Private ruling: Division 7A - Debt forgiveness
Published: July 2013
Ruling period: 1 July 2011 to 30 June 2014

Ruling: Question and answer | Will the Commissioner exercise his discretion under subsection 109G(4) of the Income Tax Assessment Act 1936 and not treat the forgiven debt as a deemed dividend? | 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. You are the director and sole shareholder of a Company. For nearly 10 years you were a partner in a business firm (the partnership). You received an elevated income of which some of the income went into the Company. The Company loaned funds to your spouse. The Company at that time was not trading. You and your spouse's assets consisted of a main residence and two investment properties. You and your spouse divorced. The divorce was settled quickly. As part of the settlement you took over your former spouse's Division 7A loans so you would not have ongoing responsibilities to pay maintenance to your former spouse. At the time you incurred the debt you had the capacity to repay the debt. The main residence was sold and most of the proceeds went to your former spouse. Your former spouse also received one of the investment properties. The other investment property was sold and the proceeds were used, in part, to repay tax liabilities and to partly repay the Division 7A loans. The remainder of the funds from the sale of the other investment property was injected into the Company, which you started after your divorce and after you left the partnership. The work you were looking for did not materialise in volumes to sustain the team you employed. You downsized the Company so that you were the only person working in the Company full time with limited support from your current spouse. The combination of the divorce, leaving the partnership and the difficulties getting the new business running left you with considerable debt and no assets. The downsizing of the Company reduced the cost base and the business began to work better and showed some prospects of success in the longer term; potentially to a level which would allow you to pay off the debts that had accumulated. You satisfied the loan making the minimum repayments required. You were diagnosed with a medical condition. You were immediately admitted to hospital and remained there for some months receiving intensive treatment. You ceased all work in the Company. You do not have any income protection insurance. You have low energy and suffer side effects from the treatment. You remain under the care of the hospital and continue to receive daily medication. You are in the very high risk category for relapse. You have been living on government benefits. Recently you recommenced light consulting work and manage a short time per week. You do not see any prospect of you working more than a short time each week for the next couple of years. You are in receipt of a small income from the partnership in the form of post retirement payments. Your have provided a letter from your specialist which states you will not be returning to work for at least another 12 months. You have an outstanding loan with the Company. There are no remaining assets which can be used to repay the Division 7A loans to the Company. You intend to deregister and liquidate the Company. You are considering bankruptcy.

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

Reasons for decision: Summary: Under Division 7A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) amounts paid, lent or forgiven by a private company to certain associated entities are treated as dividends, unless they come within specific exclusions. The provisions apply where the recipient of the payment, loan or forgiven amount is a shareholder or an associate of a shareholder of the private company. Under subsection 109F(1) of the ITAA 1936 a private company is taken to pay a dividend to an entity (being a shareholder of or associate of a shareholder of the company) at the end of its year of income if all or part of a debt owed by the entity to the company is forgiven in that year. The amount of the dividend equals the amount of the debt forgiven, subject to section 109Y of the ITAA 1936. However subsection 109G(4) of the ITAA 1936 provides that a private company will not be taken to pay a dividend in such circumstances if: a) the debt was forgiven because payment of the debt would have caused the entity undue hardship; 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 Explanatory Memorandum to Act No 47 of 1998 states: "The Commissioner has a power to exclude a forgiven debt from the operation of this Division where the Commissioner is satisfied that the shareholder or associate would suffer undue hardship. 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." The CCH Federal Tax Reporter states that, whilst it is unclear what will constitute "circumstances beyond the entity's control" for this purpose, 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 or unfavourable stock market fluctuations. | Detailed Reasoning - Application to your circumstances: To be eligible for debt forgiveness you must satisfy all the requirements set out under 109G(4) of the ITAA 1936. You have satisfied all requirements of section 109G(4) of the ITAA 1936. The original loan was made to your former spouse, when you and your former spouse divorced, as part of the divorce settlement, you took over your former spouse's Division 7A loans so you would not have ongoing responsibilities to pay maintenance to your former spouse. At the time you took over the Division 7A loans from your former spouse you were in a partnership and receiving an elevated income. You were able to satisfy the loan making the minimum payments required. You left the partnership to concentrate on your own business. The combination of the divorce, leaving the partnership and the difficulties getting the new business running left you with considerable debt and no assets. Although there was difficulty in getting your new consultancy business up and running, the downsizing of the Company reduced the cost base and the business began to work better and showed some prospects of success in the longer term; potentially to a level which would allow you to pay off the debts that had accumulated. You were diagnosed with medical condition and due to the effects of the condition and the side effects of the treatment your specialist has advised you will not be able to work at least for another 12 months. You have no income protection. You are currently deriving an income from government benefits and performing consultancy work on a limited basis of a short time per week. You are in receipt of a small income from the partnership in the form of post retirement payments. There are no remaining assets which can be used to repay the Division 7A loans to the Company. You intend to deregister and liquidate the Company. 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 you and the Company.

Does Part IVA apply to this ruling?: Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable. | We have not considered the application of Part IVA to the arrangement you asked us to rule on.