Natural love and affection changes to debt forgiveness rules

The commercial debt forgiveness rules apply when a creditor releases, waives or otherwise extinguishes a debtor's obligation to repay a debt. The rules are designed to rectify the duplication of tax deductions as between the creditor and debtor.

The rules have an important exception - when the forgiveness is made for reasons of natural love and affection. Until recently, a forgiving creditor could be an individual, a company or an individual acting in the capacity of a trustee.

This month the ATO has revised its earlier position by handing down a draft Taxation Determination TD 2019/D9 which provides that a creditor must be a natural person in order to forgive a debt for reasons of natural love and affection.

The Provisions?

The rules correct the duplication of tax deductions that would otherwise arise from the forgiveness of commercial debt. Duplication could occur because, while a creditor might be entitled to a tax deduction or a capital loss when a debt is forgiven, the debtor, while relieved of the liability to repay the debt, is not assessed on any gain and therefore could continue to claim deductions for accumulated revenue, capital losses and other undeducted expenditure.

When the rules apply, the amount equal to the tax benefit obtained, known as the "net forgiven amount" is applied to reduce the debtor's tax balance of the following items which are otherwise available to reduce the taxpayer's assessable income:

• prior income tax losses;
• prior net capital losses;
• certain deductible expenditures including the opening adjustable value of depreciating assets; and
• CGT cost bases.

Section 245-40(e) of the Income Tax Assessment Act 1997 excludes a debt forgiven for reasons of natural love and affection from the application of the commercial debt forgiveness provisions.

Forgiveness rules in practice

A family trust - 'Smith Family Trust' - is an Australian resident trust. John Smith is the trustee. John Smith has a son - James who is the trustee of another trust ('James Property Trust'). Its beneficiaries are all family members of James and therefore are also related to John Smith. The Smith Family Trust loans money to the James Property Trust. The James Property Trust is solvent and has sufficient assets to meet its liabilities, including this debt.

The Smith Family Trust decides to forgive James Property Trust's debt. John Smith is motivated by natural love and affection for his son and the other beneficiaries of the James Property Trust who will benefit from the forgiveness.

Applying the previous interpretation of the forgiveness rules, the exception from the debt forgiveness rules applies - on the basis that the debt is forgiven for reasons of natural love and affection. Under the draft Taxation Determination TD 2019/D9, the debt could not be forgiven for reasons of love and affection as explained below.

ATO view on natural love and affection

The ATO's recent draft determination means that in order to satisfy the 'natural love and affection' exception, the forgiving creditor:

• cannot be a company; and
• cannot be an individual acting in their capacity as trustee of a trust.

According to the ATO, 'natural love and affection' imports strong emotions of caring, fondness and attachment that arise in consequence of ordinary human interaction. This interpretation serves to identify the motivation for the forgiveness. The ATO has said that the requisite connection between the motivation and the forgiveness can only be satisfied when the creditor feels the love and affection.

The ATO reasons that an individual acting in their capacity as a trustee cannot forgive a debt for reasons of natural love and affection because the fiduciary relationship will govern the decision taken by the trustee.

The ATO will not devote compliance resources to apply the views expressed in the draft determination in relation to debts forgiven prior to 6 February 2019 that would have been covered by the previous determination allowing forgiving creditors to be trustees and companies.

However, if the Commissioner is asked or required to state a view (for example, in a private ruling or in submissions in a litigation matter), the Commissioner will do so consistently with the views set out in the final, new determination.

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Commercial team.

More Cleardocs information on related topics

You can read earlier ClearLaw article on a range of topics