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When a business is struggling to pay its creditors there are protocols in place to help relieve some immediate pressure. Companies may need to restructure, re-organise and in some cases be wound up when they are in dire financial stress. The term “Debt-Forgiveness” can be a little deceiving as it does not mean all debt is wiped away clean.
When a debt is forgiven, it does not mean the tax liability disappears. Tax law requires tax obligations to still be met, even if the debt has been forgiven. The system is in place to ensure people cannot manipulate an unfair advantage with their obligations. Companies that have their debts pardoned may have fewer tax breaks in the future as a result.
The government provides debt forgiveness provisions for a few different reasons. Shady bookkeeping and under-the-table activities are minimised when companies abide by the debt forgiveness rules. It also is a way the company can stay in business while trying to sort out debts in a legitimate way.
In the absence of the debt forgives rules, it would provide the creditor with a revenue loss or a capital loss and the debtor would not have been assessed on the gain and would continue to claim deductions for the loss and possibly other costs as well. This situation could end up providing a duplicate tax break on behalf of the creditor and debtor. With tax forgiveness rules in place, it helps eliminates this unfair advantage by reducing certain future deductions as well.
The Fine Print
The tax laws are very specific and list specific circumstances these rules will apply in:
- The creditor’s obligation to pay the debt has been waived, released or extinguished other than by payment in full.
- The statute of limitations has expired and the debtor loses its right to sue for recovery of debt.
- When the debtor and creditor enter into a mutual agreement regarding the debt and the creditor pays a portion, small amount or nothing at all.
- The debt is assigned to a third-party and “debt parking” occurs and
- A subscription of shares is in place to enable the debtor to clear some or all of the debt with the subscription monies.
The Rules of Commercial Debt Forgiveness
A commercial debt is where the interest on the debt if it was payable on the debt, would be deductible.
The debtor’s “net forgiven amount” is calculated using a simple formula. Gross forgiven amount of the debt, less:
- Assessable income amounts included as a result of the forgiveness
- Allowable deduction reductions as a result of the forgiveness
- CGT assets reductions as a result of the forgiveness
= the net forgiven amount of the debt.
When both the creditor and debtor are companies under common ownership, the debtor’s net forgiven amount is reduced to the extent that the creditor agrees to forego capital losses arising or revenue deductions from the debt forgiveness.
The total net forgiven amount then can be applied successively to:
- Carry forward tax and capital losses
- Tax written down values of depreciating assets and balances deductible over time
- Reduce the cost bases of CGT assets
Once all these amounts are reduced to zero, any remaining net forgiven amount is cleared permanently.
Market value may determine consideration of the forgiveness of any “non-money” debt. There are rules in place to determine consideration where there may be a debt for equity swap or third-party debt parking.
There are instances where debt forgiveness does not apply:
- When the debt waiver is a fringe benefit
- If the amount is included in the assessable income of the debtor
- When there is an act relating to bankruptcy
- The forgiveness is affected by will
- The reason is for natural love and affection
There are many other instances to be aware of as well, such as in respect to employment. In this case, the forgiveness could be seen as a fringe benefit and be taxed accordingly. An exclusion may also apply if the forgiven amount is included in the assessable income of the debtor. This can happen when a company pays a dividend under Division 7A and the debt owed to the company is forgiven.
There are many stipulations when it comes to debt forgiveness and Division 7A is one of them. This situation occurs when a company grants a debt forgiven and it is deemed to be a dividend paid to a shareholder under Division 7A. This rule applies to debts forgiven on or after 4 December 1997, the date the Division 7A rules were enacted.
There are instances where the debt forgiveness may be considered ordinary income. This happens when the taxpayer’s gain is a result of the released debt that would have arisen from normal activities of the taxpayer. It also may be deemed ordinary income if it displays attributes such as when the gains are periodic, recurring and expected.
When the financial climate is in stress there is normally a huge increase in debts forgiven, loans written off and bankruptcies filed. Debt forgiveness is not a common occurrence today however it should not be taken lightly, with all the implications that follow. It’s important to understand your tax obligations and “forgiveness” as it applies to the tax laws. If you have any questions about debt forgiveness and how it can affect you and your business, please give our office (tax agents located in Caulfield) a call to discuss your particular tax needs.
Hillyer Riches Management Pty Ltd is a Corporate Authorised Representative (No 466483) of Capstone Financial Planning Pty Ltd. ABN 24 093 733 969. AFSL / ACL No. 223135.This document contains general advice only and is not personal financial or investment advice. Also, changes in legislation may occur frequently. We recommend that our formal advice be obtained before acting on the basis of this information.