Private ruling: Bad debt deduction
Date of advice: 4 September 2017
Published: December 2017
Ruling period: Income year ended 30 June 2012 | Income year ended 30 June 2013 | Income year ended 30 June 2014 | Income year ended 30 June 2015 | Income year ended 30 June 2016
Date scheme commenced: Income year ended 30 June 2012

Ruling: Q1: Is Head Co entitled to a bad debt deduction under paragraph 25-35(1)(a) in relation to the amount of unpaid service payments it has written off in the year ended 30 June 2016? | A1: No. | Q2: Alternatively, is the service income assessable to Head Co in an income year at the end of which the corresponding drawdown receivable remains unpaid? | A2: Yes. | Q3: Alternatively, is Head Co entitled to a deduction under section 8-1 in respect of the loss arising from the difference between the amount of drawdown receivables and the amount actually received in satisfaction of the drawdown receivables in the income year in which the amount was actually paid under the Facility Agreement? | A3: No. | Q4: If the answer to Question 1 is affirmative, do the Taxation of Financial Arrangements (TOFA) provisions in Division 230 prevent Head Co from claiming a bad debt deduction under paragraph (a) of subsection 25-35(1) in year ended 30 June 2016? | A4: Not applicable, as the answer to question 1 is negative.

Relevant facts and circumstances: 1. Head Co is the head company of the X tax consolidated group. 2. Sub Co is a subsidiary member of the X tax consolidated group. 3. B Co is a third party. 4. A Co is the parent of B Co. Service Agreement 5. Sub Co entered into the Service Agreement with B Co, under which Sub Co provided services to B Co. 6. On performance of its services under the Service Agreement, Sub Co was entitled to service payments (the service income). 7. Under the terms of the Service Agreement, B Co issued Sub Co with an invoice within five business days of each calendar month. 8. Sub Co recognised the service payments as revenue on an accruals basis. 9. Under the terms of the Service Agreement, B Co paid the invoiced amount within 2 business days of providing the invoice to Sub Co, by making a drawdown under a new secured loan facility pursuant to the terms of a Facility Agreement. Facility Agreement 10. Head Co and B Co entered into a Facility Agreement, with A Co as Guarantor. 11. B Co was a new business and did not have the necessary liquidity to facilitate the payment of the service payments. It also did not have an established credit rating and was unable to obtain external finance to facilitate the service payments. 12. Head Co made the commercial decision to fund the service payments by providing a short term secured loan facility under the Facility Agreement, on the basis that B Co would have the ability to obtain external finance within two to three years. 13. Head Co has not entered into, and has not contemplated entering into, any other facility agreements with any other entities it provides similar services to. 14. B Co could not use the funds provided under the Facility Agreement for any other purposes, other than for the service payments owed to Sub Co. 15. Where B Co utilised the funds provided under the Facility Agreement, B Co delivered a draw down request to Head Co at the same time it issued an invoice to Sub Co. 16. A condition precedent under the Facility Agreement included that Head Co was only obliged to make a Loan available if the draw down request contained an irrevocable direction from B Co to Head Co, directing Head Co to pay directly to Sub Co the proceeds of the loan. It was also stated under this clause that this payment to Sub Co was in satisfaction of B Co’s obligation to pay the amount specified in any invoice owing to Sub Co under the Service Agreement. 17. Accordingly, the terms of the draw down request provided that: ● The proceeds of this Loan will be credited against the service payments owing to Sub Co. ● B Co irrevocably directs Head Co to pay directly to Sub Co the proceeds of this Loan in satisfaction of B Co’s obligation to pay the service payments owing to Sub Co under the Service Agreement. 18. Each drawdown was required to be repaid quarterly. However, as the outstanding Loan amounts remained unpaid, they were rolled over into a new drawdown. 19. All amounts under the Facility Agreement were to be fully repaid by B Co by the end of 31 July 2014. However, the secured loan facility was extended to a new Maturity Date of 31 July 2015. 20. Variable interest accrued on the outstanding balance owed by B Co and was payable quarterly. 21. To protect against B Co’s default risk, under the secured loan facility, Head Co obtained a security interest in the form of a fixed and floating charge over all of B Co’s present and after-acquired property, including its assets and unpaid capital. In addition, Head Co obtained a security interest in the form of a mortgage over the shares of A Co. 22. A Co provided a guarantee to Head Co in respect of the secured loan facility. 23. B Co was unable to source external financing to refinance the secured loan facility before 31 July 2015. 24. The unpaid amount owing to Head Co under the secured loan facility from B Co was $50,000,000 as at 30 June 2015. 25. Head Co, which had a mortgage over the shares in A Co, became a creditor first in line to receive any proceeds from a liquidation of A Co’s assets. For this reason, A Co put itself up for sale after it failed to refinance the debt. 26. A Co notified Head Co during the tender process that it would not be in a position to repay the whole debt. 27. Head Co wrote off $10,000,000 owing to it from B Co under the secured loan facility in its financial accounts for the year ended 30 June 2015. This amount had not been settled or waived by Head Co prior to this date. 28. The Board of Head Co authorised the write off in the 2016 income year during the preparation of the financial accounts for the year ended 30 June 2015, as provided by the board minutes dated 16 July 2015. 29. Post-write off, on 31 July 2015, Head Co received $40,000,000 in settlement of the secured loan facility for the unpaid drawdown amount. 30. On the same date, Head Co also received approximately $1 million as repayment of all outstanding interest owed by B Co to Head Co under the secured loan facility.

Relevant legislative provisions: Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) | Section 8-1 of the ITAA 1997 | Paragraph 25-35(1)(a) of the ITAA 1997 | Division 230 of the ITAA 1997

Reasons for decision: Summary: Is Head Co entitled to a bad debt deduction under paragraph 25-35(1)(a) in relation to the amount of unpaid service payments it has written off in the year ended 30 June 2016? No, the debt in respect of the unpaid service payments was extinguished from proceeds that B Co applied pursuant to the Facility Agreement with Head Co. Therefore, a bad debt deduction for unpaid service payments was not available under paragraph 25-35(1)(a) as no such debt existed. The loan amounts under the Facility Agreement were written off as bad but not previously included in Head Co’s assessable income. Therefore, a bad debt deduction is also not available for the loan amounts owing under the Facility Agreement. Alternatively, is the service income assessable to Head Co in an income year at the end of which the corresponding drawdown receivable remains unpaid? Yes, the service income was assessable to Head Co in the income year that the service income fell due. On the facts, the earnings methods to income being derived will apply to Head Co. Based on the terms of the Service Agreement, upon Sub Co performing the services under the Service Agreement and the invoice being issued, it has earned the relevant service payment. There are no further steps that Sub Co needed to take in order to become entitled to payment. Therefore, upon Sub Co performing the services under the Service Agreement, a recoverable debt has been created in respect of the service payments. As such, for the purposes of section 6-5, the Commissioner considers that the service income was assessable to Head Co in the income year that the service income fell due. Alternatively, is Head Co entitled to a deduction under section 8-1 in respect of the loss arising from the difference between the amount of drawdown receivables and the amount actually received in satisfaction of the drawdown receivables in the income year in which the amount was actually paid under the Facility Agreement? No, as the loss in respect of the outstanding Loan amounts incurred by Head Co is capital, or of a capital nature, and for that reason is excluded from being deductible under section 8-1. On the facts provided, Head Co is in the business of providing services. As B Co was a new business, it would not have been able to engage Sub Co without first raising funds. The character of the advantage sought in providing the Loan amounts under the secured loan facility was that Head Co could establish a trading relationship in the form of the Service Agreement with B Co and derive service income. This secured an enduring benefit for Head Co in the form of an ongoing contract to provide services under which Head Co would derive service income. Head Co has not entered into, and has not contemplated entering into, any other secured loan agreements with any other product providers apart from B Co. As such, the provision of the Loan amounts was not a normal incident of Head Co’s trading activities and was consistent with being on capital account. If the answer to Question 1 is affirmative, do the Taxation of Financial Arrangements (TOFA) provisions in Division 230 prevent Head Co from claiming a bad debt deduction under paragraph (a) of subsection 25-35(1) in year ended 30 June 2016? Not applicable, as the answer to question 1 is negative.