Flash: Bad Debt and Limited Recourse Debt Amendments

TaxFlash
July 2012
Bad debt and limited recourse debt amendments

Changes to the taxation of related party bad debts and the taxation of limited recourse debts were announced in the 2012 Federal Budget. Treasury has now released discussion papers describing the proposed amendments. Submissions on the proposals close on 10 August 2012. We invite clients to provide us with comments for our Treasury submissions.
BHP BILLITON DECISION

Both sets of amendments represent the Governments response to the High Court decision in the case of Commissioner of Taxation v BHP Billiton. The case involved an internal financier in the BHP Billiton Group making a loan to a special purpose subsidiary to construct a plant using a new production process. Ultimately the plant proved unsuccessful, resulting in the subsidiary being unable to repay the loan. The lender company claimed a deduction for a bad debt on the basis it was engaged in the business of money lending, while the borrower did not recognise any adjustment to its capital allowance deductions under the limited recourse debt provisions. The Tax Office denied the bad debt deduction and further claimed the borrower should recognise an adjustment on the basis the borrowing, taken out to purchase the plant, was a limited recourse debt. The court found for the taxpayers in both instances.
Align the characterisation of bad debts

Treasury proposes to: Deny a deduction for a related party bad debts, where the amount that gives rise to the bad debt has not been included in the creditors assessable income; Allow a capital loss to the creditor (we assume the usual Capital Gain Tax rules will apply to the calculation of the capital loss, including the market value substitution rule); Where the debtor would have been assessable on any gain because of the forgiven debt (e.g. the debtor also was a money lender), then that gain will be on the capital account arising at the same time as the creditors capital loss; and Other debtors would remain subject to the commercial debt forgiveness rules.
BAD DEBTS RELATED PARTIES

The key to the amendments for related party debts is the misalignment between the treatment for borrowers and the treatment for lenders. The lender claims a deduction, while the borrower does not recognise a corresponding amount of assessable income on the bad debt.
The bad debt deduction will be denied where the creditor is a related party and the amount has not been included in the creditors assessable income. This means related party trade debts will not be targeted by these amendments as the creditor would have included the debt in assessable income (on the provision of goods or services to which the debt relates). The treatment of trade debts does not need to change as it is generally already symmetrical. Where the debtor incurred the debt in the ordinary course of its business (e.g. purchase of trading stock) the forgiveness of the debt would be assessable income for the debtor (as per the principle in Warner Music).
Related parties
Treasury proposes to insert a definition of related party into the bad debt provisions that aligns with the definition of associate in the Controlled Foreign Company rules and associate entity in the Debt/equity rules. The intention is to target all related parties, not simply related companies. The only exclusion will be members of a consolidated group.
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Losses on impairment under TOFA

Treasury also proposes to amend the Taxation of Financial Arrangements (TOFA) provisions in Division 230 on impaired related party debts where the amount of the debt has not been included in the creditors assessable income. The creditor will instead have a capital loss.
At the inception of the loan, a person would not have the power to limit the creditors rights where there is only the possibility of any person acquiring that power.
Treatment of forgiveness gain

Treasury also proposes to amend the commercial debt forgiveness rules such that forgiven amounts that would have been assessable income (e.g. where the debtor is also a money lender) will not be assessable income. Instead they will be dealt with under the commercial debt forgiveness provisions (other than amounts assessable under the limited recourse debt provisions). It is interesting Treasury says it wants to align the treatment of intercompany bad debts for debtor and creditor, yet these provisions do not achieve that in many cases. While the amendments limit the creditor to a capital loss, the debtor continues to be caught by the complex debt forgiveness provisions, which reduce revenue losses carried forward before reducing capital balances i.e. the amendments in fact create further asymmetries in the tax law. These amendments will take effect from 8 May 2012.
These comments were made in the context of a loan to a special purpose company borrowing to acquire plant where the special purpose companys only asset was the plant acquired under the arrangement. This meant the creditors only recourse was to that plant. The Tax Office argued the loan was limited recourse because the creditor only had recourse against those assets, and as the value of those assets had fallen, the creditor had limited recourse to collect the debt. The court did not agree.
Proposed amendment
Treasury proposes to introduce a new definition of limited recourse debt to include arrangements where at the beginning, the creditors rights against the debtor, in the event of default in payment of the debt, are limited wholly or predominantly (whether or not by contract) to certain rights in respect of the financed property or other property. They provide this example to illustrate the amendment: Company C, a special purpose vehicle acquires an asset for $325 million, and it has no other assets. It finances the acquisition using $65 million equity provided by its nonresident parent company and $260 million debt provided by a bank. The bank only has recourse against the assets of Company C on default although there is no contractual limitation on the banks rights against the debtor. Under the proposed amendments, the debt would be a limited recourse debt as the banks rights against Company C are effectively limited wholly or predominantly to the assets of Company C (notwithstanding there is no contractual limit). This amendment will take effect from 8 May 2012.
LIMITED RECOURSE DEBT

Where a taxpayer acquires an asset with limited recourse finance, the taxpayers capital allowance deductions (e.g. depreciation) can be reduced where the full amount of the debt is not repaid because of the limited recourse nature of the finance agreement. The current law requires that the limited recourse nature of the arrangement must be a contractual term of the arrangement. This was confirmed in the BHP case, where the court considered the words the rights of the creditor are capable of being limited contained in the legislation, and made the following comments. The creditors rights are only limited where, at the inception of the loan, the borrower or someone else has the capacity to limit the creditors rights.
SUBMISSIONS
As noted, submissions on both proposals close on 10 August 2012. We will be making a submission on the proposals and would like to incorporate your comments.
TaxFlash - July 2012
Should you require assistance or additional information, please contact your PKF Tax Adviser Lance Cunningham Director of Taxation PKF Australia Limited Level 10 1 Margaret Street Sydney NSW 2000 Australia T +61 2 9240 9736 E [email protected]
PKF Australia Limited is a national network of legally independent member firms that trade as PKF. Member Firms of PKF Australia Limited have offices in ACT, NSW, QLD, SA, TAS, VIC and WA. Member Firms of PKF Australia Limited, are also Member Firms of the PKF International Limited network of legally independent firms. Neither PKF Australia Limited nor its member firms accept responsibility or liability for the actions or inactions on the part of any member firm or firms of PKF Australia Limited or of PKF International Limited. Disclaimer: The material contained in this publication is in the nature of general comment and information only and neither purports, nor is intended, to be advice on any particular matter. Readers should not act or rely upon any matter or information contained in or implied by this publication without taking appropriate professional advice. All financial figures are quoted in Australian Dollars unless otherwise indicated.
TaxFlash - July 2012

Flash: Bad Debt and Limited Recourse Debt Amendments

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TaxFlash

Bad debt and limited recourse debt amendments

BHP BILLITON DECISION

Align the characterisation of bad debts

BAD DEBTS RELATED PARTIES

Losses on impairment under TOFA

Treatment of forgiveness gain

LIMITED RECOURSE DEBT

TaxFlash - July 2012

TaxFlash - July 2012

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