Capital gains tax: reduced cost base - bad debt deducted

Is a capital loss available when (CGT) event C2 in section 104-25 of the Income Tax Assessment Act 1997 (ITAA 1997) happens to a debt for which a deduction was allowed under section 25-35 of the ITAA 1997?

Yes, a capital loss will be available when CGT event C2 in section 104-25 of the ITAA 1997 happens to the debt. The amount of the capital loss will be the difference between the capital proceeds for the debt and its reduced cost base. Section 110-55 of the ITAA 1997 applies so that the reduced cost base of the debt is reduced by the amount already recognised as a deduction under section 25-35 of the ITAA 1997.

The taxpayer is carrying on a business of money lending. One of the unsecured debtors of the taxpayer was declared bankrupt.

The debtor's trustee in bankruptcy declares that no dividend will be paid to unsecured creditors. An amount was allowed as a bad debt deduction under section 25-35 of the ITAA 1997 in the 1999-2000 income year.

The unsecured debtor was subsequently released from all provable debts in accordance with the Bankruptcy Act 1966.

CGT event C2 in section 104-25 of the ITAA 1997 happens to a debt when it is released, discharged or satisfied. A capital loss arises if the capital proceeds from the debt are less than its reduced cost base - subsection 104-25(3) of the ITAA 1997.

The reduced cost base of the debt is determined under section 110-55 of the ITAA 1997. Subsections 110-55(4) or 110-55(9) of the ITAA 1997 ensure that, in this case, the reduced cost base of the debt will be reduced by the amount that has been or can be deducted under section 25-35 of the ITAA 1997 in respect of it.

Subsection 110-55(4) of the ITAA 1997 relevantly provides that the reduced cost base of an asset does not include an amount to the extent that you have deducted or can deduct it. Accordingly, the reduced cost base of the debt is reduced by the amount deducted in the 1999-2000 income year under section 25-35 of the ITAA 1997.

Because there was some uncertainty about the scope of subsection 110-55(4) of the ITAA 1997, subsection 110-55(9) of the ITAA 1997 was inserted. It applies to CGT events happening on or after 21 October 1999 ( New Business Tax System (Integrity and Other Measures) Act 1999 Schedule 4, Item 2).

Subsection 110-55(9) of the ITAA 1997 states that the reduced cost base of an asset is to be reduced by an amount that you have deducted or can deduct, or could have deducted except for Subdivision 170-D of the ITAA 1997, as a result of a CGT event that happens in relation to a CGT asset. However no reduction is made for an amount that relates to a cost that could never have formed part of the reduced cost base or is excluded from the reduced cost base as a result of another provision of this section.

In this instance, the exception in subsection 110-55(9) of the ITAA 1997 will apply because the amount deducted under section 25-35 of the ITAA 1997 was excluded from the reduced cost base of the debt under subsection 110-55(4) of the ITAA 1997. If that were not the case then the reduced cost base of the debt would be reduced by subsection 110-55(9) of the ITAA 1997.