Private ruling: Income Tax – Commercial Debt Forgiveness
Date of advice: 13 June 2017
Published: October 2017
Ruling period: Year ended 30 June 2016 | Year ending 30 June 2017 | Year ending 30 June 2018
Date scheme commenced: 1 July 2015

Ruling: Q1: Does the Commissioner accept that Trust 1 will realise a capital loss upon the forgiveness of its loan receivable from Trust 2 pursuant to section 102-20 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No. | Q2: Does the Commissioner accept that Trust 2’s carry forward capital losses will be extinguished by the forgiveness of the loan pursuant to Division 245 of the ITAA 1997? | A2: Yes.

Relevant facts and circumstances: Trust 1 loaned an amount of money to Trust 2. Trust 2 is a discretionary trust. Trust 1 is a beneficiary of Trust 2. Trust 2 used the loan funds to make investments that were subsequently unsuccessful and later sold those investments at a loss. An amount of $XXX remains outstanding from the loan. No formal written agreement was entered into in respect of the loan and interest has never been charged by Trust 1 in respect of the outstanding loan balance. Trust 2 produced a profit and made distributions to beneficiaries other than Trust 1 in multiple financial years. Since realising the investments Trust 2 is not currently undertaking any investment activities or holding any assets; Trust 2 has been essentially dormant. Trust 1 wishes to forgive the loan. Trust 2 has prior year, carry forward capital losses of $XXX.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 102-20 | Income Tax Assessment Act 1997 section 104-5 | Income Tax Assessment Act 1997 section 104-25 | Income Tax Assessment Act 1997 section 108-5 | Income Tax Assessment Act 1997 paragraph 108-20(2)(d) | Income Tax Assessment Act 1997 section 245-1 | Income Tax Assessment Act 1997 section 245-10

Reasons for decision: Detailed Reasoning - CGT – Trust 1: You can only make a capital gain or capital loss if a capital gains tax (CGT) event happens to a CGT asset (Subsection 102-20 of the Income Tax Assessment Act 1997 (ITAA 1997)). Subsection 108-5(1) of the ITAA 1997 defines a CGT asset to be any kind of property, or a legal or equitable right that is not property. One of the examples provided in the notes to section 108-5 of the ITAA 1997 is a debt owed to the taxpayer. Thus, an unpaid loan would be considered to be a debt that is owing to a taxpayer. CGT event C2 in section 104-25 of the ITAA 1997 happens if a taxpayer's ownership of an intangible CGT asset ends in certain ways, including because the asset expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited. The time of the event is when a taxpayer enters into the contract that results in the asset ending. If there is no contract, the event happens when the asset ends (subsection 104-25(2) of the ITAA 1997). Subsection 108-20(1) of the ITAA 1997 states that a capital loss that is made from a personal use asset, including a personal use asset that is a debt, is disregarded. A 'personal use asset’ is defined in subsection 108-20(2) of the ITAA 1997. Paragraph 108-20(2)(d) of the ITAA 1997 provides that a 'debt’ is a personal use asset unless the debt has arisen: a. in the course of gaining or producing the taxpayer’s assessable income; or b. from carrying on the taxpayer’s business. Paragraph 47 of Taxation Ruling TR 96/23 provides that the test of what is a personal use asset requires a finding that the debt came to be owed for a primary purpose other than of gaining or producing income or in the carrying on of a business of the lender. Therefore, if the debt was expected to promote and enhance the income-earning activity of the lender or came to be owed in the carrying on of the lender’s business, the debt would not be a personal use asset and a capital loss would be allowed. Trust 1 did not earn any interest income from the loan and there has been no suggestion that Trust 1 is carrying on a business of lending money. It has been contended that although interest has never been charged in respect of the outstanding loan balance, it was always intended that interest was to be paid once Trust 2 was profitable and in a position to pay interest. However, the financial reports provided show that Trust 2 produced a profit in multiple income years where no interest was charged and that trust distributions were paid to other beneficiaries. This indicates that Trust 2 had the potential to pay interest on the loan had Trust 1 charged interest. Therefore, we cannot conclude that Trust 1’s primary purpose in making the loan was to earn interest income. It has previously been argued that interest on funds borrowed by a beneficiary who on lends the funds interest free to a trust is deductible where the trust uses those funds for its income earning activities because the beneficiary expects to receive assessable income in the form of a trust distribution. However, Taxation Ruling IT 2385 states that beneficiaries of discretionary trusts are not entitled to a deduction for expenses in relation to trust income unless the beneficiaries were presently entitled to the trust income when the expenses were incurred. The ruling states that a beneficiary of a discretionary trust only has a mere expectancy of receiving income from the trust until the trustee exercises their discretion. Therefore, a beneficiary who borrows funds and on lends them interest free to a discretionary trust for the trust to use in its income earning activities would not be entitled to an interest deduction as they only have a mere expectation of receiving income in the future. The beneficiary would only receive income in the future if the trustee exercises their discretion in the beneficiary’s favour. It is possible that when the trust does earn income from using the funds, distributions could be made to other beneficiaries which is what occurred in this case. Therefore, the primary purpose for Trust 1 in making the loan to Trust 2 was not for Trust 1 to earn assessable income, rather it was so that Trust 2 could earn assessable income. Whether or not any or all of the resulting profits earned by Trust 2 would be distributed to Trust 1 was up to the discretion of the trustee of Trust 2 and the financial reports show that in all but one income year, any profits were distributed to beneficiaries other than Trust 1. As the loan was not made by Trust 1 in earning its assessable income or carrying on its business, it is deemed a personal use asset under paragraph 108-20(2)(d) of the ITAA 1997 and therefore any capital loss must be disregarded by Trust 1. | Detailed Reasoning - Commercial debt forgiveness – Trust 2: A debt is forgiven if the debtor is freed from the obligation to pay it. For the purposes of the commercial debt forgiveness rules in Division 245 of the ITAA 1997, a commercial debt includes a debt where, if interest was charged on the debt, the interest would have been deductible to the debtor (paragraph 245-10(b) of the ITAA 1997). As Trust 2 used the funds borrowed from Trust 1 in earning its assessable income, Trust 2 would have been entitled to a deduction for interest if interest had been charged by Trust 1. Therefore, the loan owed by Trust 2 to Trust 1 meets the definition of a commercial debt in the hands of Trust 2 for the purposes of Division 245 of the ITAA 1997. Consequently, if the loan is forgiven, Trust 2 will be required to offset the forgiven amount against its carry forward capital losses. As the loan exceeds Trust 2’s carry forward capital losses, these losses will be extinguished if the entire loan is forgiven. | Detailed Reasoning - Note:: We acknowledge that it may on the surface appear contradictory that the loan is a personal use asset for Trust 1 and a commercial debt for Trust 2. However, it must be recognised that the nature of an item in the hands of one party to a transaction does not determine the nature of the item in the hands of the other party, for example, an amount that is capital expenditure in the hands of the payer may be a revenue receipt in the hands of the recipient ( GP International Pipecoaters Pty Ltd v. FCT (1990) 170 CLR 124; Poole v. FCT ; Dight v. FCT (1970) 1 ATR 715). As the primary purpose of the loan was for Trust 2 to earn assessable income, rather than necessarily Trust 1, the loan is deemed under paragraph 108-20(2)(d) of the ITAA 1997 to be a personal use asset in the hands of Trust 1 for the purposes of applying the CGT provisions to Trust 1. However, the loan meets the definition of a commercial debt in the hands of Trust 2 for the purposes of applying Division 245 to Trust 2 as Trust 2 used the funds borrowed from Trust 1 in earning its assessable income and therefore would have been entitled to a deduction for interest if interest had been charged.