Deductions and expenses: unpaid present entitlement and bad debt deduction

Is the taxpayer, a beneficiary of a trust, entitled to a deduction under section 25-35 of the Income Tax Assessment Act 1997 (ITAA 1997) for unpaid present entitlement amounts that have been written off as bad debts?

No, the taxpayer is not entitled to a deduction under section 25-35 of the ITAA 1997 as the requirement in paragraph 25-35(1)(a) was not met. The present entitlement to income resulted in an amount calculated pursuant to Division 6 of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) being included in the taxpayer's assessable income under section 97 of the ITAA 1936. Whilst the entitlements may have become debts at a later time, neither the entitlements themselves nor the debts that they gave rise to were included in assessable income.

The taxpayer was a beneficiary of a trust.

In each of the 1996-97 to 2001-02 income years (inclusive), the taxpayer was made presently entitled to income of the ABC Trust. None of the present entitlements were paid.

During the 2011-12 income year, the trustee of the ABC Trust was wound up and the trustee advised the beneficiary that there was no likelihood of the entitlements being paid.

During the 2011-12 income year, the beneficiary determined that the unpaid present entitlements were bad debts and they were written off in its books of account as bad.

The taxpayer sought to claim a deduction under section 25-35 of the ITAA 1997 in the 2011-12 income year.

The taxpayer is not in the business of lending money.

A deduction for a bad debt may be claimed under section 25-35 of the ITAA 1997 if the requisite conditions are satisfied.

Paragraph 25-35(1)(a) provides that: You can deduct a debt or part of a debt that you write off as bad in the income year if: (a) it was included in your assessable income for the income year or for an earlier income year; or (b) it is in respect of money that you lent in the ordinary course of your business of lending money.

Taxation Ruling TR 2010/3 states in part: 34. When a beneficiary is presently entitled to an amount from a trust estate, it has an equitable right to that amount. That is, the beneficiary has rights in equity and not, without more, as a result of any debtor-creditor relationship

Whilst the rights arising from a present entitlement can, in some circumstances, become, or crystallise into an equitable debt (for example, upon calling for payment of that entitlement), the right that arises on the creation of a present entitlement is not a debt. [1]

Moreover, the amount included in the taxpayer's assessable income is not the amount of the present entitlement. Rather it includes in its assessable income its proportionate share of the trust's 'net income' [2] calculated by reference to the proportionate share of the income of the trust to which the taxpayer is presently entitled. That is, the amount assessed to the taxpayer may be a very different amount than the amount to which it was entitled to receive from the trust.

As the taxpayer has not brought a debt into account as assessable income and does not carry on a business of lending money, the bad debt cannot be claimed as a deduction under section 25-35 of the ITAA 1997.