Beaconsfield (03) 9707 0555
Cranbourne (03) 5995 2700
Pakenham (03) 5940 4555
“Pardon” is a word that can sound somewhat archaic — which could be why the term “debt forgiveness” is barely mentioned in discussions on “bankruptcy”, even though the two concepts are related. Bankruptcy is dramatic, Hollywood; debt forgiveness seems dated, even mildly medieval.
In reality debt forgiveness, on the face of it, is a means by which commercial debts are wiped away, at least in part. In Australia debt forgiveness protocols are designed to help entities that cannot pay all of their loans restructure so they can repay as much as possible. Often, but not always, debt forgiveness is a precursor to or a result of bankruptcy.
Tax considerations go along with any forgiven debt. They don’t disappear. Tax law has mechanisms to make sure people who have bad debts forgiven still honour their tax obligations to the revenue and can’t manipulate the system to get an unfair advantage. So an important take away point is that entities that have debts pardoned will generally see a commensurate decrease in their future tax breaks.
Debt forgiveness provisions exist to help curb hairy bookkeeping and arbitrage opportunities as a result of bad debts. Debt forgiveness would typically provide the creditor with a revenue loss (or in some cases, a capital loss). Meanwhile in the absence of debt forgiveness rules, the debtor may not have been assessed on any gain, and could continue to claim deductions for revenue and capital losses, as well as other deductible costs.
This kind of situation could constitute a doubling-up of tax breaks between the two taxpayers. So the commercial debt forgiveness provisions take aim at duplications by applying the forgiven amount with a view to reducing certain future deductions.
The legislation lists a few “circumstances” under which debts may be forgiven:
How do the commercial debt forgiveness rules work?
A commercial debt is defined as a debt in respect of which interest, (or amounts akin to interest), if it was paid or payable in respect of the debt, would be deductible.
The debtor’s “net forgiven amount” can be calculated using a simple equation. Gross forgiven amount of the debt, less:
= net forgiven amount of the debt.
Where the debtor and creditor are companies under common ownership, the debtor’s net forgiven amount can be reduced to the extent that the creditor agrees to forego their revenue deduction or capital loss arising from the debt forgiveness.
The total net forgiven amount is then applied successively to:
Once all of these amounts are reduced to nil, any remaining net forgiven amount simply disappears forever.
As with CGT, market value rules may apply to determine consideration in respect of the forgiveness of a “non-money” debt. Specific rules also apply to determine consideration for the purposes of the debt forgiveness provisions where debt parking applies or where there is a debt for equity swap.
Exclusions to debt forgiveness provisions
Debt forgiveness provisions do not apply to debts forgiven:
There are other exclusions to be mindful of as well, 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. Exclusions may also apply if the forgiven amount sees it included in the assessable income of the debtor. This can happen (as detailed above) 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 gives rise to ordinary income. For example this can occur when a taxpayer’s resulting gain from a released debt deemed to have arisen from the ordinary activities of the taxpayer, or it otherwise displays generally accepted characteristics of ordinary income (such as if such gains are periodic, recurrent and/or expected).
A few years ago taxpayers saw an unprecedented result out of the global financial crisis — a huge increase in the number of loans written off or compromised. Forgiveness in those circumstances may not be so prevalent now, but it’s important taxpayers remain conscious of the broad definitions of “forgiveness” listed in tax law. Making sure the consequences of a forgiveness is understood before it takes place — in no small part by consulting the myriad of laws on the subject — is vital, and don’t forget that the creditor will also have vested interests in the details of the arrangement as they will bear tax consequences too.
Division 7A is one of many sizeable banners that come within the ambit of the debt forgiveness rules. This is because a forgiven debt could be deemed to be a dividend paid to a shareholder (and therefore taxable), unless certain conditions are met. It applies to debts forgiven on or after 4 December 1997, being the date the Division 7A took effect.
DISCLAIMER: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, councilors, 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 96 075 950 284).