interest-free, assume that there was interest that was payable. And if so, if that interest would give you a tax deduction, then it would be a commercial debt. So anything that doesn't fit this definition of a commercial debt falls outside of the commercial debt forgiveness provision. So if someone is, for instance, some family members were to lend someone a bit of money to help pay a deposit on a house and then subsequently forgive that, assuming that house wasn't an investment property. So it was just a private residence, then we wouldn't have a commercial debt. However, if it were for the purposes of investing, putting into a business or investing in the property or something, then we would have a commercial debt because the interest would be tax deductible. Now, once we have identified that we have a commercial debt, we then have to identify whether or not that debt has been forgiven. Now, a debt can be forgiven in a number of different ways. The first way, the most plain vanilla way, is that the debt is somehow released, waived, or otherwise, extinguished, but without full repayment of it. Now, it could be due to an agreement between the different parties involved, that this debt be released. It could be through other means as well. Now, there is a couple of statutory extensions to what is a debt forgiveness. The first is where a debt has become statute barbed, and that depends upon which state you're in. But basically, a means of debt has become that old. You cannot sue for recovery of that debt. So if someone has let a debt go for that long, where it cannot be recovered in the court system, then it is for all intents and purposes under the tax system treated as being forgiven. What time frame are you talking about? Depends on the state. So a debt in New South Wales and Victoria is taking to be statute barbed once six years has passed. Now, it isn't six years within the date of the original lending, or the original making of the debt. It is within six years that the debt was last acknowledged by the borough. So, for instance, if you have a borough who's issuing financial statements, where that debt is clearly denoted on that financial statement, that could be taken as being acknowledgement of the debt still in existence. Alternatively, they can acknowledge that the debt still exists by simply writing a letter. Let writing a letter to the lender, acknowledging that yes, we did borrow this money, and yes, we still owe it to you. That's enough to reset the six-year time limit. If the borough knows, they could just stay quiet. Exactly. So if the borough tries to just stay quiet about the debt, then potentially it could become statute barbed. It doesn't necessarily mean it is, and this is a debt recovery issue, not a tax issue, but part of it could be that if the original debt was in writing, like a bank loan, then I don't believe it becomes statute barbed after six years. I don't believe there needs to be this acknowledgement. Now, the next scenario is where forgiveness can arrive. Is in a scenario known as debt parking, and that is where the debt is reassigned to a related party, where both the lender and the borrowers were both partied to the arrangement. So with debt parking, we're looking at a scenario where the new lender is an associate of the existing borough. So it's where the original lender has reassigned their rights to receive the debt to another party, and that other party is somehow related to the borough. Why would they do that? Maybe as part of a group restructuring or some. Yeah, it could be some type of group restructuring, or it could be an arrangement, where you have a company that is in trouble, and you might have a large investor, or you might have a holding company overseas, and it's basically buying out the lender. If it's buying out that lender, then there could be a debt forgiveness scenario. An example could be if we had a multinational owning a subsidiary in Australia that had raised money from some sort of investor or consortium of lenders or something like that. The business fell on hard times, and the holding company, the parent company, didn't want the Australian subsidiary to collapse, that it went out and it purchased that debt from the lenders. Now, that purchase of the debt could be taken to be a debt forgiveness. So it does look at the market value of that debt at that time. So basically, if that debt was not worth its face value, we could very well have a debt forgiveness scenario. And the final scenario where you can have a commercial debt forgiveness is where you have a lender who actually subscribes for shares in the debtor company, and that subscription enables the repayment of the original debt. It's almost a debt for equity swap, but there is actually a cash transaction behind it. Cash goes to the borrower as a subscription of shares, and then comes back to the investor, to the lender, as a repayment of their original debt. Again, that type of transaction doesn't automatically mean there's something forgiven. It depends upon the market value of the shares which you issued at that time, and the market value of the debt. So once we have established that we have firstly a commercial debt, and then a circumstance where that debt is forgiven, then we need to work through the debt forgiveness exemptions. So there are a number of exemptions from the debt forgiveness provision. And exemption means that the forgiveness won't be taxable. The impact of the forgiveness won't have any tax impact, yes. And so the first scenario is that there is a debt waiver for interbenefit. So naturally there has been a for interbenefit tax impost as a result of the debt forgiveness, so there's no need to have an income tax consequence. It has already been captured by our tax system in one way, shape or form. Another way is if it's included in accessible income, including if it's accessible under the division seven A. So if you have a forgiveness under division seven A, then we don't have a double up under the commercial debt forgiveness. Again, the tax system somewhere has dealt with it. It doesn't need to deal with it again. Third way is under bankruptcy. So again, if someone is personally made bankrupt, the tax system doesn't want to try and hit them up with further imposts as a result of debt forgiveness. Bankruptcy does not include administration, receivership or liquidation. So it's personal bankruptcy only, not corporate. Commercial debt forgiveness that results under a will. So if someone under a will has been relieved of their debts by the deceased, then that is not treated under the commercial debt forgiveness provisions. Same thing with commercial debt forgiveness by reason of natural love and affection. Excuse the slightly unusual term for our tax system. And that's a scenario where as it would be some sort of family member or partner forgiving a debt. Now the tax offers do have some literature on this in terms of if a company had lent money to someone, can it forgive the by-reads the reasons of natural love and affection. And the tax offers believes it can. Seriously. Seriously, I believe you'd be very careful in that circumstance. And I believe if you've got a private company you forgiving debts to someone by way of natural love and affection. I would have thought you'd more likely have Div7A type issues instead, but a company not through itself, but through its directors and shareholders can forgive a debt of a breeze of natural love and affection. And also interestingly enough, the release of tax debts is not a commercial debt forgiveness, so that's very handy. Not that the tax office is a very forgiving. Now there is another case or another arm to commercial debt forgiveness and that is where there can be circumstances where a commercial debt or the release of that debt is actually accessible income. So we do have a case from many many years ago during the 80s called Warner Music Australia. And in this case the taxpayer was accruing sales tax as a result of selling cassette tapes as we listen to music back then. And it had deducted these accrued sales taxes despite the fact that it wasn't satisfied that it had to pay them. And long story short, Warner Music was successfully not having to pay some or all of its sales tax. I believe they didn't have to pay they had to pay some but not all. And Warner Music argued well it claimed a deduction for the full amount and that the release of what it didn't have to pay was not accessible. And according to that case found that where there is an intimate connection between the release of a debt and the taxpayer's business that it should form part of ordinary income and therefore not fall within the commercial debt forgiveness provisions. If we're saying commercial debt forgiveness does not result in accessible income then what is the implication? Well what it does and I and if you remember I touched on the fact that it does have a longer term implication to it. So the government is trying to call back tax on debt forgiveness but not immediately at the outset because again you're most likely dealing with a very distressed taxpayer giving them some form of accessible profit at the beginning will probably just tip them back over the edge again. Once we've worked through the whole legislation we've identified that we have a commercial debt and that it's been forgiven and we've worked at the value of that debt and we've concluded that the value of the debt is more than what was paid to extinguish it if any. Then that amount is known as the net forgiven amount and then this net forgiven amount is applied against the certain tax attributes of that taxpayer. So we take certain tax attributes and we reduce them by the net forgiven amount. Now the first thing we reduce is the opening value of any tax losses that you have. So if you have tax losses then your value of your tax losses will be reduced by your net forgiven amount. If you have more net forgiven amount then tax losses then we move on to the second thing which is capital losses. So again if you've exhausted all your tax losses or you didn't have any tax losses we then turn to capital losses. Now if we haven't anything left over after reducing our capital losses by our net forgiven amount we then have to apply our net forgiven amount against future tax reductions. Now these include the cost base of the appreciable assets, the adjustable value of your depreciating assets. The closing written down value of any capital work so the division 43 amounts get reduced. Any borrowing costs that you have will be reduced and some one point which is really really significant is any R&D deductions that you have will be reduced by this net forgiven amount at this third stage. So if we've used up our losses and capital losses we then look to these future deductions including R&D deductions. And the reduction of those reductions will happen no matter whether that had anything to do with those assets or those. Absolutely. Absolutely. Absolutely. So it doesn't have to be that the loan boss for that asset or. No. And then lastly so if all else fails or we still haven't that forgiven amount left over then the only other thing we can go after or the tax system can go after is the cost base of your CGT assets. So if you have any capital gains tax assets good will shares property etc the cost bases are to be reduced by our net forgiven amount as well. Now if for some reason you still haven't amount left over or if all of these figures were zero you had none of these attributes then the commercial debt forgiveness in essence has no implication to you. But there'll be very few tax payers I would imagine that would have absolutely none of those. If you're looking at a typical corporate scenario where there's debts being forgiven most commonly you will see tax losses in there. If they've got debts and they can't repay them chances are they've been building up losses as a result. So that's normally the first one. Getting down to that third point your future tax deductions in practice I've rarely gotten there because usually there are so many tax losses sitting there but that said I have had one scenario where we have gotten to our third stage we have gotten down to looking at depreciable assets and we had one client their depreciable assets got completely wiped out all the future value of their depreciation. The depreciable assets was now became zero. Now given that they had no tax losses and now they wiped out their depreciation it meant that going forward their future tax impost were much higher. No depreciation no tax losses so the amount of income tax they're paying at the corporate level would therefore be much greater. Now where you have a group of companies and you've got one member of the group forgiving alone to another member of a group you can elect. So both parties can elect, it's a quarter two forty five ninety election, to disregard the commercial debt forgiveness provisions as long as the lender foregoes a capital loss or a tax deduction for what they are forgiving. So in other words if the lender chooses not to take any loss on forgiveness then there's no implication to the borrower which is fair enough but only a group of related companies can make that election. Now if we're in a tax consolidated regime and we have two parties both under a consolidated group forgiving a debt from one to another under the single entity rule this is an intergroup to transactional and is therefore eliminated disregarded so we don't have a commercial debt forgiveness in that instance and the only other thing to note that with the net forgiven amount if we are dealing with a partnership then once we go through the four tax attributes that are reduced if we have anything left over at all that amount gets divided up to the partners themselves and so the partners individually will have some sort of residual net forgiven amount that they will then have to seek or look at applying against their own personal tax attributes. So how is the natural given amount actually calculated? So the net forgiven amount is calculated via a two-step process so firstly you have to ascertain the market value of the debt at the time of forgiveness. Now that sounds more complex than what it is because if we're forgiving a debt and we're at the time where the borrower can't repay so that debt probably isn't worth very much however there are various assumptions the legislation makes including that the capacity to repay the debt at the time of forgiveness was the same at the time of the original making of the debt, the original lending and secondly that at the time the debt was originally lent that the borrower was solvent and had that capacity to repay the debt. So it really does take it back to almost face value of the debt. There is a second approach which is basically the same but it removes any impact of variables that could fall into the mix such as forex rates. If we're dealing with a debt that's in a different currency our debt is going to move up and down in value when we look at valuing things in Australian dollars. So the second approach is to remove these market variables from the mix. And does use the foreign exchange rate at the time the debt was entered into? Yes so that we've got consistency. That could mean that we end up having two different figures and one could be better than the other. So we can choose as to which one we adopt if the market variables have pushed the market value of the debt down then we can use our first method but if the market variables have to push the market value of the debt upwards from its face value, that we can take the second approach. So there is a bit of wiggle room there. Now the next step, once we determine what was the original debt, or what was the value of the debt, the gross value of the debt, we then have to subtract the consideration that was paid in respect of their forgiveness. Now, generally that would be fairly straightforward. If there was an agreement that if I lent you $100 and I then agreed that if you give me $60, we'll call it even, that the original debt was $100, or the market value of the debt, the gross value of the debt was $100. The amount provided was $60, I'm left with $40, that's going to be subject to the commercial debt forgiveness provisions in some way, shape or form. However, if we have a scenario which isn't quite plain vanilla, then we have to look at some market values. So for instance, if we have a debt parking arrangement, where I'm the borrower, I've borrowed some money, and outside of my control, that loan has been reassigned from one party to another, and that the assign A happens to be a related party to me, then the consideration is the value of the debt at the time of the assignment. So if it's a value, it was assigned for market value, then we shouldn't have too much of a problem. The issue is, though, the valuation at this point in time doesn't have this solvency assumption that we make when we determine our gross amount of a debt. So if we're in a situation where we have a very distressed company, and it's one of its debts gets reassigned to a related party, then most likely that market value of that debt is not going to be face value. It could even be worthless. And the fact that someone else may have paid full face value for it doesn't mean it was worth face value. If the borrower had no assets and was racking up losses, then the debt probably wasn't worth very much at that time. Same thing if we issue shares of we have a debt for equity swap. A debt for equity swap is most definitely something which you need to consider the commercial debt forgiveness provisions for. The market value of the shares that you issued are the crucial determiner in a debt for equity swap. For issuing shares to satisfy a debt, we need to make sure that the value of the shares we are issuing is roughly equivalent to the value of the debt to avoid a debt forgiveness problem. Okay, so to summarize, firstly, you must ascertain that we have a debt which is a commercial debt. We then have to identify a point where that commercial debt is forgiven, noting that the definition of forgiveness is extended under these laws. And if we do have a forgiveness, then we need to ascertain the net forgiven amount. So that's looking at the gross value of the debt and any consideration paid as a result of the forgiveness. And then we need to look at applying this net forgiven amount against tax attributes of the borough. So in order, tax losses, capital losses, future tax reductions, and the cost base of CGT assets. Welcome back. We didn't cover how accredited treaties are forgiven debt, but this is usually very straightforward. The credit handcuffs are lost and hence claims a tax deduction. In the next episode, episode four, King Tan walks us through the lifecycle of a tax dispute with the ATO. Until then, thank you for listening. Bye for now and see you in the next episode. (upbeat music) (upbeat music) (upbeat music) (upbeat music)