As much of Canada begins to loosen social restrictions surrounding Covid-19, many owners will be taking stock of the economic impact of the pandemic on their businesses. While the full economic picture is not yet known, many business are expected to realize losses, and consideration should be given to ensuring those losses can be optimally utilized, particularly since the Canadian tax system does not provide for consolidation within a corporate group.
One method of using losses within a corporate group is to amalgamate corporations. An amalgamation is the process whereby two or more corporations combine and continue as one corporation. An amalgamation might be an effective loss utilization strategy in circumstances where a business owner has two corporations, and one is expected to be profitable while the other is expected to realize losses. By amalgamating, the losses of one corporation can be used to offset the profits of the other. In considering an amalgamation for purposes of loss utilization, care should be taken to ensure that none of the “stop-loss” rules in the Income Tax Act (the “Tax Act”) will prevent the amalgamated entity from using the losses. Consideration should also be given to the timing of such amalgamation, which will trigger a year end for both amalgamating corporations. In addition, amalgamations are time-sensitive transactions that must comply with the applicable corporate law and must, therefore, be coordinated in advance of a proposed amalgamation date. Generally, however, the amalgamated corporation should be permitted to deduct the non-capital losses of the predecessor corporations on a go-forward basis.
On the liquidation of a subsidiary, a corporation’s non-capital losses may be transferred to its parent company, provided certain conditions are met. A subsidiary’s losses are available to the parent in the taxation year that begins after the commencement of the windup, meaning timing should be carefully considered before a windup is commenced. If the parent and subsidiary have the same taxation year end, a liquidation should generally have the same outcome as an amalgamation in terms of the ability of the parent company to use the losses of the subsidiary.
Transfer of Assets
Another potential planning opportunity is the transfer of assets within an affiliated corporate group. This strategy may be effective if one corporation intends to sell an asset with an accrued gain, while another corporation within the affiliated corporate group has non-capital losses. It may be possible to transfer the asset from one corporation to the other on a tax-deferred basis pursuant to subsection 85(1) of the Tax Act, in order to shelter the gain on the asset with the non-capital losses of the transferee corporation. For this strategy to be effective, the property must be property that qualifies for rollover treatment pursuant to subsection 85(1) of the Tax Act – land inventory, for example, does not qualify as eligible property pursuant to subsection 85(1) of the Tax Act. In addition, various anti-avoidance rules in the Tax Act must also be carefully considered to ensure that the transaction has its intended effect.
Affiliated corporations might also consider whether intercompany fees could be used to shift income from a profitable corporation to a corporation with non-capital losses. A common example of this is a management fee paid between affiliated corporations. However, the overall effectiveness of such fees as a loss utilization strategy depends on the fees being deductible for the payor corporation. As such, such fees must have a business purpose and must be incurred by the payor corporation for the purpose of gaining or producing income from business or property. However the fee is characterized, the payor corporation must be able to demonstrate the services being received from the payee corporation – a mere journal entry, with no actual services being provided, is insufficient to establish a business purpose for the intercompany fees.
In addition, the fees must be reasonable. If the fees are not reasonable in the circumstances, the unreasonable portion may be disallowed pursuant to subsection 67(1) of the Tax Act. What is reasonable in any situation will depend on the specific facts and circumstances, but generally speaking if the fees charged represent the fair market value of the services provided and are equivalent to what would be charged in an arm’s length situation, they are likely to be considered reasonable. In respect of management fees, in particular, the Canada Revenue Agency (“CRA”) has previously said that management fees will generally be considered reasonable if they represent a 15% markup over the cost of providing the management or administration services. Although this is a non-binding administrative position, it provides some guidance on what may be considered reasonable in circumstances where intercompany fees are challenged by the CRA.
Prior to implementing an intercompany fee, a corporation should consider its effect on any outstanding banking covenants. In addition, the benefits of such fees must be weighed against general commercial considerations; it should always be considered whether the tax advantage is worth the cost of implementation or the impact on commercial operations.
Another method of using losses within an affiliated group is through the use of intercompany loans. A loan strategy uses the same general mechanism as intercompany fees – its success depends on the profitable corporation receiving a deduction in respect of the interest payments made to the corporation seeking to use its non-capital losses. Also, similar to intercompany fees, it requires that the borrowed funds be used by the profitable corporation for the purpose of gaining or producing income from business or property. Oftentimes this income earning purpose takes the form of an investment by the profitable corporation back into the loss corporation that made the loan, usually in the form of shares. If a loan strategy is adopted, the use of the borrowed funds must be carefully considered to ensure that the requisite income earning purpose is present, such that the payor corporation is able to receive its interest deduction.
As with intercompany fees, before implementing an intercompany loan a corporation should always check any outstanding banking covenants and consider any other relevant commercial considerations.
The above are brief examples of some of the loss utilization strategies that can be employed within an affiliated corporate group. Depending on a corporation’s circumstances, one or more of these strategies may be an effective method to ensure that anticipated losses are optimally utilized within an ownership structure. Each method comes with its own risks, and parties who wish to implement these strategies should consult their tax and legal advisors prior to implementation to ensure all legal issues and risk factors are fully considered.
If you have any questions or would like to discuss the use of tax losses, please contact a member of the Miller Thomson LLP Corporate Tax Group.