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Monday Ramblings – Can I get a CGT loss when I forgive a debt?

I know this is the second question I get asked – the first is can I get a revenue deduction which is “NO… COME ON MAN!” unless you are a money lender (section 8-1) or the debt has been treated as income and this is a bad debt (section 25-35) – but this is the more substantive question. So the question is…

I have a loan between two entities and I want to clean up the balance sheet so I would like to forgive the loan and I want to know if I can get a capital loss in the entity that is forgiving the loan?

First question is whether a debt is a CGT asset.

The answer is YES and note 1 in in section 108-5, the section where CGT assets are defined, states:

Note 1:

Examples of CGT assets are:

  • land and buildings;
  • shares in a company and units in a unit trust;
  • options;
  • debts owed to you;
  • a right to enforce a contractual obligation;
  • foreign currency.

The second question is what is the cost base of the debt?

Under Division 110 the cost base of a debt starts with the amount of the debt. But then the modifications in Division 112 apply, and especially the market value substitution rule in section 112-20.

Under this section, the first element of cost base is its market value at the time of acquisition if you did not incur expenditure to acquire it, some or all of the expenditure cannot be valued or, most importantly here, you did not deal at arm’s length with the other entity.

Example

A Co asks the bank for $100,000 but the bank refuses due to the current debt load of A Co. So B Co, a related entity, loans the amount to A Co.

What is B Co’s cost base for the CGT asset of the $100,000 loan? Whatever the market value of the loan is. Given a bank at arm’s length would not make the loan it is almost certain that the market value is less than $100,000. If the loan was to try to keep A Co afloat as it is on the brink of insolvency, then the cost base could be close to $0.

The third question is, was there a CGT event when the debt was forgiven?

YES. CGT event C2 (section 104-25 of the ITAA 1997) applies where an intangible CGT asset is abandoned, surrendered or forfeited, so it is pretty clear when a debt is forgiven a CGT event arises.

The fourth question is what was the consideration given to forgive the debt?

Generally there will be no actual consideration given for the forgiveness of a debt, but just like calculating the cost base, the market value substitution rule (section 116-30) can replace the actual capital proceeds with market value consideration. 

If a taxpayer does not receive any capital proceeds or the parties are not dealing with each other at arm’s length, the market value of the relevant CGT asset is taken to be the amount of the capital proceeds. This will be the case in most debt forgivenesses.

Example

A Co is profitable but pumps all its earning back into expansion. It owes B Co, a related party, $100,000. A third party wants to buy A Co but wants the balance sheet free of debt. A Co does not want to sell any of its assets to repay B Co so B Co agrees to forgive the debt.

The cost base of the debt is $100,000, and B Co forgives it for an actual payment of $0. But no capital loss arises as the market value substitution rule applies and the deemed consideration is $100,000 as B Co is solvent and could pay the loan

The last question is whether the debt a personal use asset?

If after all the above you still have a capital loss, then we need to consider if the debt is a personal use asset.

We need to do this for two reasons:

  • Any capital loss made from a personal use asset is disregarded (118-20). 
  • Any personal use assets acquired for $10,000 or less are exempt, meaning there will be no capital loss (section 118-10)

The definition of a personal use asset (subsection 108-20(2)) includes:

(d) a debt arising other than:

(i) in the course of gaining or producing your assessable income; or

(ii) from your carrying on a *business.

Often this arises where a parent lends money to their child interest free when they have the ability to repay it but some time later the child goes bankrupt. At this is a personal use asset, the parent will not get a capital loss.

SUMMARY

Just because a loan is on a balance sheet does not mean it has a cost base as if the loan was made when the entity was insolvent the market value rule made the cost base $0. 

Just because nothing when through the P&L does not mean the loan was forgiven for no consideration as if the loan was forgiven when the entity was not insolvent the market value rule will make the consideration often the face value of the loan.

And if either of these occur, then there is no capital loss.

And when this occurs, I then get asked how to treat this in the accounts. And my answer is the same as it is to any question about accounts… who cares? 

By Ken Mansell

As a stay at home Dad most of the week this is my way of pretending I am still the tax counsel of ASX and SEC listed companies, working at big 4 firms, working at the Federal Treasury, on the Henry Review and at Parliament House for the previous government.

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