Simple debts are not as simple as you think!

The issue

There seems to be a fairly common misconception that an individual can claim a capital loss for a debt which is not fully recovered. This is generally incorrect.

When a lender does not recover a simple debt in full there is no disposal for capital gains tax purposes and therefore there cannot be a loss. The legislation says:

Where a person incurs a debt to another, whether in sterling or in some other currency, no chargeable gain shall accrue to that (that is the original) creditor……on a disposal of the debt, except in the case of the debt on a security……….

It follows from this that there will be no capital loss for amounts not recovered (although if some fairly onerous conditions are met it may be possible to obtain relief for irrecoverable loans to a trading company).

This simple position can get more complicated if a debt is discharged in consideration for the receipt of property.

Property acquired by creditor in satisfaction of his debt

When a creditor discharges his debt for property then the tax acquisition cost of the property will be its market value and the creditor will not realise a capital loss. This is consistent with the position above. However, the rules are more friendly if the property is later disposed of at a gain. This is because any gain can then be reduced so as not to exceed the gain that would have occurred if the property had been acquired for the face value of the debt.

Example

Mr Trump owes Mr Johnson £1M which Mr Johnson lent him some time ago. Mr Johnson gets tired of chasing this loan and eventually accepts a property worth £500,000 in full and final settlement of the loan. Some years later Mr Johnson is able to sell the property for £650,000 and is curious to know his tax position. Prima facie he has a gain of £150,000 but fortunately is able to reduce this to nil which would have been the position if the property had been treated as being acquired at the £1M face value of the debt (well that would have given rise to a £350,000 loss but the adjustment is only able to reduce a gain).

Forbes Dawson comment

This legislation is not widely known about but could be used to improve the tax position when debts are not repaid in full. For example if a creditor accepts an amount in full and final settlement then it may make sense for him or her to accept that settlement as an asset rather than cash. If shares (for example) were accepted then the creditor would have the comfort of knowing that he or she would only be subject to tax on any gains once the value of the shares exceed the face value of the loan. This is quite a small detail but could save significant tax in the long run. Clearly the creditor would also need to be happy with the commercial risks surrounding the asset and ideally would have intended to acquire it in any event.

 

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