Commercial Debt Forgiveness
Commercial debt forgiveness plays a big role in insolvency. But is not a top-of-mind topic – bankruptcy sounds more dramatic. Nevertheless the tax treatment of commercial debt forgiveness is important. Get it wrong and you could tip an entity into insolvency – the exact opposite of what debt forgiveness is trying to achieve.
The creditor usually incurs a revenue or capital loss and claims a corresponding tax deduction for the forgiven debt.
If you didn’t recognise any tax effect on the debtor side, you would have a tax deduction on the creditor side with no offsetting effect on the debtor side – throwing the doors wide open to manipulate the system. Related parties could pretend to be dealing at arm’s length and forgive huge amounts of artificial debts with a tax deduction on one side and nothing on the other.
But if Australian tax law forced debtors to fully recognise a forgiven debt straight away as assessable income, it could easily tip struggling entities into insolvency.
So the commercial debt forgiveness rules aim for a compromise between these two extremes. There is a tax effect on the debtor side – not straight away but later.
When it comes to forgiven debts, there are two sets of rules – one for commercial debts forgiven after 27 June 1996 and one for non-commercial debts or debts forgiven before 27 June 1996. Let’s ignore the later since non-commercial debts often don’t have a tax effect – forgiven or not – and 1996 is a long time ago anyway.
The rules for commercial debt forgiveness apply to commercial debts forgiven after 27 June 1996 – bingo – that’s our date. Commercial debts are debts with deductible interest or, if interest free, interest would have been deductible if interest had been charged.
Forgiveness arises where the taxpayer’s obligation is
- Released, waived or otherwise extinguished
- Statute barred or
- Subject to ‘Debt Parking’ – debt assigned to a related party
Commercial debt forgiveness rules do not apply to:
- Debt waivers treated as a fringe benefit
- Amounts included in assessable income (including Div 7A)
- Actions under Bankruptcy Law
- Deceased Wills
- Natural love and affection
- Tax Debts
Net Forgiven Amount
The net forgiven amount is the market value at the time of forgiveness and is deducted from (in that order):
- Prior year revenue losses
- Prior year capital losses
- Deductible expenditure
- Cost base of assets
Whatever is left over after all this, you can disregard (except for partnerships where the excess is distributed to the partners).
Where a private company forgives a debt owed by a shareholder or their associates, the net forgiven amount maybe treated as a Division 7A dividend.
So if we had to summarise the commercial debt forgiveness in one sentence: Creditors claim a tax deduction and debtors reduce their prior year loss, tax deduction or cost base for the net forgiven amount.
If you want to read more, here is some ATO guidance.
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Last Updated on 07 May 2018
Robert Campbell - Taxation Advisor at McLeod Campbell & Associates