The unprecedented COVID-19 pandemic is having a significant financial impact on many Canadian businesses regardless of their size.
A business experiencing financial difficulties may attempt to negotiate a full or partial reduction in amounts owed to its creditors. In such event, the debtor should be mindful that the amount of any debt forgiveness will, in accordance with the Income Tax Act (Canada) (the “ITA”), reduce the tax attributes of the debtor and possibly result in an income inclusion for purposes of the ITA.
The debt forgiveness rules, which apply to both individual and corporate taxpayers, only extend to “commercial debt obligations”. Therefore, debts incurred for personal purposes are not subject to the debt forgiveness rules. Generally, a commercial debt obligation is incurred to earn income from a business or property. Examples of a commercial debt obligation include a loan from a financial institution to finance the business activities of a business or an unpaid amount to a supplier. The debt does not have to be interest bearing to constitute a commercial debt obligation.
The amount of any debt reduction is considered a “forgiven amount” and, in general terms, grinds down tax attributes in the following order, as prescribed by the ITA :
- Non-capital and restricted farm losses of prior years,
- One half of the balance of allowable capital losses (ABILs) of prior years,
- One half of the balance of capital losses of prior years.
If there remains any forgiven amount after applying items 1 through 3, the debtor may elect to reduce the tax attributes of items 4-8 below or include an amount into its income, as follows:
- The debtor can elect to reduce the capital cost or the undepreciated capital cost, as the case may be, of any depreciable property,
- The debtor can elect to reduce certain resource expenditures,
- If the debtor has applied items 4 and 5, the debtor can elect to reduce the cost of any non-depreciable capital property (other than personal-use property),
- If the debtor has applied items 4 through 6, the debtor can elect to reduce the cost of certain shares and debts,
- if the debtor has applied items 4 through 7, the debtor can elect to reduce the excess of its capital losses for the year over its capital gains for the year.
If there remains any forgiven amount following the application of items 1 through 8, one half of such balance will be added to the taxable income of the debtor for the year, unless the debtor elects to transfer that balance to a Canadian corporation or a Canadian partnership related to the debtor.
The foregoing provide only a general summary of the principal consequences of the application of the debt forgiveness rules under the ITA. These rules are complex and require careful analysis to mitigate their application. To the extent possible, a business should plan for the timing of any debt forgiveness in order to limit the consequences of these rules.
Miller Thomson is closely monitoring the COVID-19 situation to ensure that we provide our clients with appropriate support in this rapidly changing environment. For articles, information updates and firm developments, please visit our COVID-19 Resources page.