Lending of funds between entities is common amongst family groups.
In the absence of any formal loan agreements, debt funding is both simple and cost effective. Cancelling or forgiving those debts, on the other hand, is not as easy and raises a number of issues.
Let’s look at an example
Entity ABC has made a number loans to an associated entity, entity XYZ to assist entity XYZ in funding its business activities. For whatever reason, entity XYZ is no longer able to repay entity ABC and so it has been suggested that entity ABC forgive the loan owed by entity XYZ.
However, for capital gains tax (CGT) purposes the loan owing to entity ABC by entity XYZ is a capital asset of entity ABC. Therefore, the forgiveness of the debt potentially triggers aCGT event giving rise to a capital loss for entity ABC. However, entity ABC is not entitled to a capital loss if the debt is characterised as a “personal use asset”.
The characterisation of the loan as a personal use asset is determined by whether the loan is held in the ordinary course of its business for income producing purposes. Providing the loan was granted by entity ABC for the purpose of deriving interest payments or other income producing purposes, the loan is not a personal use asset to entity ABC.
On the other hand, if no interest is being payable on the debt and the loan was made for no other reason than to provide assistance to entity XYZ, the loan will be a personal use asset. On this basis, entity ABC would not be entitled to a capital loss on the forgiveness of the debt.
Where the debt is forgiven you need to consider whether the forgiven amount is assessable as ordinary income to entity XYZ and whether the commercial debt forgiveness rules apply. This would be the case if the forgiveness was an ordinary incident of the business of the debtor. For example, if the debt arose in the course of buying trading stock and the supplier agreed to wave part of the debt, it may be considered to be assessable income for the debtor.
The loan owing to entity ABC is deemed to be a commercial debt where any interest payable on the loan was deductible to entity XYZ. In the event that no interest was payable, the debt is still classified as a commercial debt to the extent that any interest expense would have been deductible to entity XYZ. The loan owing to entity ABC satisfies this condition as funds from the loan were used to finance the company’s operating activities.
Under the commercial debt forgiveness rules, as a result of the loan forgiveness, entity XYZ is required to reduce the following amounts (in the order listed):
- carried forward tax losses;
- carried forward capital losses;
- written down value of depreciable assets; and
- CGT cost base of certain assets.
The moral of the story is that the debt may be forgiven, but it is certainly not forgotten.
If you would like to discuss the application of the commercial debt forgiveness rules to your situation, please contact Ellingsen Partners.