The taxation implications of ‘debt forgiveness’
“Pardon” is a word that can sound somewhat archaic — which could be why the term “debt forgiveness” is barely mentioned in discussions on “bankruptcy”, even though the two concepts are related. Bankruptcy is dramatic, Hollywood; debt forgiveness seems dated, even mildly medieval.
In reality debt forgiveness, on the face of it, is a means by which commercial debts are wiped away, at least in part. In Australia debt forgiveness protocols are designed to help entities that cannot pay all of their loans restructure so they can repay as much as possible. Often, but not always, debt forgiveness is a precursor to or a result of bankruptcy.
Tax considerations go along with any forgiven debt. They don’t disappear. Tax law has mechanisms to make sure people who have bad debts forgiven still honour their tax obligations to the revenue and can’t manipulate the system to get an unfair advantage. So an important take away point is that entities that have debts pardoned will generally see a commensurate decrease in their future tax breaks.
Debt forgiveness provisions exist to help curb hairy bookkeeping and arbitrage opportunities as a result of bad debts. Debt forgiveness would typically provide the creditor with a revenue loss (or in some cases, a capital loss). Meanwhile in the absence of debt forgiveness rules, the debtor may not have been assessed on any gain, and could continue to claim deductions for revenue and capital losses, as well as other deductible costs.
This kind of situation could constitute a doubling-up of tax breaks between the two taxpayers. So the commercial debt forgiveness provisions take aim at duplications by applying the forgiven amount with a view to reducing certain future deductions.
The legislation lists a few “circumstances” under which debts may be forgiven:
- the creditor’s obligation to pay the debt (or part of it) is released, waived, or otherwise extinguished other than by repayment in full
- the debtor loses its right to sue for recovery of the debt because of the operation of a statute of limitations
- the creditor enters into an arrangement with the debtor, where the obligation to pay the debt ends at a mutually agreed time and the creditor pays only a token amount, if anything
- “debt parking” occurs (certain assignments to third parties), and
- a subscription for shares occurs to enable the debtor to discharge some or all of the debt with the subscription monies.
How do the commercial debt forgiveness rules work?
A commercial debt is defined as a debt in respect of which interest, (or amounts akin to interest), if it was paid or payable in respect of the debt, would be deductible.
The debtor’s “net forgiven amount” can be calculated using a simple equation. Gross forgiven amount of the debt, less:
- amounts included in assessable income as a result of the forgiveness,
- reductions in allowable deductions as a result of the forgiveness,
- reductions in cost bases of CGT assets as a result of the forgiveness,
= net forgiven amount of the debt.
Where the debtor and creditor are companies under common ownership, the debtor’s net forgiven amount can be reduced to the extent that the creditor agrees to forego their revenue deduction or capital loss arising from the debt forgiveness.
The total net forgiven amount is then applied successively to:
- carry forward tax losses and capital losses
- tax written down values of depreciating assets, and balances of the amounts deductible over time
- reduce cost bases of CGT assets.
Once all of these amounts are reduced to nil, any remaining net forgiven amount simply disappears forever.
As with CGT, market value rules may apply to determine consideration in respect of the forgiveness of a “non-money” debt. Specific rules also apply to determine consideration for the purposes of the debt forgiveness provisions where debt parking applies or where there is a debt for equity swap.
Exclusions to debt forgiveness provisions
Debt forgiveness provisions do not apply to debts forgiven:
- if the debt waiver constitutes a fringe benefit
- if the amount of the debt has been, or will be, included in the assessable income of the debtor
- under an act relating to bankruptcy
- where forgiveness is affected by will
- for reasons of natural love and affection.
There are other exclusions to be mindful of as well, such as where the forgiven debt can be seen to be in respect of employment. In these cases, the benefit of being forgiven a debt will typically constitute a fringe benefit, and be taxed as such. Exclusions may also apply if the forgiven amount sees it included in the assessable income of the debtor. This can happen (as detailed above) where a private company is deemed to have paid a dividend (under Division 7A) where a debt owed to the company is forgiven.
There are even situations where the forgiven debt gives rise to ordinary income. For example this can occur when a taxpayer’s resulting gain from a released debt deemed to have arisen from the ordinary activities of the taxpayer, or it otherwise displays generally accepted characteristics of ordinary income (such as if such gains are periodic, recurrent and/or expected).
A few years ago taxpayers saw an unprecedented result out of the global financial crisis — a huge increase in the number of loans written off or compromised. Forgiveness in those circumstances may not be so prevalent now, but it’s important taxpayers remain conscious of the broad definitions of “forgiveness” listed in tax law. Making sure the consequences of a forgiveness is understood before it takes place — in no small part by consulting the myriad of laws on the subject — is vital, and don’t forget that the creditor will also have vested interests in the details of the arrangement as they will bear tax consequences too.
Division 7A is one of many sizeable banners that come within the ambit of the debt forgiveness rules. This is because a forgiven debt could be deemed to be a dividend paid to a shareholder (and therefore taxable), unless certain conditions are met. It applies to debts forgiven on or after 4 December 1997, being the date the Division 7A took effect.