Chapter 8 - Debt remission
Introduction
8.1 Under current policy settings debt remission generates taxable income for the LTC’s shareholders. This is because of the interaction of the LTC rules with the financial arrangements rules. There is concern that when a shareholder is also the creditor this outcome can be inappropriate because the shareholder will have suffered a non-deductible loss on the same loan. This chapter discusses this issue and how it can be resolved.
8.2 Outside of the above situation, the chapter discusses a legislative clarification to ensure that the debt remission income arises as intended when a LTC either liquidates or elects out of the LTC rules.
Related parties debt remission in asymmetric situations
8.3 The February 2015 consultation document Related parties debt remission dealt with situations where the debt, if capitalised, would lead to no change in ownership of the debtor. These aspects are not further discussed in this paper.
8.4 However, for “look through” entities (ordinary partnerships, limited partnerships and LTCs) there is a variation of this situation that also seems to result in an inappropriate outcome. The issue is, therefore, not necessarily confined to LTCs.
8.5 Consider a simple LTC situation with several shareholders, all of whom are unrelated. One of those owners lends a sum of money to the LTC. This loan would be a financial arrangement and therefore subject to the financial arrangements rules in subpart EW of the Income Tax Act. Sometime later the LTC is in financial difficulty and the loan is remitted, giving rise to debt remission income.
8.6 Under current tax law all shareholders would derive debt remission income in proportion to their respective shareholdings. From a policy perspective this outcome is logical for the shareholders that did not advance the loan as they have in effect made a gain.
8.7 However, the creditor shareholder has actually made an economic loss (of the portion that is “attributed” to the other shareholders). Yet that shareholder is taxed on their share of the remission income with no tax deduction for their actual loss.[33] This result is not the desired policy outcome.
Example
George and Mario own, respectively, 60 percent and 40 percent of GEL Enterprises Limited (GEL), a look through company. In addition, George has advanced $1 million to GEL. Some years later GEL is effectively insolvent and George chooses to remit the loan.
From a taxation perspective, Mario derives taxable debt remission income from GEL’s base price adjustment (the BPA) of $400,000 and there are no policy problems with this. George derives $600,000 of taxable debt remission income but is denied a tax deduction for any of his $1 million loss. Economically George has lost a net $400,000, but he has taxable income of $600,000.
Proposed solution
8.8 The proposal is to turn off the creditor shareholder’s share of the debt remission income.
Example
In the above example, this would mean George would not have the $600,000 debt remission income so that overall he would be $400,000 out of pocket which matches the transfer to Mario, and Mario is taxed on that transfer as debt remission income.
8.9 Submissions on this proposal and on an appropriate application date are welcome. The change could be backdated to the inception of the LTC rules (1 April 2011) but this could result in compliance and administrative costs. We seek feedback on the extent to which shareholders of LTCs who have lent money to the LTC have found themselves in the above situation and have had to pay tax.
Loans to partnerships
8.10 Arguably the above approach should also apply to a creditor partner’s share of debt remission income when a partner has made a loan to a partnership and the loan cannot be subsequently repaid. Comments on this aspect and examples of practical situations in which it has been a problem are welcome.
Clarifying remission income on exiting the LTC rules
8.11 A concern underlying the removal of LAQCs was their use in the avoidance of remission income. Under standard tax rules a taxpayer can claim a deduction for an expenditure or loss for income tax purposes when it is incurred, even if payment has not taken place. Normally this is not an issue as any unpaid portion of expenditure is subsequently clawed back through the remitted income rules. However, shareholders of LAQCs could avoid this remission income.
8.12 Remission income arises in the year of remission, rather than in the year in which the deduction was originally claimed.[34] If remission income arose in an income year after the company had revoked its LAQC status, the directors and shareholders were not personally liable for the tax liability of the company, as that liability only applied in respect of an income year during which the company was an LAQC. As a result, shareholders could claim LAQC losses and then eliminate personal liability for the tax on the remitted income simply by revoking LAQC status before remission income was derived by the LAQC. The intention was that this outcome could not be achieved through a LTC.
8.13 The Income Tax Act makes it clear that remission income is intended to arise for LTC owners when they either elect to take their company out of the LTC rules or the LTC is liquidated, through their deeming to have disposed of their interests at market value. There has been some debate over whether this is the outcome in practice, although the intention is clear.
8.14 The issue is around the market value of any impaired third party loans at the time of disposal, with some practitioners arguing that the market value of a loan, distressed or not, is the present value of its future cash flows without considering its distressed impairment. This approach ignores the risk associated with the loan.[35] There are suggestions that this argument is being used to avoid remission income from distressed debt when a LTC “elects” out of the LTC regime or liquidates.
Proposed solution
8.15 A retrospective amendment is proposed to put an end to the above debate and to ensure that the debt remission income rules apply as intended – in other words remission income does arise for LTC owners when they either liquidate or elect to take their company out of the LTC rules.
[33] Even though a base price adjustment is required, the base price adjustment formula in effect negates the loss arising from the non-payment by including the amount remitted.
[34] Remission income includes an amount of debt that has been forgiven to a debtor.
[35] That risk should, however, be reflected in the market price that a third party would be prepared to pay for the loan.