Private ruling: Commissioners discretion Division 7A debt forgiveness
Published: January 2013
Ruling period: 1 July 2009 to 30 June 2012

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: Entity 1 was incorporated; Entity 1 set up Entity 2. The Directors of Entity 1 were Individual X, Individual Y and Individual Z. Entity 2 entered a commercial business arrangement with two other parties to start a processing business. The other two parties each set up a new trust, Entity 3 and Entity 4. The three trusts then formed a partnership named Entity 5. The beneficiary of Entity 2 is Entity 6. The Trustees and beneficiaries of the Entity 6 are Individual X and Individual W. The three parties contributed a sum of money each as capital to purchase machinery. The funds contributed by Entity 2 came from Entity 7; a related entity to the Entity 6. The directors and shareholders of Entity 7 are Individual X and Individual W. The loan from Entity 7 to Entity 2 falls under the Division 7A provisions and a loan agreement was put in place. Entity 2 was going to repay the loan from its share of the partnership income of Entity 5. The money borrowed to go into Entity 5 was used mainly to purchase highly specialised equipment and leasehold fit-out. For two financial years all required repayments were made on the loan. As a result of the increase in the Australian Dollar competitors to the manufacturer and supplier, who supplied Entity 5, started importing cheaper products and the supplier was placed under stress. The manufacturer and supplier made a considerable loss before interest and tax and they went on a cost cutting drive which included less work for Entity 5 and job cuts. The business was running at a loss and the partners were required to provide further funds to the partnership; these funds were contributed by Entity 2. Due to the economic outlook and the business continuing to run at a loss, the business was sold and the partnership of trusts closed down. The Asset was purchase by one of the partners, Individual Z; however this amount was insufficient to pay out the loans made by the partners. The Division 7A loan repayments will not be repaid because Entity 2 sole purpose was to operate the business and no income has been received by the trust. Entity 2 is not bankrupt under Part X of the Bankruptcy Act. The debt was forgiven after the partners had two years of substantial losses.

Relevant legislative provisions: Income Tax Assessment Act 1936 subsection 109F(1) | Income Tax Assessment Act 1936 subsection 109G(4) Reason for decision | 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. | 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'' | 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. | Entity 2 entered a commercial business arrangement with two other parties to start a steel processing business. | All required loan repayments were made for two financial years. | As a result of the increase in the Australian Dollar competitors to the manufacturer and supplier, who supplied you, started importing cheaper products and your supplier was placed under stress. | The manufacturer and supplier made a considerable loss before interest and tax and they went on a cost cutting drive which included less work for Entity 5 and job cuts. Consequently; you lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond your control. | Entity 2 debt was forgiven after the partners had two years of substantial losses. | Therefore, the Commissioner will exercise his discretion under subsection 109G(4) of the Income Tax Assessment Act 1936 and not treat the forgiven debt as a deemed dividend.

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. 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'' 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. Entity 2 entered a commercial business arrangement with two other parties to start a steel processing business. All required loan repayments were made for two financial years. As a result of the increase in the Australian Dollar competitors to the manufacturer and supplier, who supplied you, started importing cheaper products and your supplier was placed under stress. The manufacturer and supplier made a considerable loss before interest and tax and they went on a cost cutting drive which included less work for Entity 5 and job cuts. Consequently; you lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond your control. Entity 2 debt was forgiven after the partners had two years of substantial losses. Therefore, the Commissioner will exercise his discretion under subsection 109G(4) of the Income Tax Assessment Act 1936 and not treat the forgiven debt as a deemed dividend.