Private ruling: Ordinary income - bad debts
Date of advice: 18 December 2018
Published: April 2019
Ruling period: 30 June 20XX
Date scheme commenced: 1 June 20XX

Ruling: Q1: Will the accrued interest and fees charged on the Loan be assessable to the Company as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: Yes | Q2: Will the gains made on repayments made on the Loan be assessable to the Company under section 26BB of the Income Tax Assessment Act 1936 (ITAA 1936)? | A2: Yes | Q3: Can the Company claim a deduction for interest accrued that it writes off as a bad debt, pursuant to subsection 25-35 of the ITAA 1997? | A3: Yes, to the extent that the interest has been included as assessable income. | Q4: Will CGT event C2 under section 104-25 of the ITAA 1997 happen when the Loan is waived? | A4: Yes, provided the waiver is properly documented. | Q5: Does Part IVA of the ITAA 1936 apply to the Company’s purchase of the Loan, or its renegotiation? | A5: No

Relevant facts and circumstances: 1. The Company is an Australian registered company with a sole director (the Director). 2. The Trust is an Australian resident trust. 3. The Trustee of the Trust (the Trustee) is an Australian registered company with a sole director, the Trustee Director. 4. The Trustee Director is not related to the Director in any way. The Trust is not a related corporation of the Company in any way. 5. During the 20XX income year, a bank (the Bank) advanced a loan facility (the Loan) to the Trustee. 6. During the 20XX income year, the Trustee defaulted on the repayment of the Loan and the Bank sold all the real property security and applied the net sale proceeds against the loan balance. 7. In 20XX the Trustee Director mentioned to the Director that he had unpaid loans to the Bank but wanted to keep trading in the Trust. The Director had no knowledge of the financial position of the Trust nor the business of the Trust other than general knowledge that it had been conducting property development transactions. 8. The Company is a totally separate and independent company owned and controlled by the Director. There is no connection between the individuals or their respective companies outside of the below arrangement. 9. The Director and the Company had no prior involvement with any of the business of the Trust nor the transaction involving the Trust and the Bank. 10. The Director considered that if they could acquire the loans and the Trustee Director was successful in future business activities with the Trust that they could make a gain by acquiring the Loan, restructuring it, possibly advance further capital to the Trust and charging fees and earning interest. 11. During 20XX the Company and the Bank entered into a Deed of Assignment which assigned the lender’s interest in the Loan from the Bank to the Company. 12. During 20XX the Company acquired the Loan to the Trust for an amount substantially less than the Loan’s balance. 13. Following acquisition of the Loan by the Company, interest commenced accruing under the terms of the Loan as income of the Company. This interest was payable to the Company by the Trustee under the terms of the Deed of Assignment in respect of the Loan. 14. The amount of interest income that accrued on the loan during each income year was included as taxable income in the income tax return of the Company for the relevant income year. 15. No amount of this interest was actually paid to the Company and the Director resolved that this amount would not be realised. Accordingly an equal amount was included as an expense, as bad debt, in the accounts and also the income tax return for the Company for each income year. 16. The Director considers that it is unlikely that the Trustee will ever repay the full Loan. 17. The Director is proposing to negotiate a re-structure of the Loan with the Trustee in accordance with the following broad commercial parameters 18. You have asked us to assume that the Loan will be restructured as per the provided draft term sheet, an overview of which is given here: a. the Company write off part of the loan amount repayable under the Loan. b. the Trustee will pay the Company fees and interest. c. the Trustee will make repayments on the Loan each income year. 19. If the renegotiation of the Loan is unsuccessful with the Trust, the Director currently intends to write off the investment by the Company in the Loan. 20. Division 230 of the ITAA 1997 does not apply to the arrangement.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Section 25-35 | Income Tax Assessment Act 1997 Section 104-25 | Income Tax Assessment Act 1997 Section 108-5 | Income Tax Assessment Act 1997 Section 110-25 | Income Tax Assessment Act 1997 Section 110-55 | Income Tax Assessment Act 1997 Section 110-45 | Income Tax Assessment Act 1997 Section 115-10 | Income Tax Assessment Act 1997 Section 116-20 | Income Tax Assessment Act 1997 Section 116-30 | Income Tax Assessment Act 1936 Section 26BB | Income Tax Assessment Act 1936 Section 160M | Income Tax Assessment Act 1936 Section 177D

Reasons for decision: Summary: 1. The accrued interest and fees charged made on the Loan will be assessable as ordinary income under section 6-5 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: 2. Section 6-5 of the ITAA 1997 provides that your assessable income for an income year includes income according to ordinary concepts that you have derived during that income year. This includes earnings from ordinary business dealings. 3. The interest income and fees charged on the Loan are considered to be income according to ordinary concepts. Thus, they are ordinary income and will be included in your assessable income under section 6-5 of the ITAA 1997. | Summary: 4. The gains made on repayments made on the Loan are assessable to the Company under section 26BB of the ITAA 1936. | Detailed Reasoning - Detailed reasoning: 5. Subsection 26BB(2) of the ITAA 1936 relevantly states: Where a taxpayer disposes of a traditional security or a traditional security of a taxpayer is redeemed, the amount of any gain on the disposal or redemption shall be included in the assessable income of the taxpayer of the year of income in which the disposal or redemption takes place. 6. The Loan is a traditional security as, in accordance with subsection 26BB(1) of the ITAA 1936, the Loan: a. is a security, pursuant to 159GP; b. was originally issued after 10 May 1989; c. does not have an eligible return; and d. is not trading stock of The Company. 7. Although the term, redemption, is not defined for the purposes of the traditional security provisions it is defined in Division 16E of the ITAA 1936 as follows: ’redemption’, in relation to a security, means the discharging of all liability to pay any amount or amounts under the security representing a return of the issue price of the security 8. As the repayments discharge all the liability to pay an amount equal to the repayment, being a return of the ‘issue price of the security’ (i.e. the loaned amount), the repayments are redemptions. Subsection 26BB(2) will include the gain on any partial redemption/s as assessable income in the year of income in which the redemption/s takes place. 9. For example, if repayments of $50,000 are received in the first income year the Company holds the Loan, The Company would include a gain of $50,000 less the reduced cost base in its assessable income of that income year. This would also reduce the cost base of the Loan to nil – see Question 4 below. In the second income year the entirety of any repayments received in that income year would be included in the Company’s assessable income for that income year under subsection 26BB(2). Thus, if $50,000 of repayments are made in the second income year, $50,000 will be included in the Company’s assessable income. | Summary: 10. Pursuant to section 25-35 of the ITAA 1997, the Company can claim a deduction for interest accrued that it writes of as a bad debt to the extent that interest has been included as assessable income. | Detailed Reasoning - Detailed reasoning: 11. Subsection 25-35(1) of the ITAA 1997 relevantly states: You can deduct a debt (or part of a debt) that you write off as bad in the income year if: (a) it was included in your assessable income for the income year or for an earlier income year; or …. 12. Pursuant to subsection 25-35(1) of the ITAA 1997, the Company can make deduction for interest accrued on the Loan (or part thereof) that it writes off as a bad debt in each income year to the extent that the interest that accrues on the Loan has been included in its assessable income. 13. It will be necessary that you make and record a decision that a debt is bad before the end of the tax year in which the income from the debt accrued. Taxation Ruling 92/18 “Income tax: Bad debts” at paragraph 5 states: “The bad debt has to be written off in the year of income before a bad debt deduction is allowable under section 63 [the predecessor to section 25-35 of the ITAA 1997]. The writing-off of a bad debt does not necessarily require highly technical accounting entries. It is sufficient that some form of written record is kept to evidence the decision of the taxpayer to write off the debt from the accounts.” Making a record of a bad debt deduction is not only prudent, but is a condition that has to be met before a bad debt claim can be made. It is sufficient for an electronic record to be made if that record is indelible. 14. If you have, after a bona fide assessment based on sound commercial factors, come to the conclusion that there is little or no likelihood that interest accruing on the loan will be received, you may classify that loan as a “non-accrual loan”. Any interest accrued thereafter will not be treated for tax purposes as having been derived until it is actually received. This decision can be made at your discretion and is not compulsory. 15. Taxation Ruling 94/32 “Income tax: Non-accrual loans” discusses the circumstances in which a loan can be recognised as “non-accrual”. You should note that a decision that a loan is “non-accrual” only affects interest that accrues after that decision has been made (see paragraph 7). Interest that has accrued until that date that is not received should be returned as assessable income and, if the conditions in section 25-35 of the ITAA 1997 are met (see the answer to question 3 below), a bad debt deduction may be available. | Summary: 16. If the Loan is waived/forgiven and is properly documented as such, CGT event C2 under section 104-25 of the ITAA 1997 will occur. Any resulting capital gain or loss will be calculated in accordance with this provision. | Detailed Reasoning - Detailed reasoning: 17. The Commissioner does not consider that the Company is in the business of lending money (i.e. The Company’s activities do not constitute a business of money lending for the purposes of section 25-35 of the ITAA 1997). Thus a deduction for bad debts under subsection 25-35(2) of the ITAA 1997 is not available to the Company for the purchase price of the Loan. 18. Note 1 to subsection 108-5(2) of the ITAA 1997 relevantly provides that debts owed to you are CGT assets. Thus the Loan is a CGT asset. 19. TR 96/14 Income Tax: traditional securities (TR 96/14) explains at paragraph 13: Section 26BB and section 70B were introduced into the Act by the Taxation Laws Amendment Act (No 3) 1989 and apply to traditional securities acquired after 10 May 1989. The former subsection 160ZB(6) was also enacted at that time. It provided that capital gains and capital losses were not to be taken to have accrued in relation to traditional securities 'disposed of... within the meaning of section 26BB'. A failure to satisfy the strict test of disposal in the traditional security provisions, therefore, will not prohibit a loss under the capital gains provisions where the definition of disposal is broader. For example, paragraph 160M(3)(b) applies to deem a disposal where there has been a 'cancellation, release, discharge, satisfaction, surrender, forfeiture, expiry or abandonment of the asset'. A properly documented forgiveness would usually come within that provision. 20. Former subsection 160M(3) of the ITAA 1936 has been succeeded by subsection 104-25(1), which provides: CGT event C2 happens if your ownership of an intangible *CGT asset ends by the asset: (a) being redeemed or cancelled; or (b) being released, discharged or satisfied; or (c) expiring; or (d) being abandoned, surrendered or forfeited; or (e) if the asset is an option - being exercised; or (f) if the asset is a *convertible interest - being converted. 21. As explained in TR 96/14, where the Loan is written off such that there is a properly documented forgiveness, CGT event C2 will happen. 22. Subsection 104-25(3) of the ITAA 1997 states: You make a capital gain if the *capital proceeds from the ending are more than the asset’s *cost base. You make a capital loss if those *capital proceeds are less than the asset’s *reduced cost base. 23. Section 116-20 of the ITAA 1997 relevantly states: (1) The capital proceeds from a *CGT event are the total of: (a) the money you have received, or are entitled to receive, in respect of the event happening; and (b) the *market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event). 24. If no capital proceeds are received from a CGT event, subsection 116-30 provides that you will be taken to have received the market value of the CGT asset that is the subject of the event at the time of the event. The market value of the Loan at this time may be nil, however, this will need to be determined at the time of the event. 25. Section 110-25 sets out the general rules about ‘cost base’ and ‘reduced cost base’. Relevantly, according to subsection 110-45(3) of the ITAA 1997, any recoupments of expenditure on the asset (which includes repayments of the loan), will reduce the cost base (and therefore the reduced cost base, see subsection 110-55(2)) by the amount of the recoupment, except so far as the amount has been included in your assessable income. Thus a repayment of the Loan will reduce the cost base of the Loan, unless the repayment amount is included in assessable income. 26. From the information provided, the cost base (and reduced cost base) of the Loan will accordingly be the purchase price of the loan less any repayments of the Loan not included in assessable income (to a maximum of the purchase price of the Loan). Please refer to Division 110 of the ITAA 1997 for more information on the cost base. 27. If, in relation to the forgiveness of the Loan, the total capital proceeds received are less than the reduced cost base of the Loan, then the difference will be a capital loss. If the capital proceeds are greater than the cost base of the Loan, the difference will be a capital gain. 28. Note that discount capital gains cannot be made by companies, pursuant to section 115-10 of ITAA 1997. 29. Note that any gains made during the ownership period prior to this event are included as income under section 26BB of the ITAA 1936 as discussed above at Question 2. For example, if a repayment of $50,000 is made in an earlier income year, the Company would include a gain of $50,000 less the reduced cost base in its assessable income of that income year under section 26BB of the ITAA 1936 and have the cost base of the Loan reduced to nil under subsection 110-45(3) of the ITAA 1997. | Summary: 30. Part IVA of the ITAA 1936 will not apply to the Company’s purchase of the Loan, nor its renegotiation as presented in the private ruling application. | Detailed Reasoning - Detailed reasoning: 31. Section 177D of the ITAA 1936 provides that Part IVA will apply to a scheme where the scheme was entered into for the purpose of enabling a taxpayer to obtain a tax benefit. It provides certain matters that the Commissioner will have regard for in considering whether Part IVA applies. 32. The Commissioner has not identified any tax benefit that could be obtained from the scheme described in the facts. Consequently, the Commissioner does not consider Part IVA would apply to this scheme.