Bad debt deductions for holders of debt - base maintenance
Summary of proposed amendment
This is the second of two bad debt measures in this bill. This change will align the tax rules with the current policy settings for taking bad debt deductions by limiting bad debt deductions that can be taken by holders of debt to the true economic cost.
The base maintenance changes apply from the date of introduction of the Taxation (Annual Rates, Foreign Superannuation, and Remedial Matters) Bill. As part of these changes, there will also be a rule that will require taxpayers who have taken excess deductions (that is, deductions exceeding the cost of acquisition and any income returned) to return those amounts as income in the 2014–15 year. The changes are also subject to a “savings” provision for taxpayers who are currently in the tax disputes process in relation to any prior bad debt deduction for the debt.
Under the current rules, a creditor in a financial arrangement who deals in or holds the same or similar financial arrangements can take bad debt deductions for amounts owing even where they have not suffered a cash loss.
The following example illustrates this issue.
In year 1 A lends B $1,000, repayable at the end of year 5. In year 2 C buys the debt off A and only pays $200 to purchase the debt (because B was facing financial difficulties so was considered unlikely to repay the full debt). Assuming the terms of the financial arrangement were not varied, B now owes C $1,000 at the end of year 5. Under the current law if C’s business includes dealing in or holding those financial arrangements, C could arguably take a bad debt deduction for the entire $1,000. This deduction could potentially be taken in the same year that C purchases the debt, even though the financial arrangement does not mature until year 5. If A was a holder or dealer of financial arrangements it will have taken a deduction of $800 for the loss on sale of the debt.
While the base price adjustment (a wash-up calculation that is performed when the financial arrangement comes to an end) will square up any excess deductions taken giving an income result where appropriate, the creditor (C in the example) is still able to benefit from a timing advantage (and potentially a permanent advantage).
This timing advantage arises because the bad debt deductions could be taken well before income from the base price adjustment is recognised. This result is not in line with the current policy settings for bad debt deductions, and it means taxpayers can take a deduction for an amount greater than the cash/economic loss incurred. The timing advantage also presents a risk to the integrity of the revenue base.
The proposed changes will align the tax rules with the current policy settings for taking bad debt deductions by limiting bad debt deductions to the true economic cost.
Both original and subsequent holders of debt who carry on a business of dealing in or holding the same or similar financial arrangements will be limited to taking bad debt deductions up to the true economic loss. This means original holders will be able to take bad debt deductions up to the amount lent, and subsequent holders will be able to take bad debt deductions up to the purchase price.
Deductions for amounts greater than the economic loss will be allowed if the amounts have previously been returned as income.
As an anti-avoidance measure, a holder of debt who deals in or holds the same or similar financial arrangements will only be able to take bad debt deductions for the true money at risk. This means that if the purchase of a debt was funded by a limited recourse arrangement, a bad debt deduction will only be allowed to the extent to which the limited recourse arrangement does not relate to the debt.
In certain circumstances taxpayers who have taken bad debt deductions of more than the economic loss before the date of introduction of the Taxation (Annual Rates, Foreign Superannuation, and Remedial Matters) Bill, will be required to return the excess deductions as income in the 2014–15 year.