Commercial Debt Forgiveness – Is It Really That Simple?

The commercial debt forgiveness rules have been around since 1996, and they were put in place to level the playing field. Without these rules, a lender who forgives a debt could still get a tax benefit—like a revenue deduction or capital loss—while the borrower often wouldn’t face any tax consequences. Generally speaking, a forgiven debt doesn’t count as ordinary income for the borrower, so the rules aim to fix that imbalance.

But, for these rules to kick in, several things need to line up:

• There must be a debt.
• That debt needs to be a commercial one.
• The debt has to be forgiven.
• You’ll also need to calculate the gross and net forgiven amounts, which should be positive.

If all these boxes are ticked, the net forgiven amount will then affect certain tax attributes of the borrower.

What Counts as Debt?

Debt, for the purposes of these rules, has its usual meaning, but the definition extends to include things like non-equity shares that a company might issue.

What Makes a Debt “Commercial”?

A debt is considered commercial if:

• Some of the interest (or similar charges) paid or payable on it is deductible, or
• No interest is payable, but if it were, some of it could be deducted. For example, if a controlling shareholder loans money to their company interest-free, that still counts as a commercial debt.
• The debt is still commercial even if a specific provision of the law stops the interest from being deductible.

What Does It Mean for a Debt to Be Forgiven?

There are several ways a debt can be forgiven:

1. Release or Waiver: This is the most common scenario, where a debt is forgiven when the borrower is released from the obligation to repay, either partially or fully. This could include a complete failure to repay or an agreement to pay creditors a certain percentage of the debt.
2. Statute of Limitations: If the creditor doesn’t sue for recovery within a certain period (usually six years in Australia), the debt can be considered forgiven.
3. Assignment of the Debt: If the lender assigns the right to receive the debt to someone else—like an associate of the borrower—the debt might be considered forgiven.
4. Debt-for-Equity Swap: This happens when a debt is swapped for shares in the borrowing company.

Excluded Forgiveness

Certain types of debt forgiveness won’t trigger the usual tax consequences:

1. Fringe Benefit: If the forgiveness counts as a fringe benefit (like forgiving a loan to an employee), it falls outside these rules.
2. Already Included in Income: If the debt was already included in the borrower’s assessable income in some way, it doesn’t trigger these rules.
3. Bankruptcy: If the debt forgiveness is related to bankruptcy, it won’t have an impact under these rules.
4. By Will: Debts forgiven in a will are excluded from the rules.
5. Natural Love and Affection: If the debt is forgiven out of love and affection, the forgiveness might be excluded, though this is subject to certain conditions.
6. Tax-Related Debts: Forgiving tax-related liabilities doesn’t fall under these rules.

How to Calculate the Gross Forgiven Amount

The gross forgiven amount of a debt usually starts with the debt’s market value at the time it’s forgiven. Generally, this is just the face value of the debt. However, this can change if things like exchange rates or interest rates have had an impact.

If the borrower couldn’t meet their debts when they borrowed the money, and the loan wasn’t on arm’s length terms, the value might be lower than face value. There are also specific rules for calculating the value of non-recourse or limited-recourse debts, or debts that have been assigned multiple times.

Net Forgiven Amount

After working out the gross forgiven amount, you reduce it by:

• Any amount already included in the borrower’s assessable income,
• Any deductions reduced because of the forgiveness,
• Any reductions in the cost base of an asset under CGT provisions,
• In some cases, the lender’s deductions or capital losses if they’re related companies.

The final net forgiven amount is then applied in a specific order to reduce tax attributes like revenue losses, capital losses, and the cost base of CGT assets.

Division 7A and Debt Forgiveness

Division 7A comes into play with private companies and their shareholders, deeming certain payments, loans, and debt forgiveness as dividends. Typically, if Division 7A applies, Division 245 won’t.

There are some nuances, though. For example, debt rearrangements within private groups could trigger Division 7A, particularly through debt parking, but this doesn’t necessarily mean Division 245 will apply.

Distributable Surplus

The distributable surplus rule ensures that dividends under Division 7A are only deemed where there are profits available. But, when it comes to payments or forgiveness, the ATO’s interpretation means it’s almost impossible to avoid or reduce a dividend based on a lack of distributable surplus.

Other Things to Consider

One last point—if a debt is forgiven, it will increase the borrower’s retained earnings. For companies and unit trusts, this could mean that when these earnings are eventually paid out, there might be tax consequences like unfranked dividends or CGT events.

Conclusion

The debt forgiveness rules are complex and need to be carefully considered in any restructuring or transaction involving debt. It’s always a good idea to get professional advice before forgiving any debt.