On 7 July 2010 the ATO released a Fact Sheet entitled “Division 7A – Debt forgiveness by Private Companies”.
Practitioners should obtain a copy of this document from the ATO website because it contains important information that seems to be often overlooked when dealing with receivables for accounting purposes. This will affect both private companies with loans due from shareholders or their associates, or by a trust with unpaid present entitlement in favour of a corporate beneficiary.
The effect of a debt being forgiven is that the amount forgiven generally forms part of the debtor’s assessable income as a dividend that is deemed to have been paid by a private company in the income year in which the forgiveness occurred. As the character of the amount involved is neither a payment nor a loan, it cannot be repaid with interest to avoid the operation of Division 7A.
There has been a final tax ruling recently released on the issue of whether an unpaid present entitlement by a trust in favour of a corporate beneficiary, constitutes a loan from the beneficiary to the trust. Practitioners are urged to also obtain a copy of Taxation Ruling TR 2010/3 entitled “Division 7A loans: trust entitlements”, and ATO Draft Practice Statement PS LA 3362, which provides practical guidance on the administrative aspects of Taxation Ruling TR 2010/3. These documents will also have relevance on the question of forgiven debts.
For the purpose of discussing forgiven debts, regard must be had to the way in which a debt has been forgiven, and these are set out in Schedule 2C of the Income Tax Assessment Act 1936, as amended by section 109F.
One of the ways in which a debt can be forgiven for Division 7A purposes is that it becomes statute barred. A debt that came into existence after 4 December 1997 will be subject to these rules in section 109F, being the date when Division 7A took effect, but it could also have applied to debts arising before that date.
Practice statement PSLA 2006/2(GA) essentially says that the Commissioner will not enforce the provisions of Division 7A to loans that become statute barred where the loans were made prior to the commencement of Division 7A.
In that practice statement the Commissioner said that he would not take “active compliance action” for pre-Division 7A Loans, however it does not mean that the Commissioner could not avail himself to another rule within Division 7A to treat a debt as being forgiven, even if it is statute barred.
Under the Fact Sheet, a debt can be forgiven if the obligation to repay the debt is released, waived or otherwise extinguished or becomes statute barred (which is usually a six year period, except in the Northern Territory where it is three years). The period commences from the date that the right to sue to recover commences but can be extended if the debtor acknowledges or makes part payment.
There is a discretion available to the Commissioner that advisers should be aware of. Subsection 109G(4) allows the Commissioner to treat a forgiven debt as not giving rise to a deemed dividend. In doing so, he must be satisfied that:
- the debt was forgiven because payment of the debt would have caused the entity undue hardship;
- when the entity incurred the debt, the entity had the capacity to pay the debt; and
- the entity lost the ability to pay the debt in the foreseeable future as a result of circumstances beyond the entity’s control.
Finally, practitioners should be aware of the potential effect of section 109F(6). That provision allows the Commissioner to form the view that a debt will be forgiven if a private company will not insist on the repayment of that debt. The forgiveness occurs when the view is formed. That begs the question: how would a debt that has remained dormant as a receivable in the balance sheet be treated?
Now is a good time to review the balance sheets of your private company and trust clients. Any debit balances that would otherwise be caught by Division 7A, unless they are under written loan agreement where the proper minimum loan repayments are being made, need to be reviewed and rectified.
By Arthur Athanasiou, Accredited Tax Law Specialist, Partner – Rigby Cooke Lawyers.