Protecting capital losses – common issues with related party loans

The last few months have been tumultuous for Australia and within the tax world, we have seen a raft of new legislation being introduced to save the Australian economy. However, in trying to stay agile and keeping up to date with the changes, we may lose sight of the usual hidden issues contained within our complex tax system. One of these is the “personal use assets” provision and its impact on the capital gains tax (CGT) treatment of loans advanced by individuals (or any other entity) to prop up struggling businesses.

Scenario

A beneficiary of a discretionary family trust, Bob, who essentially runs the business provides a loan to the Trust on interest free terms. This is the only loan Bob has provided to any person/entity.

The purpose of keeping it interest free was so that Bob does not put undue stress on the operations of the Trust. As a result of COVID-19, the business can no longer trade and is wound up and the loan is forgiven by Bob to the Trust.

From the Trust’s point of view, the commercial debt forgiveness (CDF) rules would apply and we have not considered them in detail here.

From Bob’s point of view, he will have assumed that he will crystalise a capital loss on forgiveness of the loan but, herein, lies the main issue.

The issues – personal use assets

Capital losses made from personal use assets are ignored for CGT purposes and cannot be used to offset capital gains in the current or future financial years. Personal use assets include a debt (i.e. a loan receivable) which is not made:
 
  • in the course of gaining or producing assessable income; or
  • from carrying on a business.
When providing an interest free loan, it may be difficult to establish a nexus between the loan and income producing activities because, simply put, there is no interest income. Bob’s income from the Trust would ordinarily be a distribution of profit and it is unlikely there is a nexus between the loan and the profit distribution because Bob is not guaranteed to receive income from the Trust as the Trustee has discretion in how the income will be distributed (i.e. even if there is a profit, some other beneficiary may receive the income and not Bob).

In this circumstance, the ATO may take the view that Bob did not make the loan in the course of gaining or producing assessable income (or in carrying on a business) and any capital loss that would otherwise arise on forgiveness of the loan may be ignored because that loan could likely be considered a personal use asset.

Alternatively, had Bob charged interest on the loan, the loan would have been made in the course of gaining or producing assessable income (i.e. the interest) and the personal use asset provisions would not apply. If Bob carried on a business of providing loans, the loss may be allowable, but it is assumed this is not the case. 

Critically, the issue when making an interest free loan to a discretionary trust (as Bob has done above) is that no nexus can generally be established to generating future income.

What if the interest free loan was advanced by a shareholder to a company - would that change anything?

In FCT v Total Holdings (Australia) Pty Ltd, the taxpayer was able to successfully argue that interest free loans were made in the course of producing assessable income. The argument put forward by the taxpayer was that it provided interest free loans to a subsidiary so that the subsidiary became profitable sooner which would allow it to pay dividends to the parent company and thereby created a nexus between the interest-free loan and the eventual dividend income the parent company will receive. This argument is used often where shareholders provide interest free loans to companies, but these principles should not be relied upon without considering the facts of each case separately. Care must be taken when a non-shareholder provides an interest free loan to a company as they would not ordinarily be able to rely on the principles in the Total Holdings case to establish a nexus to generating future income.

Other issues - quantum of capital loss and the market value substitution rules

If it is determined that the ‘personal use asset’ provisions do not apply, another lurking issue is the market value substitution (MVS) rules for both proceeds and cost base in respect of CGT assets. Where parties may not be dealing with each other at arm’s length (common in related party dealings), the MVS rule can replace the cost base of a loan for the lender with the market value of the loan at the time of making it – meaning the cost base is limited to its market value at that time. This is important to consider because ordinarily the market value of the loan (the asset) will be dependent on various factors including the borrower’s ability to repay the loan at the time the loan funds were disbursed.

Using the scenario above, if Bob’s loan to the Trust was not considered a personal use asset, but at the time of making the loan there was little to no hope that the Trust had the capacity to repay him, the MVS rule may ‘kick in’ and reduce the value of the loan to a lesser amount (maybe even nil!). The market value would then be used in calculating the capital loss.

Where there are related party borrowings, a simple but useful question to consider is – would a third party such as a bank be comfortable with providing a loan under the same terms?

Parting words

Merely writing off (or journaling out) a loan in the financial statements is not enough to claim a capital loss - there needs to be a formal deed of release or another form of binding agreement between the lender and the borrower. The date of the agreement is of great importance as this would normally be the date the CGT event takes place and would determine which year the quantified capital loss would crystalise.

Further, the CDF rules (which are complex) and their application need to be considered by the borrower on release of the loan. The value of the loan under the CDF rules for the borrower generally mirror the outcome of the MVS rules for the lender.

Due to the impact of COVID-19 and business owners having to inject funds for say working capital, it is important that you consider these issues to “protect” your capital losses or you may miss out. It’s equally important to remember that these provisions could apply to any historical loans made. For business owners, these provisions can result in an even worse situation with no prospect of loan repayments and also no future capital losses.

Contact your Moore Australia specialist if you wish to discuss this in further detail.