Private ruling: Commissioner's Discretion – debt forgiveness
Published: July 2013
Ruling period: 1 July 2012 to 30 June 2015

Ruling: Question and answer | Will the Commissioner exercise his discretion pursuant to subsection 109G(4) of the Income Tax Assessment Act 1936 such that the proposed forgiveness of debt owing from the Trust to Company Y does not give rise to a deemed dividend under Division 7A? | Yes.

Relevant facts and circumstances: This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling. Company B acts as trustee for the Trust, a discretionary trust constituted by Deed of Settlement. The Trust is a special purpose investment holding vehicle associated with the Family and Group 2. An investment opportunity was identified for the Trust. The investment related to a property (the Property). The property is held by the trustee of a trust, Trust 2. Trust 2 is a unit trust that was originally associated with, and independently managed by, the Group. Company X was the former trustee of Trust 2. The Property is the major asset of Trust 2. The Property was largely unoccupied and in a dilapidated state. The proposal of the previous management of Trust 2 (Company X) was to redevelop the Property into a mixed development. The development proposal had stalled because of significant local resident opposition. The planning approval for the proposal was formally rejected. At the time the investment was being considered by the Trust, Trust 2 (and the group of entities of which it was part) was in considerable financial distress and under significant pressure from financiers. Trust 2 had a significant net assets deficiency (being excess of debt liabilities over total value of assets) and the term of the external debt facilities had expired. Given the distressed financial position of Trust 2, and the group of which it was a part, the managers and underlying owners of Trust 2 were open to approaches from external parties that may have been in a position to provide financial rescue package. At the time the investment was being contemplated the balance sheet of Trust 2 revealed that; Costs expended by Trust 2 on the Property was into the millions. During the due diligence process, the Property (in its then unimproved state, without development permits) was assumed to have a value considerably less than its cost The development costs had been funded by external debt and unit-holder debt, with the balance being funded by sundry creditors. Based on the estimated market value of the Property, a considerable net asset deficiency was therefore assessed to exist in Trust 2. The Trust was one of a number of unrelated investors that formed a consortium (the Consortium), of sorts, to analyse and assess the upside of the prospective investment and, subject to identifying an appropriate financial upside, to seek external advice as to how such an investment might be best structured in the interest of the various consortium participants. A significant amount of effort and cost was expended in the process and the conclusion reached was that the Property represented a very promising investment opportunity, which was likely to generate high short term returns. The primary development strategy proposed by the Consortium for the Property was quite different from that proposed by the then existing management and involved the development of a mixed use site. In the event that development approval was not obtained for the primary development strategy, a more modest development plan was envisaged. The financial structure ultimately proposed for the Consortium participants involved the injection of new loan funding into Trust 2 via a number of steps, much of which would be applied to significantly reduce the external debt of Trust 2. As part of the restructure, the participants in the Consortium would acquire existing unit holder debt, at a discount to face value, and also would acquire options to acquire further subordinated related party debt and equity interest in Trust 2 for nominal consideration. The reduction in external debt in Trust 2 was forecast to be sufficient to reduce the loan to valuation in Trust 2 such that the ongoing costs of the development would be able to be debt funded. From a management perspective, the proposal also involved the replacement of Company X as trustee of Trust 2 with a new entity associated with the Consortium. The new entity, Company Y, was incorporated as trustee of Trust 2 and a new management team was appointed to take over day-to-day management of and responsibility for the development of the Property. Financial forecasts prepared for the investment proposal prior to the investment being made by the Trust and the other participants in the Consortium indicated that, under the primary development strategy, the consortium would receive a considerable development return of the amount proposed to be invested within a 38 month time frame (under the secondary strategy, a forecast return slightly less of the funds invested was forecast). From the Trust’s perspective, the expectation was that once permits were obtained for its investment, it would look to partially or fully divest its investment and realise a shorter term profit return on its Investment prior to the completion of the development. The proposal was put to and, after some negotiation, agreed with by the relevant parties, including the external lenders to Trust 2, the existing management of Trust 2 and the unit holders of Trust 2. The proposal was consummated, with the Trust acquiring part of its interests in the Trust 2 structure. The interests acquired by the Trust (the Trust 2 Investments) included the following: (a) an interest in loan notes owing by Trust 2 (“the Loan Notes”). (b) an interest in other loan notes owing by Trust 2 that were subordinated In terms of repayment priority to other liabilities of Trust 2 (“the Subordinated Notes”). These loan notes were acquired for a nominal cost. (c) a call option granted by existing unit holders in Trust 2 in favour of the Trust over respect of the issued units in Trust 2. The purchase price and the exercise price for this call option was a nominal amount. (d) a call option granted by providers of subordinated related party debt to Trust 2 in favour of the Trust in respect of subordinated loans provided to Trust 2 After the acquisition of the interests, further funding was required by Trust 2 in respect of the proposed development project and the Trust (and other members of the Consortium) provided some further unsecured loan funding. When the Trust was established it was a dormant entity prior to acquiring the Trust 2 investments. Since establishment, its only activity has been the acquisition and holding of the Trust 2 investments. Subject to the Property increasing in value as a consequence of the permits being obtained and, potentially, development activity commencing, the Loan Notes (that were purchased at a discount) were expected to assume their full face value, the Subordinated Notes (which were purchased at a nominal price) was also expected to assume value and the options in respect of units and loans were also expected to assume value. The realisation of this uplift could have occurred for the Trust by remaining involved in full for the duration of the development, but from the Trust’s perspective the objective was to seek to realise part or all of this profit by way of divestment of interests once development approval had been obtained. Unfortunately for the Trust (and the other consortium participants), the proposal did not eventuate anywhere near as successfully as envisaged, due to a number of factors that were unforeseen at the time that the investment was made. Whilst the replacement management for Trust 2 was ultimately successful in obtaining development permits this process proved much more difficult and took much longer than was expected, with the conditions of the development permits obtained being such that there was no value added. There were considerable problems experienced with the individuals appointed as executive managers of the management entity that replaced the former Group management and, as a result, a number of material problems occurred with the proposed development of the Property. These problems were quite serious and went beyond questions of competence and simple mismanagement. As a result, a decision was made by the Consortium to terminate the executive management team and appoint a new professional independent manager to manage Trust 2 and its development and to assess the best way of realising value from the proposed development. The new independent manager was appointed. Subsequent to the appointment of new independent management it emerged that the proposed development was not economic and the best course of action was to sell the investment and mitigate the losses of the participants. This conclusion was reached after a lengthy process of analysis by the new manager. A contract of sale has been entered into between Company W as custodian of Trust 2 and Company V, a subsidiary of an Overseas Group. The Overseas Group is an unrelated entity and independent of any other party referred to in this private ruling. The contract of sale is expected to settle in the near future. The independent manager has advised the Trust and the other Consortium participants that the net sales proceeds from the sale of the Property will be just sufficient to cover external debt owing by Trust 2 to the Bank and external creditors. The debt owed by Trust 2 to the Bank; both the senior and mezzanine components were secured and ranked ahead of all related party debt. There will be insufficient funds from the sale to repay any debt owing from Trust 2 to the Trust (or other Consortium participants) and for any value to be extracted from the various options that the Trust holds over units and debt interests in Trust 2. In other words, the value of the Trust’s investments has been totally lost. Funding Investments of the Trust The funding of the Trust 2 investments was provided by way of loans from a related company, Company Z and loans from a related trust, Trust 3. Company Z is a private company that has considerable cash reserves and a significant “distributable surplus” for the purposes of section 109Y of Division 7A of Part Ill of the Income Tax Assessment Act 1936 (“ITAA 1936”). The Trust, as the borrower, is an associate of a shareholder of Company Z for the purposes of Division 7A. Accordingly, the loan from Company Y to the Trust is a Division 7A loan and has been put on complying Division 7A loan terms which satisfies the requirements of section 109N of the ITAA 1936. The loan from Trust 3 to the Trust is not subject to Division 7A as Trust 3 does not have any unpaid resent entitlements owing (directly or indirectly) to a private company. The holding of the Trust 2 acquired by the Trust was funded by the Trust 3 loan. The second tranche of Trust 2 acquired by the Trust was funded by the Company Z loan. The additional funding for the project that was provided as an additional unsecured loan for the Project was also provided to the Trust by Company Z and added to the Company Z Loan. The term of the loan between Company Z and the Trust was not more than 7 years. Under the Division 7A complying terms of the Company Z loan repayment obligation were met, determined in accordance with the provisions of subsections 109E(5) and (6) of the ITAA 1936. Debt forgiveness The only assets of the Trust other than the Trust 2 investments (which are worthless) is a settled sum. The Trust has no other investments of any material quantum. The Trust does not have any assets of any material value and is not expected to derive any income or funding in the future from any other source. It is clear that the Trust will be unable to repay the Company Z loan or the Trust 3 loan from its own resources, so it is likely that these loans will be forgiven, either as a matter of legal fact or by the passing of time and the operation of the statute of limitations rules on debt enforceability. Trust 2 investments are the only investments of any significance ever held within the Trust and the sole reason for the Trust’s inability to repay its liabilities is the diminution in value of the Trust 2 investments to the point that these are of no commercial value. Given the Trust 2 investments are not expected to yield any value for the Trust, it is expected that the vast bulk of the existing balance of the loan from Trust 3 to the Trust will be written off. The debt forgiveness of the loan between Company Z and the Trust will give rise to a deemed dividend. The Trust will be wound up.

Relevant legislative provisions: Income Tax Assessment Act 1936 subsection 109F(1) | Income Tax Assessment Act 1936 subsection 109G(4)

Reasons for decision: Summary: Subsection 109F(1) of the Income Tax Assessment Act 1936 (ITAA 1936) provides that a private company is taken to pay a dividend to an entity at the end of the company’s income year if during that year the company forgives all or part of a debt owned by an entity who is a shareholder or an associate of a shareholder. The debt forgiven will still be deemed a dividend if it is forgiven after the entity ceases to be a shareholder or an associate of a shareholder if a reasonable person would conclude that the debt was forgiven because the entity was a shareholder or their associate at some time. Subsection 109G(4) of the Income Tax Assessment Act 1936 Commissioner may treat forgiveness as not giving rise to dividend. A private company is not taken under this Division to pay a dividend because of the forgiveness of a debt owed by an entity if the Commissioner is satisfied that: (a) the debt was forgiven because payment of the debt would have caused the entity undue hardship; and (b) when the entity incurred the debt, the entity had the capacity to pay the debt; and (c) the entity lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond the entity's control. The Commissioner has an overriding discretion to allow a forgiveness of a debt which would otherwise be a deemed dividend under Division 7A, by ignoring the effect of section109F of the ITAA 1936, provided that payment of the debt would cause the entity "undue hardship". It is a condition for the Commissioner's discretion to be exercised that the Commissioner is satisfied that when the debt arose the recipient had the capacity to pay the debt and that the recipient "lost" the ability to pay the debt as a result of circumstances beyond the entity's control. It is unclear what will constitute circumstances beyond the entity's control. However, it may be expected that such circumstances may include loss of market share, loss of competitive advantage, high staff costs and turnover, unfavourable exchange rate variations, unfavourable stock market fluctuations. The Explanatory Memorandum to Act No 47 of 1998 states: In exercising his discretion the Commissioner will take into account the ability of the shareholder or associate to repay the loan at the time it was granted, at the time it was forgiven and at any foreseeable future time. The Commissioner will only exercise his discretion if he is satisfied that the shareholder had the ability to pay at the time of receipt of the loan and lost the ability to pay, permanently, through no fault of his or her own'' | Detailed Reasoning - Application to your circumstances: To be eligible for debt forgiveness the Trust must satisfy all the requirements set out under 109G(4) of the ITAA 1936. The Trust has satisfied all requirements of section 109G(4) of the ITAA 1936. Financial forecasts prepared for the investment proposal prior to the investment being made by the Trust and the other participants in the Consortium indicated that, under the primary development strategy, the consortium would receive a considerable development return of the amount proposed to be invested within a 38 month time frame (under the secondary strategy, a forecast return slightly less of the funds invested was forecast). From the Trust’s perspective, the expectation was that once permits were obtained for its investment, it would look to partially or fully divest its investment and realise a shorter term profit return on its Investment prior to the completion of the development. Subject to the Property increasing in value as a consequence of the permits being obtained and, potentially, development activity commencing, the Loan Notes (that were purchased at a discount) were expected to assume their full face value, the Subordinated Notes (which were purchased at a nominal price) was also expected to assume value and the options in respect of units and loans were also expected to assume value. Unfortunately for the Trust the proposal did not eventuate anywhere near as successfully as envisaged, due to a number of factors that were unforeseen at the time that the investment was made. Whilst the replacement management for Trust 2 was successful in obtaining development permits this process proved much more difficult and took much longer than was expected, with the conditions of the development permits obtained being such that there was no value added. There were considerable problems experienced with the individuals appointed as executive managers of the management entity that replaced the former Group management and, as a result, a number of material problems occurred with the proposed development of the Property. These problems were quite serious and went beyond questions of competence and simple mismanagement. A decision was made by the Consortium to terminate the executive management team and appoint a new professional independent manager to manage Trust 2 and its development and to assess the best way of realising value from the proposed development. Subsequent to the appointment of new independent management it emerged that the proposed development was not economic and the best course of action was to sell the investment and mitigate the losses of the participants. This conclusion was reached after a lengthy process of analysis by the new manager. A contract of sale has been entered into between Company W as custodian of Trust 2 and Company V, a subsidiary of an Overseas Group. The Overseas Group is an unrelated entity and independent of any other party referred to in this private ruling. The contract of sale is expected to settle in the near future. The independent manager has advised the Trust that the net sales proceeds from the sale of the Property will be just sufficient to cover external debt owing by Trust 2 to external creditors. This means that there will be insufficient funds from the sale to repay any debt owing from Trust 2 to the Trust and for any value to be extracted from the various options that the Trust holds over units and debt interests in Trust 2. In other words, the value of the Trust’s investments has been totally lost. The funding of the Trust 2 investments was provided by way of loans from a related company to the Trust, Company Z. The Trust does not have any assets of any material value and is not expected to derive any income or funding in the future from any other source. When the Trust was established it was a dormant entity prior to acquiring the Trust 2 investments. Since establishment, its only activity has been the acquisition and holding of the Trust 2 investments. Trust 2 investments are the only investments of any significance ever held within the Trust and the sole reason for the Trust’s inability to repay its liabilities is the diminution in value of the Trust 2 investments to the point that these are of no commercial value. The Trust will be wound up. | Detailed Reasoning - Conclusion: Accordingly, the Commissioner will exercise his discretion under subsection 109G(4) of the ITAA 1936 to not treat the forgiveness of debt as a deemed dividend for the loan between the Trust and the Company.