Private ruling: Bad debt deductions
Published: September 2013
Date scheme commenced: 1 July 2010

Ruling: Q1: Is the Trust able to deduct the outstanding loan principal amount of the debts it has written off in the income year ended 30 June 2011 as a bad debt deduction under paragraph 25-35(1)(b) of the Income Tax Assessment Act 1997 (the ITAA 1997)? | A1: Yes

Relevant facts and circumstances: The Trust is a discretionary unit trust. The unit holders are discretionary trusts that are controlled and benefit entities related to members of the family group. The trustee of the Trust has been the trustee since the Trust was established. The directors and relatives have always been members of the family group. The Trust has made a family trust election that continues to have effect from 1 July 200X. The trust made income distributions in the 20XX income year (20XX income distributions) to members of the Trust's family group as defined for the purposes of the provisions in Schedule 2F to the Income Tax Assessment Act 1936 (ITAA 1936). Apart from the 20XX income distributions the Trust made no other income or capital distributions in the period 1 July 200Y to 30 June 20XX. The Trust has carried on lending activities for more than 15 years, providing loans to unrelated members of the public and to related parties with the activities centred on lending for a profit. The Trust had successfully been involved in money lending activities that funded a number of property developments. The Trust owns listed and unlisted investments and derives investment income from these investments. The Trust is in receipt of income from other sources. The loans made by the Trust were recorded in the Trust's accounts as Receivables, as opposed to investments. The Trust's lending activities make up approximately X% to Y% of the Trust's total assets. Substantial interest income has been returned from various loans advanced in earlier years. In later years bad debts have reduced the interest income derived by the trust. The Trust sourced its borrowing clients through trusted referrers, based on an evaluation of the borrower, the project and the security. The interest rate charged was based on commercial judgement and negotiation with the borrower. The security that was taken by the Trust was dependant on the borrower's financial situation A Loan Documentation checklist was provided to a loan referrer or borrower for completion in respect of each loan made. Documentation and loan schedules were prepared on the basis of the checklist and provided to the borrower. The Trust kept timely records of all payments and receipts in relation to lending activities and a file was kept for each loan. Loans were monitored on a monthly basis and where a borrower failed to meet a loan obligation the directors would contact the borrower and try to work through loan repayment. Actions taken included: · Recovering higher default interest for late repayment, · Renegotiating the outstanding loan and taking up more security, · Commencing legal proceedings for debt recovery. No formal advertising to the general public of lending activities was undertaken. The Trust made loans to other entities over time as it was in the business of money lending. The Trust borrowed funds from related entities and had access to private wealth generated by related entities. Borrowings from related entities were generally on an interest free basis. You account for interest income on a cash basis and maintain your accounting records on a cash basis. Interest owing on outstanding loan balances is not brought to account until received. The balance owing that is recorded in your financial statements as Receivables consists of amounts of principal owing on the loan only, and does not include accrued interest as shown on the Loan Facility Schedules, with the exception of specific amounts of capitalised interest. For the year ended 30 June 20XX, the Trustee resolved, via a written minute of a meeting of its directors to write off various loan principal amounts as bad debts: Borrower 1 Debt The Trust commenced lending to this group for the purpose of property development. Loans to the Borrower 1 were based on a commercial analysis of the development project and the security provided. Numerous advances were made over the specific period. The term of the advances varied greatly and the interest was capitalised monthly in arrears. The rate of interest increased where the amount was not repaid by the due date. Guarantees or security was generally in the form of signed exchanged contracts on property. A detailed loan schedule for loans to Borrower 1 shows the same interest rate over the entire period, the opening monthly balance, interest accrued monthly on the outstanding balance, loan facility draw-downs, cash receipts/repayments of principal and interest, and the closing monthly balance. The repayments of principal were applied against the principal amounts advanced by the Trust over the course of the loan facility. These amounts were not applied against the interest accrued on the debt. With the exception of the amounts of interest repayment listed above, the loan schedules provided indicate that there was no apparent apportionment of the principal repayments between principal and interest income. An Agreement of Guarantee and Indemnity was entered into by the Trust (as the lender), and the guarantor in relation to the borrowings by Borrower 1 from the Trust. Under this agreement, the guarantor guaranteed the due and punctual performance of all obligations and undertakings to the lender, including a guarantee to pay the debt to the lender at the time specified or upon demand by the lender. An Administrator was appointed to Borrower 1 during the 200Z income year. A Deed of Charge was entered into between the Trustee (the chargee) and Borrower 1, affecting a fixed and floating charge over all of the assets of the Borrower 1 in the event of default. Loans to various entities in Borrower 1's group were consolidated into a joint loan facility under a Deed of Loan, making members of Borrower 1's group jointly and severally liable to repay the Trust amounts borrowed by group members. The amount specified in the Deed of Loan comprised loan advances and accrued interest on the loan advances and accrued interest payable on units issued to the Trust by Borrower 1. When the loans were consolidated the Trust took out more security in the form of second, third and fourth ranking mortgages over various properties owned by Borrower 1. The security held in the development of Borrower 1 was not enforceable because of the priority of prior registered mortgages held by mortgagees and a shortfall in funds on settlement of the secured properties that were disposed of as mortgagee in possession sales. The Trust also obtained written personal guarantees from associates of Borrower 1 in respect of the debt owed. A Deed of Variation of Deed of Loan / Guarantee, was later executed between associates of Borrower 1 and the Trust. This deed acknowledged that Borrower 1 and related entities were jointly and severally liable for the debts owed to the Trust. The Trust did not obtain formal valuations of Borrower 1's assets as the group was achieving above average market sales rates, indicating that the group should be able to meet its loan obligations to the Trust. Borrower 1 was generally tardy with repayments. While the Trust did not cause outstanding loans to be repaid, a higher penalty interest rate was applied. The interest accruing on the outstanding debts was not brought to account on an accruals basis for income tax or accounting purposes. A cash basis of accounting was used to recognise interest income. The directors of the Trustee made a commercial decision not to instigate formal debt recovery proceedings against Borrower 1 because Borrower 1 was achieving a high rate of sales and was obtaining additional funding. Borrower 1's debt went bad when the head company went into administration and then into liquidation. A Formal Proof of Debt or Claim (Form 535, Corporations Act) was lodged with the Deed Administrator of Borrower 1 stating the amount owed to the Trust by Borrower 1. The Trust's Balance Sheet for the relevant year includes Receivables under Non-Current Assets. The principal owed by Borrower 1 is included in your Receivables in the relevant year. The Trust took the appropriate steps to recover the debts owed by Borrower 1. Several entities in Borrower 1's group, who were parties to the Deed of Loan, have been deregistered. Borrower 1 is liable to pay the group's debts, but as this entity is in liquidation you consider it highly unlikely that the debt will ever be repaid. You have received an amount under the personal insolvency agreements of associates of Borrower 1 which will be included in the Trust's income. Borrower 2 Debt The Trust commenced lending to this group in the 19ZZ year. The loans were made to various entities within the group, following a referral to the Trust. The purpose of the loans was to provide working capital for the fledgling business. The loans have been acknowledged as owing by Borrower 2 in the financial accounts of the group members. The expectation was that the loan funds advanced to the group would be repaid by funds raised through a stock market float or through funds from private equity investors. The pro forma Loan Documentation checklist was not completed for loans to this group. The Trust later increased its share interests in the group to almost Z%. By taking up further equity, the Trust aimed to provide coverage for the loans made to the group in the event of other major private investors or private equity interests providing funding that would enable the group to refinance its debt to the Trust. The Trust did not obtain formal valuations of Borrower 2's assets. The documentation provided as evidence of multiple loans or advances by the Trust to Borrower 2 was in the form of Exchange of Letters signed by both parties to the loan agreement. The Exchange of Letters provide for the acceptance of the terms and conditions, as specified in the letters, by both parties. The letters stated that the term of each loan was variable, dependant upon when funds were available or an equity injection was received. Repayment was to be made when funds became available. The interest rate varied from 12% to 15%, compounding monthly. Detailed loan schedules show interest rates of 12% and 15% over the period, the opening monthly balance, interest accrued monthly on the outstanding balance, loan facility draw-downs, cash receipts/repayments of principal and interest, and the closing monthly balance. The Trust provided for doubtful debts in relation to Borrower 2's debts. The repayments of principal detailed above were applied against the principal amounts advanced by the Trust over the course of the loan facility. These amounts were not applied against the interest accrued on the debt. With the exception of some amounts of interest repayments the loan schedules indicate that there was no apportionment of the principal repayments between principal and interest income. A Deed of Charge was entered into between the Trust and related entities (the Chargee), and Borrower 2 (the company), effecting a fixed and floating charge over the assets of the company in the event of default. The security under the deed was given to the Chargee in consideration of the Chargee entering into the Deed of Loan and refraining from demanding or suing for payment of any of the secured money that is presently payable. Similar deeds were entered into on the same date with other Borrower 2 group entities. Separate Deeds of Loan were entered into between the Trust and Borrower 2 group entities. The Deeds of Loan specified the agreed advances to each entity (principal plus accrued interest), a specific rate of interest, an advance period commencing and terminating 12 months later, a principal repayment date, and security in the form of fixed and floating charges over the assets of each borrowing entity. A further deed was executed, titled Guarantee and Indemnity - Company - Interlocking, between the Trust and Borrower 2 and related entities, as guarantors. This deed, which was unlimited as to amount, indemnifies the Trust (as lender) and provides that the borrowers will repay the monies secured by this deed upon demand. The items produced by Borrower 2 were current at the time but are now obsolete to the extent that supporting them commercially is impractical. The trust has not formally sought to wind up Borrower 2 or commence debt recovery proceedings as such actions would be costly and not worthwhile, given the group's financial position. In addition, over the course of the loans, the Trust did not take formal legal steps to recover the debts owed by Borrower 2. The loans made by the trust to Borrower 2 have been acknowledged by the borrower in the financial accounts of group members. Recent financial accounts of Borrower 2 indicate that its product has become obsolete, and consequently none of the loans owed to the Trust can be repaid.

Relevant legislative provisions: Section 8-1 of the Income Tax Assessment Act 1997 | Section 25-35 of the Income Tax Assessment Act 1997 | Paragraph 25-35(1)(b) of the Income Tax Assessment Act 1997 Subsection 25-35(5) of the Income Tax Assessment Act 1997 | Division 230 of the Income Tax Assessment Act 1997 | Subsection 230-5(2) of the Income Tax Assessment Act 1997 | Divisions 266 and 267 of Schedule 2F to the Income Tax Assessment Act 1936

Reasons for decision: Detailed Reasoning - Paragraph 25-35(1)(b) of ITAA 1997: Paragraph 25-35(1)(b) of ITAA 1997 provides that a taxpayer can deduct a debt (or part of a debt) that the taxpayer writes off as bad if it is in respect of money that the taxpayer lent in the ordinary course of its business of lending money. For a deduction to be allowed under section 25-35 of the ITAA 1997, certain conditions must be met i.e. there must be a debt, the debt must be bad, the debt must be written off and the debt must have been included in the assessable income of the taxpayer. In addition, special rules contained in subsection 25-35(5) of the ITAA 1997 may affect the entitlement to deductions for bad debts. Item 5 of subsection 25-35(5) of the ITAA 1997 states that certain trusts cannot deduct a bad debt if there has been a change in ownership or control or an abnormal trading in their units. The relevant associated legislation is to be found in Divisions 266 and 267 of Schedule 2F to the ITAA 1936. Debt To obtain a bad debt deduction under section 25-35 of the ITAA 1997, a debt must exist at the time of the write-off, before it can be written off as bad. A debt exists where you are entitled to receive a sum of money from another, either in law or in equity. The Trust has made advances to the Borrower 1 and Borrower 2 over a number of years. Both the lender and the borrowers recognised the amounts advanced as loans or debt and formalised the terms and conditions of the debt in various deeds, agreements and letters. The information provided is consistent with the existence of the debts at the time of write-off, as the amounts were advanced to the borrowers, who had an obligation to repay the borrowed amounts. Bad Debt Taxation Ruling TR 92/18 Income tax: bad debts, at paragraphs 31 to 32, provide guidance on whether a debt is considered bad. TR 92/18, at paragraph 3, recognises that provided a bona fide commercial decision has been made regarding the likelihood of the non-recovery of a debt, it will be accepted that the debt is bad. In relation to Borrower 1's debts, the debtor company is in liquidation and other members of the corporate group have been deregistered. An amount under the personal insolvency agreements of the principals who provided personal guarantees in relation to the debts has been received. On the facts provided, Borrower 1's debt is a bad debt. Borrower 2's debts are objectively bad as the product being developed has become obsolete. The financial statements of the borrower indicate that it is unlikely they will ever be able to repay the debt. No steps have been taken to recover the debt or to formally wind up group members as the costs of such action out weighed the likelihood of recovering any of the debt. No further activity has been recorded on the loans. A reasonable period of time has elapsed since the original date for payment as specified in the Deeds of Loan. Interest has ceased to be calculated and charged on the loans, according to the Loan Facility Schedules provided. On an objective view of the facts, Borrower 2's debts are considered to be bad debts. Writing-off of bad debts A bad debt must be written off in the year of income to be allowable as a bad debt deduction. Where there is something in writing evidencing the lender's intention to treat the debt as bad, this requirement will be satisfied. It is not necessary for an entry to be made in the accounting records, but it is sufficient for the entity to have recorded the decision before the end of the year in which the deduction is to be claimed. The Trust provided a copy of a written minute in which the directors of the trustee company have resolved to write-off the debts of Borrower 1 and Borrower 2. The meeting of directors occurred just prior to the end of the relevant income year and the resolution applied to the same income year. On this basis, the debts in question have been written off in the relevant year of income. Carrying on a business of money lending Paragraph 25-35(1)(b) of the ITAA 1997 allows you to deduct a debt that you write off as bad in the income year if the debt was in respect of money that you lent in the ordinary course of your business of lending money. General principles on whether a taxpayer is carrying on a business have been developed from case law. Relevant factors considered in determining this issue are expressed in Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? . Applying the general principles that indicate whether or not a business is carried on to the activities of the Trust, as described in your ruling application it is open to the Commissioner to conclude that, that the Trust was in the business of money lending at the relevant times that loans and further advances on loans to Borrower 1 and Borrower 2 were made. Whether the loans to Borrower 1 and Borrower 2 were made in the ordinary course of your money lending business needs to be considered. The loans made to Borrower 1 and Borrower 2 have not generated the revenue in interest income that was expected from these lending transactions as the business activities of the borrowers did not produce the results that both the borrowers and the Trust had expected, based on an assessment of the business opportunities undertaken. In addition, the Trust has been unable to recover the loan principal amounts advanced because of the failure of the projects to produce the expected outcomes. Nevertheless, the loans to Borrower 1 and Borrower 2 were made in the ordinary course of your money lending business, despite the losses that have resulted from these lending activities. Special rules of subsection 25-35(5) of the ITAA 1997 To claim a bad debt deduction under section 25-35 of the ITAA 1997, the Trust is required to satisfy certain tests outlined in Division 267 of Schedule 2F to the ITAA 1936. Item 5 of subsection 25-35(5) of the ITAA 1997 states that certain trusts cannot deduct a bad debt if there has been a change in ownership or control or an abnormal trading in their units. The relevant associated legislation is to be found in Divisions 266 and 267 of Schedule 2F to the ITAA 1936. The Trust is considered to be a non-fixed trust, as it is a discretionary unit trust. The unit holders are discretionary trusts that are controlled and benefit entities related to members of the family group. The Trust has had a valid family trust election in place with effect from 1 July 200X. To the extent that the debts that are to be written off arose after the family trust election was made, the Trust is considered an excepted trust for the test period for the purposes of paragraph 267-25(1)(c) of Schedule 2F to the ITAA 1936. For the period up to 30 June 200X, when the Trust did not have a family trust election in place, the Trust must satisfy all of the tests listed in subsection 267-25(2) of Schedule 2F to the ITAA 1936, which provide the conditions that need to be satisfied for a bad debt deduction to be available under section 25-35 of the ITAA 1997. Conclusion on the application of subsection 25-25(5) of the ITAA 1997 Item 5 of subsection 25-25(5) of the ITAA 1997 does not preclude a deduction for bad debts in respect of the loan principal amounts as the Trust has satisfied the conditions for deducting bad debt amounts under subsection 267-25(2) of Schedule 2F to the ITAA 1936 in relation to debts incurred prior to 1 July 200X.