Small business restructuring and tax implications

How tax debt can be written off and factored into tax losses. 

Small business restructuring (SBR) appointments continues to increase as the Australian Taxation Office (ATO) collects its $66.6B debt book blown out by the COVID support years. The ATO’s increased use of director penalty notices (DPN) is forcing directors to act within 21 days to avoid personal liability for tax debt by appointing external administrators, which include SBRs for viable and eligible businesses. We’ve seen creditors, in particular the ATO, accept write-offs up to 90% of debt value.

This article gives a practical guide on the various tax issues that may arise from an SBR appointment.

Outstanding tax lodgments 

Before creditors are given an offer (restructuring plan) to consider (4-6 weeks following the SBR appointment), the ATO generally requires:

• Outstanding Activity Statements (IAS, BAS) to be lodged, including an interim BAS for the quarter the SBR commenced.

• Prior year Income Tax Returns (ITR) to be lodged if overdue.

Directors may also elect to lodge the company’s ITR for the previous financial year (if not yet due) and interim current financial year. Any tax debt arising from these lodgments (IAS, BAS, ITR) are included in the pre-appointment debt to be negotiated through the restructuring plan offer.

Upon the SBR appointment, the ATO setup new Client Activity Centres (CACs) to distinguish between pre- and post- appointment debt so future obligations can be clearly met.

Effects of related party creditors forgiving debt prior to SBR acceptance

Unlike a Deed of Company Arrangement (DOCA), there is no ability for related party creditors to subordinate their debt to provide a higher rate of return to unrelated creditors. This has led to instances of related parties forgiving their debt owed by the company undergoing SBR, which may trigger a deemed dividend under Division 7A for the related entity forgiving the debt.

Tax treatment of the debt written off through SBR 

Once the restructuring plan is fulfilled and its creditors paid, the company is released from all admissible debts or claims. At Worrells, it’s our understanding that the debt written off under the restructuring plan is treated as non-assessable non-exempt (NANE) income, which means it cannot be included in the income tax return and therefore no tax is paid on the write-off amounts.

For the creditor writing off the portion of their debt not paid through the SBR, debt forgiveness rules may apply, typically providing the creditor with a revenue loss (or in some cases, capital loss).

What happens to carried-forward tax losses after the restructuring plan is completed? 

When the restructuring plan is completed, as the debts written off are taken as ‘forgiven’, the commercial debt forgiveness rules may apply. In these circumstances, the net-forgiven amount must be applied to reduce each tax balance to the maximum extent possible, in the following order: 

• Tax losses.

• Net capital losses.

• Certain undeducted revenue or capital expenditures.

• Cost bases of certain CGT assets.

However, where the company under SBR and creditor are companies under common ownership, the company’s net forgiven amount can be reduced to the extent that the related party creditor agrees to forego their revenue deduction or capital loss arising from the debt forgiveness.

The commercial debt forgiveness rules[1] do not apply to tax-related debt. Therefore, a company’s carried-forward tax losses (or any other ‘tax balances’) are not reduced when the tax-related debt owing to the ATO is partially reduced upon the restructuring plan completion.

Permanently written-off tax debt vs ‘not economical to pursue’ 

A key benefit of using SBRs is the formal and permanent release of any tax debt under an approved restructuring plan. Whereas an informal ATO agreement creates the debt being treated as ‘not economical to pursue’. Some examples of the ATO treating debt as ‘not economical to pursue’ include: 

• the anticipated cost of future recovery is likely to exceed the debt’s amount

• the age of the debt

• the taxpayer cannot be located; however, the debt may be re-raised when the taxpayer is located

• the taxpayer’s asset position

• whether a company has ceased to trade.

This distinction is important as the ATO may decide to resume pursuing debt if public interest considerations support recovery action. For example, taxpayers with a significant history of non-compliance.

The above is provided for general information purposes only and each company’s circumstances will be unique. Any tax advice should specifically address and be tailored to the unique circumstances. In the right circumstances, we recommend that formal taxation advice be obtained first, that sets out the proposed strategy and intended actions.

For more technical information about  small business restructuring, then check out our other recent articles.

[1] under Division 245 of the Income Tax Assessment Act 1997 (ITAA 1997).