Debt forgiveness in a COVID-19 environment

The COVID-19 restrictions are slowly easing but the economic impacts are far from over.  While businesses struggle to find ways to free up cash, it is likely we will see restructuring of loans and waiving of debts.

Taxpayers and their advisors need to be aware of the taxation implications of restructuring and forgiving loans, including the Commercial Debt Forgiveness (CDF) rules, Division 7A and the CGT rules.

Key takeaway

The COVID-19 environment may lead to more debts being forgiven or treated as forgiven in the coming months.  The CDF rules and Division 7A are complex provisions with many modifications for different types of entities and debts.

Given the broad range of circumstances in which a debt may be treated as ‘forgiven’, it is possible that taxpayers may inadvertently find themselves in the CDF rules or Division 7A.  In the current economic climate, taxpayers may be restructuring loans to avoid defaulting and should be aware that in certain cases, such as where there is an assignment or a debt/equity swap, the restructure may cause the debtor to lose certain tax attributes or be assessable on a deemed dividend.

CDF rules

The CDF provisions are in Division 245 of the 1997 Act.  The rules apply to the debtor who receives the benefit of the debt forgiveness by requiring certain tax attributes (such as losses, deductions etc) to be reduced.  Importantly, the breadth of the CDF rules means taxpayers may find themselves inadvertently subject to the provisions even if they did not intend for a debt to be ‘forgiven’.

The CDF rules are an integrity measure to provide symmetry to the tax treatment of the debt.  As the creditor may be able to claim a deduction or a capital loss for the forgiven debt, a tax adjustment can be imposed on the debtor, by reducing certain of its tax attributes that would otherwise be used to decrease its taxable income in future income years.

What debts are covered by the CDF rules?

The CDF rules do not use the usual definition of ‘debt’ that applies in other provisions of the tax law.  A debt will only be covered by the CDF rules where some or all of the interest payable on the debt is, was or will be allowed as a deduction to the debtor.  If the interest is made non-deductible by a provision in the tax law (other than section 8-1 of the 1997 Act), it will still fall within the CDF rules.

If no interest is payable on the debt, it may still be subject to the CDF rules if the interest would have been deductible had it been charged.

Unpaid trust distributions will generally not be covered by the CDF rules as the amount is not a ‘debt’ unless it has been converted into a loan.

When is a debt ‘forgiven’?

There are a number of ways in which a debt can be ‘forgiven’ under the CDF rules.  The debtor’s obligation to pay may be waived or released or the parties enter an agreement to cease the liability at a future date for nominal consideration.

A debt is also ‘forgiven’ if it becomes statute barred.

Additionally, a debt is ‘forgiven’ if it is assigned by the creditor to an associate of the debtor, or there is a new arrangement where the debtor and the new creditor are parties.  As such, where loans are restructured by way of assignment between related entities, the CDF rules may be triggered.

The rules can also apply where there is a debt/equity swap where the debtor issues shares to the creditor and uses the subscribed funds to repay the debt.

Implications for the borrower

If a debtor has a debt that has been forgiven and is subject to the CDF rules, it must calculate the ‘net forgiven amount’ and apply this to reduce its tax attributes in the following order:

• Deductible revenue losses
• Deductible net capital losses
• Certain deductible expenditure
• Cost base of certain CGT assets.

If there is still a net forgiven amount left, it is disregarded (unless the debtor is a partnership in which case it is applied to the partners).

Net forgiven amount

The gross forgiven amount is the value of the debt less any consideration given to the creditor for forgiving the debt.

In most cases, the debtor is assumed to be solvent and the value of the debt is its market value on the date the debt is forgiven.  Generally, this will be the value of the asset in the hands of the creditor (most likely face value).

In some cases, the insolvency of the debtor may be taken into account giving the debt a nominal value (on the basis that it was virtually worthless).  This may occur where the debt was not entered into on an arm’s length basis and the creditor is not in the business of lending money and is an Australian resident (or the forgiveness was a CGT event involving taxable Australian property).

The consideration provided by the debtor to have the debt forgiven is generally the amount the debtor has paid (or is required to pay) and the market value of any property given (or required to be given) in respect of the forgiveness.  Market value is calculated at the date the debt is forgiven.

If the debtor did not provide any consideration to the creditor, or the parties were not dealing at arm’s length, the consideration is deemed to be the market value of the debt when it is forgiven (assuming the creditor is a resident or the forgiveness is a CGT event involving taxable Australian property).

The rules are modified where the debt was forgiven by assignment or by way of a debt/equity swap.

The gross forgiven amount (if any) is reduced by certain amounts that result from the forgiveness that will be included in the debtor’s taxable income.  The result is the net forgiven amount.

How to reduce the tax attributes?

The debtor must first reduce its tax losses by the net forgiven amount.  This includes tax losses from any income year prior to the forgiveness year.

Any net forgiven amount remaining after it has been applied to tax losses must be applied to capital losses.  This includes capital losses for any income year prior to the forgiveness year.

If there is still a net forgiven amount remaining, it is applied to reduce certain deductible expenditure incurred prior to the forgiveness year.  The CDF rules list the types of deductions that may be reduced which includes capital allowances, borrowing expenses, R&D and capital works.

Finally, if there is a net forgiven amount remaining, it is applied against the cost base of the debtor’s CGT assets.  The net forgiven amount cannot reduce the cost base of any asset lower than the reduced cost base which is calculated on the assumption it was disposed of for market value on the first day of the forgiveness year.  Certain assets are excluded including pre-CGT assets, assets acquired during the forgiveness year, personal use assets, main residence and goodwill.

Division 7A

In cases where a private company has a debt owed to it by a shareholder or their associate, the forgiveness of the debt can also trigger a deemed dividend to the debtor under Division 7A of the Income Tax Assessment Act 1936 (1936 Act).

When is a debt forgiven for Div 7A purposes?

Section 109F of the 1936 Act is the relevant deeming provision.  It picks up the same concepts of when a debt is forgiven as the CDF rules.  It also applies to debt parking arrangements in which the private company assigns the debt to an associate of the debtor.  Additionally, section 10F applies where a reasonable person would conclude the company will not insist on repayment of the debt.

Importantly, if the extended meaning of forgiveness results in the same debt being forgiven multiple times, section 109F will only operate on the earliest.  For example, if a debt has become statute barred in an earlier year of income and is formally released in a subsequent year, section 109F will only operate to deem a dividend in the earlier year when the statute barring arose.  As such, a detailed review of a debt’s history should be performed to ascertain whether section 109F has already deemed a dividend in an earlier year, such that the subsequent formal release will have no further impact.

Are there any exceptions?

Section 109G of the 1936 Act provides for various cases where a deemed dividend will not arise, including:

• where the debtor is a company (acting in its own capacity);
• the debtor becomes bankrupt; or
• the debt itself triggered a deemed dividend. This last exclusion can be important as review of the history of the debt may reveal that making of the loan triggered a deemed dividend in an earlier year, such that the formal release will not trigger a further deemed dividend.

Finally, the Commissioner of Taxation has discretion to disregard a deemed dividend arising on forgiveness of a debt if he is satisfied the forgiveness was because payment would cause undue hardship, the borrower was solvent when the debt arose and has subsequently lost the ability to repay due to circumstances beyond their control.  The impacts of COVID-19 will presumably see many applications for the Commissioner’s discretion being made.

Implications for the lender

The tax implications for the lender will depend on their individual circumstances.  If the creditor made the loan in the ordinary course of business or for income producing purposes, it may be entitled to a deduction or a capital loss for the value of the forgiven debt.

If the lender received no consideration for the forgiveness, the CGT rules will deem it to receive market value proceeds.  If the debtor is solvent, this could amount to deemed proceeds equal to the face value of the debt, resulting in no capital gain or loss being realised.

Finally, if the lender did not make the loan for income producing purposes, for example if the loan was interest-free or made to a discretionary trust, the loan will be a personal use asset for CGT purposes and the lender will be required to disregard a capital loss.