A debt that has been incurred by a business that cannot be ‘collected or recovered’ may be reduced under the Australian Taxation Office’s commercial debt forgiveness rules. These rules often play a large role in insolvency proceedings and need to be handled carefully.
Commercial debt forgiveness occurs when a creditor forgives a commercial debt owed by a debtor. This means that a debt that your business owes could be forgiven if your obligation to pay the debt is released, waived or otherwise extinguished, other than by repaying the debt in full.
The commercial debt forgiveness rules operate so that the taxpayer is required to reduce a certain specified amount (such as tax losses, net capital losses or CGT cost bases of assets) by a “net forgiven amount”. Creditors are able to claim a tax deduction and debtors reduce their prior-year loss, tax deduction or cost base for the net forgiven amount.
This year, a recent update announced by the Australian Taxation Office has clarified that the existing natural love and affection exclusion from these rules can only apply where the creditor is a ‘natural person’. As a result, companies or other trusts cannot generally rely on the exclusion. However, the ATO has noted that this could potentially include an individual in their capacity as a trustee of a trust or as a partner in a partnership
This exclusion requires a direct connection between the forgiveness of the debt and the natural love and affection, where a creditor must be an individual and the ‘object’ of their love and affection must be another individual.
The ATO has indicated that an individual may be able to forgive a debt owing by a company or trust if the forgiveness has a direct connection with the natural love and affection for an individual associated with that particular entity.
If, for example, you borrowed money from your parent to fund your start-up company (100% of which is owned by you) and you now owe them a debt that you cannot pay back, your parent can choose to forgive the debt owed by your company due to the natural love and affection exclusion. Commercial debt forgiveness may be worth investigating if you find yourself in an insolvency situation but should be consulted with your adviser to ensure that compliance and your outstanding tax obligations are being correctly met.