Understanding the Tax Implications of Forgiving a Debt

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In the ever-changing world of business finance, it’s not uncommon for a company to find itself in a position where it cannot afford to pay back a loan to an associated person, such as a shareholder or director. Consulting with a tax advisor can provide valuable guidance in navigating these complex tax implications. In some cases, the company may be closing down, and the shareholder considers forgiving the debt to clear the balance sheet. But what are the tax consequences of such an action for both the company and the shareholder? Exploring the tax consequences of such an action for both the company and the shareholder becomes crucial.

The Shareholder’s Perspective

From the standpoint of the shareholder (the lender), a forgiven loan has some distinct tax implications. To begin with, the loan is considered an asset for Capital Gains Tax (CGT) purposes, and when the loan is forgiven, CGT event C2 happens because ownership of the asset comes to an end. This means that the loan, which is now forgiven for Nil consideration, and which was an asset of the lender, crystallises a capital loss as the cost base of the loan is equal to the amount of the loan.

However, the Commissioner specifies in the “CGT Determination Number 2” (TD2) that the lender is taken to have received an amount equal to the market value of the debt at the time of disposal. The market value of the debt at the time of disposal is considered as if the debt was not waived and was never intended to be waived. It’s also crucial to establish the timing of the CGT event because the event that gave rise to CGT event C2 is when the forgiveness of the loan to the company was formally effected​.

If the borrower is unable to repay the loan, it is likely that the market value of the debt is Nil. In this case, the lender would crystalise a capital loss that can be applied to offset capital gains.

If the borrower has the ability to repay some or all of the loan, the market value of the debt would be the amount that could be repaid, up to the face value of the debt. Consequently, the lenders capital loss is reduced accordingly.

The Company’s Perspective

For the company (the debtor), the tax consequences are slightly different. When a debt is forgiven, the debt forgiveness rules may apply if the debt is a “commercial debt”. A debt is considered a commercial debt in two scenarios:

  • if the interest paid or payable would be an allowable deduction to the debtor, or
  • if interest is not payable in respect of the debt, but if interest had been payable, it would have been deductible to the debtor.

Subsection 245 E of ITAA 1997 relates to the commercial debt forgiveness rules and the order that the net amount of a forgiven commercial debt needs to be applied. The net forgiven amount is applied in the following order

  • Against the deductible tax losses held by the company.
  • Any remaining balance will be reduced against the net capital losses held by the company.
  • If there are any balances of net forgiven amounts remaining after these reductions, it will be used to reduce certain categories of deductible expenses.
  • Any balance of net forgiven amount remaining after applying all these reductions will be applied against the cost base of certain CGT assets.
  • The net amount that remains after applying it against all the categories mentioned above will be disregarded (ie not assessable and not carried forward).

Exceptions to the Rule

There are, however, a few exceptions to the commercial debt forgiveness rules included in Division 245. These rules do not apply if the debt is forgiven:

  • when the debt is waived and the waiver constitutes a fringe benefit
  • as a result of bankruptcy
  • the debt has been included in the assessable income of the debtor
  • the forgiveness is effected under a will
  • the forgiveness is a result of love and affection or
  • the debt is a tax-related liability​1​.

In the end, the tax implications of debt forgiveness are not straightforward and can vary depending on the specific circumstances of the company and the shareholder. Please contact us to discuss these provisions should you be in the position of the lender or the debtor.

Author: Darren O’Malley

*Correct as of 13 June 2023

*Disclaimer – this article has been produced by Kreston Stanley Williamson as a service to its clients and associates. The information contained in the article is of general comment only and is not intended to be advice on any particular matter. Before acting on any areas contained in this article, it is imperative you seek specific advice relating to your particular circumstances. Liability limited by a scheme approved under professional standards legislation.

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