Private ruling: Income tax - commercial debt forgiveness
Date of advice: 2 November 2018
Published: January 2019
Ruling period: Year ended 31 December 20XX
Date scheme commenced: Year beginning 1 January 20XX

Ruling: Q1: Did each Transaction involving a promissory note constitute the forgiveness of a debt under Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes. | Q2: If yes to Question 1, did each Transaction involving the promissory note result in a net forgiven amount under Division 245 of the ITAA 1997? | A2: No. | Q3: Did a gain or loss arise from a balancing adjustment under section 230-435 of the ITAA 1997 for each Transaction involving the promissory note? | A3: No.

Relevant facts and circumstances: DebtorCo acquired all of the issued shares in a subsidiary of CreditorCo. DebtorCo issued a promissory note to CreditorCo to satisfy its obligation to pay for those shares. The market value of the promissory note was equal its face value on the date of issue. The following transactions involving the promissory note were undertaken as planned (Transactions): ● CreditorCo assigned the promissory note to a new creditor ( initial assignment ) ● The promissory note was subjected to further assignments which resulted in Final CreditorCo holding the note ( subsequent assignments ). The amount of the consideration that each new creditor gave in respect of the successive assignments of the note and the market value of the note at the time of each successive assignment were both equal to the note’s face value (plus accrued interest). ● Final CreditorCo forgave the outstanding accrued but unpaid interest owed by DebtorCo on the promissory note, and ● Final CreditorCo surrendered the promissory note to DebtorCo to satisfy its obligation to pay for the subscription of ordinary shares in DebtorCo. The market value of the ordinary shares issued by DebtorCo at the time of this Transaction and the market value of the promissory note at the time the promissory note was applied in consideration for DebtorCo’s ordinary shares subscribed for by Final CreditorCo were both equal to the note’s face value.

Relevant legislative provisions: Income Tax Assessment Act 1936 subsection 26BB(1) | Income Tax Assessment Act 1936 subsection 159GP(1) | Income Tax Assessment Act 1936 subsection 159GP(3) | Income Tax Assessment Act 1997 Division 230 | Income Tax Assessment Act 1997 section 230-45 | Income Tax Assessment Act 1997 Subdivision 230-G | Income Tax Assessment Act 1997 section 230-435 | Income Tax Assessment Act 1997 subsection 230-440(3) | Income Tax Assessment Act 1997 section 230-450 | Income Tax Assessment Act 1997 sections 230-455 | Income Tax Assessment Act 1997 Division 245 | Income Tax Assessment Act 1997 section 245-10 | Income Tax Assessment Act 1997 section 245-20 | Income Tax Assessment Act 1997 section 245-36 | Income Tax Assessment Act 1997 Subdivision 245-C | Income Tax Assessment Act 1997 section 245-55 | Income Tax Assessment Act 1997 section 245-65 | Income Tax Assessment Act 1997 section 245-75 | Income Tax Assessment Act 1997 paragraph 974-160(1)(a) | Income Tax Assessment Act 1997 section 995-1

Reasons for decision: Summary: Each of the Transactions involving the promissory note constituted the forgiveness of a debt under Division 245. | Detailed Reasoning - Detailed reasoning: Division 245 applies to any commercial debt (or part of a commercial debt) that is forgiven. For the commercial debt forgiveness rules to apply there must be a forgiveness of a commercial debt. The term ‘debt’ is not defined so the ordinary meaning of ‘debt’ applies to Division 245. The Explanatory Memorandum to the Tax Laws Amendment (Transfer of Provisions) Bill 2010 states that the ordinary meaning of “debt” requires an obligation to do something which is enforceable. Debts which are subject to Division 245 include debts: ● where interest paid or payable on the debt was deducted, or can be deducted, by the debtor (paragraph 245-10(a)), and ● where interest is not payable by the debtor in respect of the debt but had interest been payable, the whole or any part of the interest could have been deducted by the debtor (paragraph 245-10(b)). DebtorCo acquired all of the issued shares in a subsidiary of CreditorCo. DebtorCo issued a promissory note to CreditorCo to satisfy its obligation to pay for those shares. The market value of the promissory note was equal its face value on the date of issue. Having regard to the terms the promissory note, the interest on the promissory note can be deducted or could have been deducted (apart from the operation of any provision of the taxation Act other than paragraphs 8-1(2)(a), (b) or (c) that has the effect of preventing a deduction (subsection 245-10(c))). Accordingly, the promissory note is a ‘commercial debt’ for the purposes of Division 245. For each Transaction involving the promissory note to constitute the forgiveness of a debt under Division 245, the conditions provided in the relevant operative provisions in Subdivision 245-B must be met. These provisions are as follows. | Detailed Reasoning - ● Section 245-35 What constitutes forgiveness of a debt: A debt is forgiven if and when: a) the debtor's obligation to pay the debt is released or waived, or is otherwise extinguished other than by repaying the debt in full; or b) the period within which the creditor is entitled to sue for the recovery of the debt ends, because of the operation of a statute of limitations, without the debt having been paid. | Detailed Reasoning - ● Section 245-36 What constitutes forgiveness of a debt if the debt is assigned: A debt is forgiven if and when the creditor assigns the right to receive payment of the debt to another entity (the new creditor) and the following conditions are met: a) either the new creditor is the debtor’s associate or the assignment occurred under an arrangement to which the new creditor and debtor were parties; b) the right to receive payment of the debt was not acquired by the new creditor in the ordinary course of trading on a market, exchange or other place on which, or facility by means of which, offers to sell, buy or exchange securities (within the meaning of Division 16E of Part III of the Income Tax Assessment Act 1936 ) are made or accepted. ● Section 245-37 What constitutes forgiveness of a debt if a subscription for shares enables payment of the debt If an entity subscribes for shares in a company to enable the company to make a payment in or towards discharge of a debt it owes to the entity, the debt is forgiven when, and to the extent that, the company applies any of the money subscribed in or towards payment of the debt. Having regard to the relevant facts and circumstances, each of the Transactions involving the promissory note constitutes the forgiveness of a debt under Division 245 as follows: | Detailed Reasoning - Relevant provision under Subdivision 245-B: Initial assignment of the promissory note section 245-36 Subsequent assignments of the promissory note section 245-36 Final CreditorCo forgave outstanding accrued but unpaid interest owed by DebtorCo on the promissory note paragraph 245-35(a) Final CreditorCo surrendered the promissory note to DebtorCo to satisfy its obligation to pay for the subscription of ordinary shares in DebtorCo. section 245-37 | Summary: Each of the Transactions involving the promissory note did not result in a net forgiven amount under Division 245. | Detailed Reasoning - Detailed reasoning: Under Division 245, where the forgiveness of a commercial debt results in a debtor having a positive ‘net forgiven amount’, the debtor will be required to reduce certain tax attributes that could otherwise reduce their taxable income (in the same or a later income year), to the extent of the net forgiven amount. To calculate the net forgiven amount of a debt, it is first necessary to calculate the ‘gross forgiven amount’ of a debt. The rules to calculate the gross forgiven amount of a debt that has been forgiven are set out in Subdivision 245-C. | Detailed Reasoning - Initial assignment of the promissory note: In accordance with the rules set out in Subdivision 245-C, the value of a forgiven debt needs to be worked out. Subsection 245-55(1) provides the primary rule for working out the value of a debt: The value of your debt at the time (the forgiveness time ) when it is *forgiven is the amount that would have been its *market value (considered as an asset of the creditor) at the forgiveness time, assuming that: (a) when you incurred the debt, you were able to pay all your debts (including that one) as and when they fell due; and (b) your capacity to pay the debt is the same at the forgiveness time as when you incurred it. According to this rule, the value of a debt when it is forgiven is its market value when it is forgiven assuming that, at the time the debt is incurred and at the time it is forgiven, the debtor is solvent (the solvency assumption). That is, the debtor is able to repay that debt and all debts as and when they fell due when the debt was incurred and has that same capacity when the debt is forgiven. The market value of the debt is the amount that would be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious buyer and a knowledgeable, willing but not anxious seller acting at arm's length ( Spencer v The Commonwealth (1906) 5 CLR 418). The solvency assumption in paragraph 245-55(1)(a) does not apply if all of the conditions in subsection 245-55(3) are met. As not all the conditions in subsection 245-55(3) are satisfied in this case, paragraph 245-55(1)(a) will apply when working out the value of the debt. Accordingly, the value of the promissory note, being its market value at the time of the initial assignment, is equal to its face value (plus accrued interest). | Detailed Reasoning - Subsequent assignments of the promissory note: Section 245-61 sets out the special rule for working out the value of a previously assigned debt: If your debt has been assigned as mentioned in section 245-36 and is later *forgiven by the new creditor, the value of that debt when it is later forgiven is: (a) if the debt was not a *moneylending debt and the creditor and the new creditor were not dealing with each other at *arm's length in connection with the assignment - the *market value of the debt at the time of the assignment; or (b) in any other case - the sum of: (i) the amount or market value of the consideration (if any) you paid or gave, or are required to pay or give, to the creditor in respect of the assignment; and (ii) the amount or market value of the consideration (if any) the new creditor paid or gave in respect of the assignment. On the facts provided: ● the initial and subsequent assignments of the promissory note constitute the forgiveness of a debt under section 245-36 (see the table in the reasoning for Question 1 above), and ● the promissory note was not a moneylending debt as defined in subsection 995-1(1), and ● the amount of the consideration given by each new creditor in respect of the successive assignments of the promissory note and the market value of the promissory note at the time of each successive assignment were both equal to the note’s face value (plus accrued interest). Accordingly, whether or not each respective creditor and new creditor in the successive assignments were dealing with each other at arm’s length in connection with the assignment of the promissory note, the value of the promissory note as worked out under subsection 245-61 for each later assignment or forgiveness was equal to its face value (plus accrued interest). However, for the forgiveness constituted by Final CreditorCo surrendering the promissory note to DebtorCo in exchange for ordinary shares in DebtorCo, the relevant value of the promissory note at the time of that forgiveness event is limited to the note’s face value (the accrued interest had been forgiven in the immediately preceding Transaction and, pursuant to the note under subsection 245-20, accrued but unpaid interest is a separate debt). | Detailed Reasoning - Amount offset: The next step is to determine if an amount is to be offset against the value of the debt under section 245-65. Specifically, the following Items of the table in subsection 245-65(1) are to be considered in this case. | Detailed Reasoning - Item 2: Item 2 of the table in subsection 245-65(1) states that the value of a debt that is not a moneylending debt is offset by the sum of each amount that the debtor has paid, or is required to pay and the market value, at the time of the forgiveness, of each item of property (other than money) that the debtor has given, or is required to give as a result of, or in respect of, the forgiveness of the debt. Item 2 only applies if none of items 3, 4, 5 and 6 applies. The applications of these items are outlined below: ● Item 3 of the table in subsection 245-65(1) only applies to a debt that is not a moneylending debt, the conditions in subsection 245-65(2) are met and none of items 4, 5 and 6 applies. ● Items 4 and 5 of the table in subsection 245-65(1) only apply when a debt is assigned under section 245-36. ● Item 6 of the table in subsection 245-65(1) only applies to debt-for-equity swaps. | Detailed Reasoning - Item 4: Item 4 of the table in subsection 245-65(1) will apply unless item 5 applies. Item 4 states that the amount which is offset against the value of a debt is the sum of the market value of any consideration paid or given (or required to be paid or given) by the debtor, in respect of the assignment, and the amount or market value of any consideration paid or given by the new creditor in respect of the assignment. | Detailed Reasoning - Item 5: Item 5 of the table in subsection 245-65(1) states that where the debt is assigned under section 245-36 and the debt is not a moneylending debt and the creditor and the new creditor were not dealing with each other at arm’s length in connection with the assignment, the amount which is offset against the value of a debt is the market value of the debt at the time of the assignment. | Detailed Reasoning - Item 6: Item 6 of the table in subsection 245-65(1) states that where the debt is forgiven under section 245-37, the amount offset is worked out by using the formula in subsection 245-65(3) which is as follows: Amount applied × Market value of shares subscribed for Amount subscribed where: amount applied means the amount applied by the company as mentioned in section 245-37. amount subscribed means the amount subscribed as mentioned in section 245-37. market value of shares subscribed for means the *market value of all the shares in the company that were subscribed for as mentioned in section 245-37, immediately after those shares were issued. On the facts provided: ● the promissory note was not a moneylending debt as defined in subsection 995-1(1) ● the amount of the consideration that each new creditor gave in respect of the successive assignments of the promissory note and the market value of the promissory note at the time of each assignment were both equal to the note’s face value (plus accrued interest) ● the market value of the ordinary shares issued by DebtorCo at the time that Transaction was implemented and the market value of the promissory note at the time the promissory note was applied in consideration for DebtorCo’s ordinary shares subscribed for by Final CreditorCo were both equal to the note’s face value and ● the conditions in subsection 245-65(2) were not met, meaning Item 3 of the table in subsection 245-65(1) was inapplicable. Accordingly, the amount which is offset against the value of the promissory note in respect of each of the Transactions involving the promissory note is as follows. | Detailed Reasoning - Relevant provision: Initial assignment of the promissory note Face value of the promissory note (plus accrued interest) Either Items 4 or 5, subsection 245-65(1) Subsequent assignments of the promissory note Face value of the promissory note (plus accrued interest) Either Items 4 or 5, subsection 245-65(1) Final CreditorCo forgave outstanding accrued but unpaid interest owed by DebtorCo on the promissory note. Nil Item 2, subsection 245-65(1) Final CreditorCo surrendered the promissory note to DebtorCo to satisfy its obligation to pay for the subscription of ordinary shares in DebtorCo. Face value of the promissory note Item 6, subsection 245-65(1) | Detailed Reasoning - Gross forgiven amount: The final step is to work out the gross forgiven amount. On the basis section 245-65 applies: ● the gross forgiven amount is the amount by which the value of the debt (when it was forgiven) exceeds the amount offset under section 245-65 (paragraph 245-75(1)(b)). ● if the value of the debt when it was forgiven is equal to or less than the amount offset there is no gross forgiven amount in respect of the debt and Subdivisions 245-D to 245-F do not apply in respect of the debt (subsection 245-75(2)). The results of working out the gross forgiven amount are as follows: | Detailed Reasoning - Relevant provision: Initial assignment of the promissory note No gross forgiven amount. See Note 1 below subsection 245-75(2) Subsequent assignments of the promissory note No gross forgiven amount. See Note 2 below subsection 245-75(2) Final CreditorCo forgave outstanding accrued but unpaid interest owed by DebtorCo on the promissory note. Results in gross forgiven amount. See Note 3 below paragraph 245-75(1)(b) Final CreditorCo surrendered the promissory note to DebtorCo to satisfy its obligation to pay for the subscription of ordinary shares in DebtorCo. No gross forgiven amount. See Note 2 below subsection 245-75(2) Note 1: The commercial debt forgiveness provisions do not apply because the value of the forgiven debt (worked out under subsection 245-55(1)) is equal to the amount of offset to be applied. As a result, there is no gross forgiven amount. It follows that there is no net forgiven amount and Subdivisions 245-D to 245-F (about how to work out the net forgiven amount of a debt and how to treat it) do not apply. Note 2: The commercial debt forgiveness provisions do not apply because the value of each of the forgiven debts (worked out under section 245-61) is equal to the amount of offset to be applied. As a result, there is no gross forgiven amount. It follows that there is no net forgiven amount and Subdivisions 245-D to 245-F (about how to work out the net forgiven amount of a debt and how to treat it) do not apply. Note 3: The gross forgiven amount at forgiveness time is the amount by which the value of the debt (worked out under subsection 245-55(1) or section 245-61, where there were earlier assignments) exceeds the amount offset worked out under Item 2 of the table in subsection 245-65(1). | Detailed Reasoning - Subdivision 245-D – calculation of net forgiven amount of a debt: Subsection 245-85(1) describes the types of amounts which, if they arise to the debtor as a result of a debt forgiveness, must be subtracted from the gross forgiven amount of a debt to arrive at the net forgiven amount of a debt. Under paragraph 245-85(1)(b), the amount by which a deduction that would have been allowable to the debtor under a provision other than Division 245 is reduced as a result of the forgiveness of the debt must be offset against the gross forgiven amount. On the facts provided, no deductions under the ITAA 1936 or ITAA 1997 have ever been or will be claimed in respect of the interest payable under the terms of the promissory note due to the interest being forgiven. Accordingly, in accordance with paragraph 245-85(1)(b), the net forgiven amount will be nil. | Summary: The Transactions involving the promissory note did not trigger the balancing adjustment provisions in Subdivision 230-G. Specifically, the following Transactions involving the promissory note did not involve a change in the debtor company and did not involve DebtorCo doing anything that would trigger the making of a balancing adjustment under subsection 230-435(1). Accordingly, the operation of balancing adjustment provisions in Subdivision 230-G does not have to be considered for these Transactions: (a) initial assignment of the promissory note, (b) subsequent assignments of the promissory note, and (c) Final CreditorCo forgiving the outstanding accrued but unpaid interest owed by DebtorCo on the promissory note. Note, in respect of the accrued interest owed by DebtorCo on the promissory note, no net loss arises to DebtorCo because the accrued interest was forgiven. In respect of the Transaction involving the surrender of the promissory note to DebtorCo by Final CreditorCo to satisfy its obligation to pay for the subscription of ordinary shares in DebtorCo, the balancing adjustment provisions in Subdivision 230-G will not apply to the promissory note: paragraph 230-440(3)(c). | Detailed Reasoning - When is a balancing adjustment made under Subdivision 230-G?: Subsection 230-435(1) provides that a balancing adjustment is made under Subdivision 230-G if: (a) you transfer to another entity all of your rights and/or obligations under a *financial arrangement; or (b) all of your rights and/or obligations under a financial arrangement otherwise cease; or (c) you transfer to another entity: (i) a proportionate share of all of your rights and/or obligations under a financial arrangement; or (ii) a right or obligation that you have under a financial arrangement to a specifically identified *financial benefit; or (iii) a proportionate share of a right or obligation that you have under a financial arrangement to a specifically identified financial benefit; or (d) an * arrangement that is a *Division 230 financial arrangement ceases to be a financial arrangement. | Detailed Reasoning - Is the promissory note a ‘financial arrangement’?: Division 230 sets out the tax treatment of gains or losses from a 'financial arrangement'. Generally, an entity will have a financial arrangement if they have under an arrangement, a cash settlable legal or equitable right to receive a financial benefit, a cash settlable legal or equitable obligation to provide such benefit, or a combination of one or more such rights and/or obligations, and paragraphs 230-45(1)(d) to (f) do not apply (subsection 230-45(1)). A right to receive or obligation to provide a financial benefit can be cash settlable under subsection 230-45(2) if, among other matters, the benefit is money, it is a right you intend to satisfy or settle by receiving money or it is an obligation that you intend to satisfy or settle by providing money. On the facts provided, the obligations of DebtorCo under the promissory note are in respect of financial benefits (as defined in paragraph 974-160(1)(a)) for the purposes of section 230-45. Further, the obligations in respect of those financial benefits are cash settlable within the meaning of paragraph 230-45(2)(a) as the benefits are monetary amounts. As the obligations under the promissory note are cash settlable obligations to provide financial benefits, the exclusions to the definition of a financial arrangement in paragraphs 230-45(1)(d) to (f) have no application. The exclusion rules in sections 230-450 and 230-455 also have no application on the facts presented. Accordingly, the promissory note is a ‘financial arrangement’. However, it should be noted that Transactions (a) to (c) above did not involve a change in the debtor company and did not involve DebtorCo doing anything that would trigger the making of a balancing adjustment under subsection 230-435(1). Accordingly, the operation of the balancing adjustment provisions in Subdivision 230-G is not relevant in respect of these Transactions. | Detailed Reasoning - When is a balancing adjustment not made under Subdivision 230-G?: Paragraph 230-440(3)(c) provides that a balancing adjustment is not made under Subdivision 230-G in relation to the ceasing of obligations or rights under a financial arrangement that is a ‘traditional security’ if: i. the ceasing occurs because the traditional security is converted into ordinary shares in, or transferred to, a company that is the issuer of the traditional security or a connected entity; and ii. the traditional security was issued on the basis that it will or may convert into ordinary shares in, or be transferred to, the issuer of the traditional security or the connected entity. As discussed above, the promissory note is considered to be a ‘financial arrangement’. | Detailed Reasoning - Is the promissory note a traditional security?: A traditional security is defined in subsection 26BB(1) of the ITAA 1936 as a security held by the taxpayer which the taxpayer acquired after 10 May 1989, is not trading stock of the taxpayer, and either: ● does not have an eligible return, or ● has an eligible return that satisfies the conditions listed in subparagraph (b)(ii) of the definition of traditional security in subsection 26BB(1) of the ITAA 1936. On the basis that the promissory note is a ‘security’ (discussed below), the definition of traditional security as defined in subsection 26BB(1) of the ITAA 1936 is satisfied. Specifically: ● the relevant creditor acquired the promissory note after 10 May 1989 and ● the promissory note is not trading stock of the relevant creditor. The term ‘security’ is defined in subsection 26BB(1) of the ITAA 1936 by reference to subsection 159GP(1) of the ITAA 1936. Pursuant to subsection 159GP(1) of the ITAA 1936, ‘security’ means: (a) stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security; (b) a deposit with a bank or other financial institution; (c) a secured or unsecured loan; or (d) any other contract, whether or not in writing, under which a person is liable to pay an amount or amounts, whether or not the liability is secured. Paragraph (b) of the definition of security does not apply because the promissory note is not a deposit with a bank or other financial institution. However, it is considered that the promissory note is a ‘security’ under one or more of paragraphs (a), (c) and (d) of the definition in subsection 159GP(1) of the ITAA 1936. | Detailed Reasoning - Eligible return: A security will have an ‘eligible return’ if, at the time of its issue, it is reasonably likely for the sum of all payments under the security (excluding periodic interest) to exceed the issue price of the security. The amount of the excess in such circumstances is said to be an ‘eligible return’ (subsection 159GP(3) of the ITAA 1936). Under the terms of the promissory note, the only amount that DebtorCo is obliged to pay (excluding periodic interest) in relation to the promissory note is the note’s principal (or face value or issue price). | Detailed Reasoning - Conclusion: On the basis that the promissory note is a ‘security’, as defined in subsection 159GP(1) of the ITAA 1936, and does not have an ‘eligible return’ under subsection 159GP(3) of the ITAA 1936, it is considered that the promissory note qualifies as a ‘traditional security’ pursuant to subsection 26BB(1) of the ITAA 1936. On the facts provided: ● the application for this private ruling has stated that the Transactions involving the promissory note will ultimately result in the promissory note being assigned from CreditorCo to Final CreditorCo and then capitalised into DebtorCo, resulting in the promissory note being cancelled, and ● the issue of the promissory note and the Transactions culminating in the transfer of the promissory note to DebtorCo and its in-substance conversion into ordinary shares in DebtorCo were both part of the overall series of transactions that were planned and executed to achieve certain business objectives. Accordingly, pursuant to paragraph 230-440(3)(c), DebtorCo will not be required to make a balancing adjustment in relation to the promissory note because: ● the obligation of DebtorCo to pay the principal amount under the promissory note ceased when Final CreditorCo surrendered the promissory note to DebtorCo in order to satisfy its obligation to pay for the subscription of ordinary shares in DebtorCo (subparagraph 230-440(3)(c)(i)), and ● the promissory note was issued on the basis that it will or may convert into ordinary shares in, or be transferred to, DebtorCo (subparagraph 230-440(3)(c)(ii)).

Reasons for decision: All legislative references are to the ITAA 1997 unless indicated otherwise.