Commercial debt forgiveness - whether creditor and debtor dealing at arm's length

Were a debtor and a creditor dealing at arm's length for the purposes of subsection 245-55(4) of Schedule 2C to the Income Tax Assessment Act 1936 (ITAA 1936) in respect of a loan which was made at non-commercial rates of interest?

No. Whilst the creditor company may have entered into the loan with the debtor company for sound business reasons, the fact that the loan was made at non-commercial rates of interest means that the debt was not incurred at arm's length for the purposes of subsection 245-55(4) of Schedule 2C to the ITAA 1936.

Debtor, a company, was at all times a wholly owned subsidiary of another company, the Creditor.

Due to Debtor having financial difficulties such that it had problems in obtaining funding from unrelated lenders, Creditor provided it with a loan that constituted a commercial debt as defined in section 245-25 of Schedule 2C to the ITAA 1936. Having regard to the prevailing market rates of interest for such loans the loan was subject to a low non-commercial rate of interest that an arm's length third creditor would not have agreed to.

The commercial debt was forgiven after 27 June 1996 such that subsection 245-35(1) of Schedule 2C to the ITAA 1936 applied.

Creditor was a resident at all times.

The debt was not a moneylending debt as defined in subsection 245-245(1) of Schedule 2C to the ITAA 1936.

Section 245-10 of Schedule 2C to the ITAA 1936 provides that Division 245 of the ITAA 1936 applies to the forgiveness of a commercial debt after 27 June 1996.

In calculating the notional value of a debt other than a non-recourse debt, both the first and second applicable amounts in subsections 245-55(2) and (3) of Schedule 2C to the ITAA 1936 respectively, are subject to the assumption that, at the time when the debt was incurred, the debtor was able to pay all its debts as and when they fell due.

Subsection 245-55(4) provides an exception to this assumption where: (a) either: (i) at the time when the debt was forgiven the creditor was a resident; or (ii) .... (b) the debtor and creditor were not dealing with each other at arm's length in respect of the incurring of the debt; and (c) the debt was not a moneylending debt.

In the present circumstances paragraphs 245-55(4)(a) and (c) of Schedule 2C to the ITAA 1936 are both satisfied, therefore the operation of the relevant subsection is dependent upon the application of paragraph (b) thereof.

The mere fact that Creditor and Debtor are related does not automatically mean that they were not dealing at arm's length in relation to the incurring of the debt.

The relevant test is whether it is reasonable to conclude that an arm's length creditor would have entered into the relevant loan on the particular agreed terms thereof.

Because of the low rate of interest in relation to the debt, it is not reasonable to conclude that an arm's length lender would have entered into the loan on the overall agreed terms.

The fact that Creditor may have had sound business reasons for making the loan on the relevant terms is not in itself conclusive in determining whether Debtor and Creditor were dealing at arm's length in relation to the incurring of the loan.