Issue
Where an arm's length 'commercial debt' is forgiven and the debtor has to apply the 'total net forgiven amount' to deductible expenditures, can the debtor choose which items of deductible expenditure are reduced under section 245-150 of Schedule 2C to the Income Tax Assessment Act 1936 (ITAA 1936)?
Decision
Yes. The debtor can choose which items of deductible expenditure are reduced and the amount applied in reduction of each such expenditure under section 245-150 of Schedule 2C to the ITAA 1936.
Facts
The debtor, an individual, entered into an arm's length loan with a company on 1 July 1999 for an amount of $16,500. The loan was for a period of 10 years and was used in the course of carrying on the debtor's retail business.
The debtor had the capacity to repay the loan at the time it was provided.
On 15 January 2001, the company chose to forgive the outstanding loan amount, including interest, of $9,100 as the debtor was experiencing severe financial difficulties and was unable to repay the debt.
The net forgiven amount of the debt was $9,100.
This was the only debt forgiven in favour of the debtor in the forgiveness year. Prior to lodging a tax return for the 2000-01 income year, being the year in which the forgiveness of the debt occurred (the 'forgiveness year of income'), the debtor had no deductible revenue or net capital losses of a prior year.
An item of depreciable plant was acquired by the debtor on 1 July 1998 at a cost of $10 000 and has been depreciated at a rate of 10% applying the diminishing value method.
Details of depreciation claimed were as follows: • Year ended 30 June 1999 $1,000 • Year ended 30 June 2000 $ 900
The opening undeducted cost for the year ended 30 June 2001 was $8,100.
Borrowing expenses totalling $1,000, incurred in respect of the loan from the company, were deductible over 5 years commencing 1 July 1999 and $200 had been deducted in the debtor's income tax return for the year ended 30 June 2000.
The debtor chose for the total net forgiven amount to be firstly applied against the depreciable plant, and secondly the borrowing expenses (its only other deductible expenditure).
Reasons for Decision
Where commercial debts owed by an individual are forgiven after 27 June 1996, the total net forgiven amount within a given income year, must be applied in accordance with the commercial debt forgiveness provisions of Schedule 2C to the ITAA 1936, to successively reduce the individual's deductible revenue losses, deductible net capital losses, deductible expenditures and the relevant cost base of certain CGT assets.
The 'total net forgiven amount', as defined by subsection 245-105(1) of Schedule 2C to the ITAA 1936, is the sum of the net forgiven amounts of the debtor, calculated in accordance with Subdivision 245-D of Schedule 2C to the ITAA 1936, for the forgiveness year of income.
As there is only one net forgiven amount for the debtor in the forgiveness year of income, the total net forgiven amount is $9,100.
As the debtor has no deductible revenue or net capital losses incurred in years of income before the forgiveness year of income, the total net forgiven amount (hereafter referred to as the 'residual forgiven amount') must be applied to reduce deductible expenditures in accordance with subsection 245-105(7) and section 245-145 of Schedule 2C to the ITAA 1936.
Subsection 245-150(1) of Schedule 2C to the ITAA 1936 allows the debtor to choose the order in which items of deductible expenditure are reduced, and the amount applied to each item provided the residual forgiven amount is applied, to the maximum extent possible, in reduction of deductible expenditures.
The debtor has chosen that the residual forgiven amount be firstly applied to the depreciable item of plant.
As the plant is subject to depreciation applying the diminishing value method, the residual forgiven amount of $9,100 is applied to reduce the undeducted cost of the item of plant at the start of the forgiveness year of income from $8,100 to nil. The amount of the reduction is taken as having been allowed as a depreciation deduction before the forgiveness year of income in accordance with subsection 245-155(2) of Schedule 2C to the ITAA 1936. As the undeducted cost of the item of plant at the start of the forgiveness year of income has been reduced to nil there are no further depreciation claims allowable in respect of the item of plant in either the forgiveness year of income or any future income year.
The residual forgiven amount to be applied to other items of deductible expenditure is $1,000.
Subsection 245-155(1) of Schedule 2C to the ITAA 1936 provides a basis for reductions to deductible expenditure where tax deductions in respect of that expenditure are calculated as a percentage, fraction or proportion of an amount (the 'base amount') without regard to amounts previously allowed as a deduction. As the yearly deduction for borrowing expenses is based on the initial expenditure of $1,000, paragraph 245-155(1)(a) of Schedule 2C to the ITAA 1936 applies to reduce this base amount.
The application of the residual forgiven amount of $1,000 to this expenditure will result in the base amount of the borrowing expenses being reduced to nil for the forgiveness year of income and later years of income under paragraph 245-155(1)(a) of Schedule 2C to the ITAA 1936. Therefore, the debtor has no entitlement to a deduction in respect of the borrowing expenses for the forgiveness year of income or any future year of income.
The debtor has previously deducted $200 in borrowing expenses for the year of income ended 30 June 2000. Paragraph 245-155(1)(c) of Schedule 2C to the ITAA 1936 applies to limit the total deductions allowed for all years of income (including years of income before the forgiveness year of income) to the base amount as reduced - that is, nil.
Accordingly, the debtor's income tax assessment for the 1999-2000 year of income will need to be amended to disallow the deduction for borrowing expenses.
The full amount of the total net forgiven amount has been applied for the purposes of section 245-105 of Schedule 2C to the ITAA 1936.