Have your debts gone… bad?
Tax Telegraph, November 2012
The practice of having loans between related parties and ‘cleaning up’ loans in closely held groups has become very common. Where there are multiple parties or multiple debts involved, it becomes important to clean up these loan balances bearing in mind any tax consequences.
On 16 July 2012, the Treasury released a discussion paper titled Improving the tax treatment of bad debts in related party financing. The discussion paper follows a 2012/2013 budget announcement by the Government that it intends to amend the income tax laws in relation to bad debts written-off between related parties outside a tax consolidated group.
Under the current law, where the creditor is carrying on a business of money lending or the debt was assessable in a prior year, the creditor may claim a deduction for the bad debt written-off during a tax year. In contrast, the debtor is not necessarily obliged to bring the same amount to account as income at that time. Where the debt is forgiven, the commercial debt forgiveness rules usually apply to reduce the tax losses and net capital losses of the debtor. As a result, the revenue collected by the Australian Taxation Office (ATO) may be reduced when a bad debt is written-off by a creditor (and a tax deduction allowed) and the debtor is not obliged to include the same amount as income.
The proposed amendment aims to produce symmetry of tax consequences for the related creditor and debtor by denying the creditor a tax deduction for the bad debt written-off and disregarding the corresponding gain to the debtor. The creditor will recognise a capital loss in respect of the amount written-off. The debtor will continue to treat the amount forgiven as non-assessable gain which reduces the tax losses or net capital losses. This is the case unless the gain is specifically made assessable under the limited recourse debt rules.
The proposed amendment impacts non-consolidated entities such as privately owned companies and trusts that provide loans to related entities. The amendments do not have application for loans between members of a tax consolidated group as they are treated as a single entity for tax purposes and the loans between entities within a group are ignored.
If the proposed changes are enacted, they will have effect from 7:30 pm (AEST) on 8 May 2012.
Who will be affected?
The proposed amendments will apply to bad debts written-off between related parties that are not members of a tax consolidated group. It is proposed to insert a definition of ‘related party’ which includes resident and non-resident that are:
- An associate – as defined in section 318 of the Income Tax Assessment Act 1936;
- An associate entity – as defined in section 820-905 of the Income Tax Assessment Act 1997.
Broadly, an associate is an entity that has a sufficient influence over another entity. For example, an associate of a company can be a person or company (together with any of their associates) that controls more than 50% of the maximum number of votes that may be cast at a general meeting of the company.
An associate entity is a party that is accustomed, under an obligation, or is reasonably expected to act in accordance with the directions, instructions or wishes of the associated entity.
The definition is broad and will include most companies and trusts where loan is advanced to a related party and subsequently forgiven and written-off.
Example – Current law
During the 2011/12 tax year, Michael Pty Limited (Michael) made a loan to a related company called Tito Pty Limited (Tito). This loan is not a limited recourse loan. The interest accrued on the principal loan was treated as assessable to Michael in the 2011/12 tax return.
In the following tax year, Tito fell into financial trouble and its position did not improve throughout the year. As such, Michael recognised the unpaid accrued interest as bad debt and the unpaid loan and accrued interest were subsequently forgiven.
Michael should be entitled to claim a deduction in the 2012/13 tax year for the accrued interest written-off as a bad debt. The amount written-off is not assessable to Tito. Instead, the forgiven amount reduces Tito’s tax losses.
Consequently, the tax collected by the ATO that year is reduced as Michael is allowed a deduction for the amount written-off and the corresponding gain is not assessable for Tito.
Example – Proposed amendment
Under the proposed amendment, Michael is not entitled to a deduction for the amounts written-off and forgiven. Instead, Michael recognises a capital loss which may be applied to reduce the net capital gains realised in the same year or in subsequent tax years.
The amount forgiven will not be assessable to Tito. The amount forgiven generally reduces Tito’s carry forward tax losses or net capital losses.
Another reason to consider tax consolidation?
Notwithstanding the initial up-front costs of forming a tax consolidated group such as upgrading accounting software and professional consultancy fees, the benefits of consolidation in the long-term may outweigh the initial outlay.
The benefits of tax consolidation include:
- Ongoing compliance costs are reduced as the group lodges a single tax return and makes consolidated PAYG instalments. The group also pools its tax losses, franking tax credits and foreign tax credits
- Intra-group transactions are ignored for income tax purposes. The transfer of shares and capital assets between group members do not give rise to CGT\making corporate restructuring less onerous
- Complex integrity provisions such as those relating to loss deferrals and debt forgiveness do not apply to intra-group transactions.
It is common for private companies to raise funds by obtaining loans from its related parties, especially during economic times where external funding is difficult to obtain. By the same token, the Government is tightening the tax rules to protect its revenue streams.
Indeed, all of the circumstances, both commercial and tax, should be carefully considered and weighed when deciding on whether your group structure needs to change or your intra-group loans need to be re-arranged.
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