[Insert DD Month YYYY]
[Insert Client Name]
[Insert Client Position]
[Insert Company Name]
[Insert Company Address]
[Suburb State Post Code]
Dear [Insert Client Name]
Re:
Commercial debt forgiveness
Whenever a debt is forgiven, assigned or otherwise dealt with consideration should always be given
to the application of the Commercial Debt Forgiveness (“CDF”) rules as these rules can impact on
various tax attributes of the borrower.
Executive Summary
When the CDF Rules apply, they can reduce the tax balance of the following items (in order):
1.
2.
3.
4.
revenue tax losses of a prior income year
capital losses of a prior income year
opening adjustable value of depreciating assets
cost base of CGT assets.
General Rules
Generally speaking, when a creditor (i.e. lender) writes off a debt this will give rise to a financial gain
to the debtor/borrower (ordinarily recorded as a credit in the P&L and a debit to the relevant liability in
the balance sheet). Whilst a creditor may be entitled to a tax deduction 1 or a capital loss when a debt
is forgiven, the debtor in most circumstances would not include the amount in their assessable
income.
Where an amount is not otherwise included in the assessable income of the debtor (e.g. as a deemed
dividend under Division 7A), the CDF rules in Division 245 of the Income Tax Assessment Act 1997
(ITAA 1997) will potentially apply to limit the non-assessable benefit that the debtor has received as a
result of the forgiveness. The CDF rules achieve this by reducing certain amounts that would
otherwise be taken into account in reducing the debtor’s taxable income for the forgiveness year or
any later years of income.
Commercial Debt Forgiveness Rules
Broadly, the CDF provisions require the debtor to work out the total of the forgiven debt amounts for
the year that are then offset to reduce the tax balance of the following items (in order):




revenue tax losses of a prior income year
capital losses of a prior income year
opening adjustable value of depreciating assets
cost base of CGT assets.
Any part of the net forgiven amount which remains after being applied against all available deductible
amounts is disregarded.
The application of the commercial debt forgiveness provisions is further discussed below.
(a) Is there a commercial debt?
1
A tax deduction will only be available under section 25-35 of the ITAA 1997 where the creditor writes off the
loan as bad and the creditor lent in the ordinary course of their business of lending money (refer, for example, to
the Full Federal Court decision in FC of T v BHP Billiton Finance Ltd; 2010 ATC 20-169).
The CDF provisions only apply to debts where part or all of the interest payable on the debt is, or
would be, an allowable deduction. This means that even if interest is not charged the debt may be
subject to the rules if, had interest been charged it would have been deductible.
The CDF provisions will also apply to a debt where the interest would have been deductible but for
the operation of a provision that has the effect of preventing a deduction that would otherwise be
allowable, e.g. the thin capitalisation provisions.
(b) Has there been a forgiveness of a debt?
A debt is forgiven if the debtor’s obligation to pay the debt is ‘released, waived or otherwise
extinguished’ other than by repaying the debt in full. If the creditor’s right to sue for recovery of debts
ceases by the operation of a Statute of Limitation this will also constitute a forgiveness of a debt.
There are other specific circumstances in which forgiveness will be deemed to have occurred, such
as debt assignments2 and some debt-for-equity swaps3.
(c) Is there an excluded debt forgiveness
It should also be noted that debt forgiveness effected under a bankruptcy law, by will or for reasons of
love and affection, will be excluded from the operation of the CDF provisions.
The waiver of a debt constituting a fringe benefit is also disregarded in relation to the CDF provisions
as is a debt that is included in the debtor’s assessable income, for example as a Division 7A deemed
dividend4 or when included as ordinary income5.
(d) How much has been forgiven (“Net forgiven amount”)
The amount that a debtor must apply against its relevant tax balances is called the net forgiven
amount. The net forgiven amount is equal to the gross forgiven amount adjusted for certain amounts
(e.g. amounts included in assessable income).
Gross forgiven amount
The gross forgiven amount is equal to the notional value of the debt less any consideration provided
or deemed to have been provided (i.e. the offsetting amount) by the debtor in respect of the
forgiveness.
Value of the debt
Broadly speaking, the notional value of a debt is its market value at the forgiveness time, assuming
that, at the time the debt is incurred and at the time it is forgiven, the debtor was solvent (the
“solvency assumption”). The solvency assumption is essentially the assumption that the debtor was
able to repay that debt and all debts, as and when they fell due, at the time the debt was incurred and
when the debt was forgiven.
There are also adjustments that must be taken into account in some circumstances if the value of the
debt is affected by market variables, such as movements in interest and foreign exchange rates.
There are also special rules for calculating the notional value of a non-recourse debt6 and a previously
assigned debt.
2
A situation where the creditor assigns the debt to an associate of the debtor or to another person who is a party
to an agreement with the debtor in relation to the assignment, unless the new creditor acquired the debt in the
ordinary course of trading on a securities market (per section 245-36 of the ITAA 1997).
3 A situation where the creditor subscribes for shares in the debtor company and the debtor applies the whole or
part of that proceeds towards payment of the debt or part of that debt (per section 245-37 of the ITAA 1997).
4 Refer to the operation of 109F of the Income Tax Assessment Act 1936.
5 Refer to Warner Music Australia Pty Limited v FC of T; 96 ATC 5046.
6 A non-recourse debt is a debt incurred for the purposes of financing the cost of acquisition, construction or
development of a property (but not including the manufacture of goods) by the debtor and the creditor only has
right of recourse against the same financed property in the event of default by the debtor in the payment of the
debt (per section 245-60 of the ITAA 1997).
Generally the solvency assumption will not apply where the creditor and debtor were not dealing at
arm’s length and the debt was not a “money lending” debt (being a debt made in the ordinary course
of a money lending business). In this case the creditor is deemed to have paid market value7
consideration for the acquisition.
Offsetting amount
If consideration is provided in relation to the forgiveness of the debt, the consideration amount will
offset and reduce the forgiven amount. All other things being equal, the offsetting amount will be the
sum of any amounts of money or market value of property that the debtor has paid and/or required to
pay for the forgiveness of the debt. There are different rules that apply in calculating the amount of the
offset given for the forgiveness depending on whether the debt is a money lending debt, not a money
lending debt, a previously assigned debt or in a debt-for equity swap situation.
In the case of a non-money lending debt, there is a market value substitution (“MVS”) rule that will
deem market value consideration to be paid and offset the forgiven amount if:


no actual consideration is given in respect of the forgiveness (i.e. a full write-off) or
the value or amount of the consideration is greater or less than the market value of the debt
(at the time of forgiveness) and the debtor and the creditor did not deal at arm’s length in
relation to the forgiveness.
This MVS rule broadly mirrors the MVS rule that is found in the CGT provisions. This is essentially to
ensure that the capital loss that arises to the creditor is equal to the gross forgiven amount of the debt
under the CDF provisions.
If the value of a debt is equal to or less than the offset amount there will be no gross forgiven amount
and consequently the punitive effect of the CDF provisions will not apply.
Calculating the net forgiven amount
Before arriving at the net forgiven amount, the gross forgiven amount of the debt is reduced for:



any amount included in the debtor’s assessable income
any reduction in allowable deductions for the debtor
any reduction in the cost bases of the debtor’s assets
to the extent that these implications arise under provisions other than the CDF rules.
Where there is a forgiveness of an intra-group debt, that is a debt owed by one company to another
company under common ownership, the companies can enter into an agreement whereby the creditor
will forego an agreed amount of its entitlement to a capital loss or a bad debt deduction arising from
the forgiveness in return for a reduction of the provisional net forgiven amount by that same agreed
amount for the benefit of the debtor. Such agreement must be in writing to be effective.
(e) Application of total net forgiven amount to tax attributes
Where a net forgiven amount arises under the CDF rules, the net forgiven amount will be applied to
reduce the debtor’s tax balances8 in the following order:
1.
2.
3.
4.
prior year revenue losses
unapplied net capital losses
deductible expenditure
cost bases of certain CGT assets.
Within each of the above four classes, the debtor can choose the relevant loss, deductible
expenditure or asset against which the net forgiven amount is to be applied and the amount to be
7
The market value is ordinarily based on the debtor’s ability to repay the debt at the time of borrowing.
The total net forgiven amount is applied to the opening balance of the amount such that the benefit that would
otherwise arise in the current year is reduced.
8
applied, but the net forgiven amount must be applied to the maximum extent possible within each
class.
Any amount remaining after exhausting all such tax attributes is not included in assessable income of
the debtor.
Some common examples of deductible expenditure are expenses relating to:






depreciating assets
assessable income producing buildings and capital works
the borrowing of money to produce assessable income (under section 25-25 of the ITAA
1997)
research and development activities
scientific research
Australian films.
The manner in which an item of deductible expenditure is reduced by a net forgiven amount depends
on whether the prime cost or diminishing value method is used to calculate deductions in relation to
the relevant expenditure. Where the prime cost method is used, the base amount will be adjusted by
the reduction amount which will be treated as a deduction allowed in a previous income year and the
amount of deduction to be claimed on the expenditure must not exceed the reduced base amount.
Where the diminishing value method is used, the written down value of the asset as at the beginning
of the forgiveness year of income will be adjusted by the reduction amount.
The cost base of most CGT assets will be subject to a reduction unless it is specifically excluded
under section 245-175 of the ITAA 1997. These excluded CGT assets include:






pre-CGT assets
personal use assets
main residence
goodwill
superannuation interests
trading stock.
Importantly, CGT assets that are subject to having their cost base reduced will include cash like
assets that would tend to be realised regularly. Such assets would include:




debtors (e.g. from trading)
bank deposits
term deposits
short term loans assets.
As such, where a debtor that has a total net forgiven amount careful consideration must be given to
how the amount is applied against the cost base of assets (if applicable).
We note that the practical application of these rules can often be difficult. If you have further queries
on any details contained within this letter or have any other tax planning issues, please contact me on
[insert telephone number of partner].
Yours faithfully
[Insert name of Partner]