Broadly speaking, the commercial debt forgiveness (‘CDF’) rules contained in Division 245 of the ITAA 1997 must be considered when a creditor forgives a ‘commercial debt’ owing by a debtor. In these circumstances, where debt arose in the course of the creditor deriving their assessable income, they will generally incur a revenue or capital loss and get a corresponding tax benefit for the forgiven debt (e.g., a tax deduction or a capital loss to offset against capital gains). However, from the debtor’s perspective, in the absence of the CDF rules, there are generally no tax implications associated with the forgiveness of the debt they owe.
As such, the CDF rules were effectively designed to remedy a potential manipulation of the tax system that may occur in these circumstances (especially between related parties). As they are specifically designed to ensure that the debtor does not get the benefit of the forgiven debt without any tax implications, the CDF rules have no application to creditors.
Background to the operation of CDF rules
Where the CDF rules apply, the ‘net forgiven amount’ of a ‘commercial debt’ is applied by the debtor to reduce the following (in order):
- Deductible revenue losses that could be deducted (if the taxpayer had enough assessable income) in the forgiveness year or a later income year. Refer to S.245-115.
- Net capital losses of income years before the forgiveness year. Refer to S.245-130.
- Certain deductible expenditure incurred before the forgiveness year, such as expenditure relating to depreciating assets, capital works and borrowing expenses. Refer to S.245-145.
- The cost bases and reduced cost bases of certain CGT assets (which excludes pre-CGT assets, personal use assets, main residences, etc.). Refer to S.245-175.
Importantly, any part of the net forgiven amount remaining after being applied against all available amounts in each class is disregarded. That is, any excess net forgiven amount remaining after these four categories of items have been exhausted is not assessable to the debtor, nor is it carried forward to future income years. However, if the debtor is a partnership, then the residual amount is transferred to the partners (on a pro rata basis). Refer to S.245-195 and S.245-215.
For the purposes of the CDF rules, a debt is a ‘commercial debt’ if, the whole, or any part, of the interest payable on the debt is, was, or will be, deductible to the debtor. Furthermore, where interest is not payable on the debt, then the debt is still a ‘commercial debt’ if, had interest been charged, it would have been deductible to the debtor. Where the operation of a provision in the income tax legislation (other than S.8-1) prevents a deduction for interest that would otherwise be deductible (or would prevent a deduction, had interest been charged), the debt is still a ‘commercial debt’ and, hence, caught by the CDF rules. Refer to S.245-10.