Article by Jonathan Wright. Click here for homepage.
Debt between related companies is commonplace. SubCo needs money to fund a new venture, so ParentCo lends the capital. SisterCo has an expense arising which is paid from BrotherCo’s bank account and accredited by the company bookkeeper as a loan.
In dealing with intercorporate debt, there’s a tax issue that’s often overlooked: what happens when debt is forgiven? This note tackles that issue, summarizing some of the factors to be considered and shedding light on the problems that might result.
The debt forgiveness provisions in the Income Tax Act (the “ITA”) apply to “commercial obligations” that are “settled”. Commercial obligations includes a debt from one entity to another where the debtor used the money for the purpose of earning income. These debts are “settled”, among other circumstances, when the debt is cancelled.
The tax consequences arise on the amount forgiven by the lender. This is the lesser of the original loan and the principal remaining, minus anything paid by the debtor in exchange for cancelling the debt.
The forgiven amount is applied first to reduce certain tax attributes on the assets of the debtor. For example, it first reduces its non-capital losses. These are losses which might otherwise have been able to reduce the future income, and thus the tax, of the debtor company.
When these are used up, the forgiven amount is applied next to reduce allowable business investment losses and capital losses, undepreciated capital cost balances, cumulative eligible capital amounts, and so on.
Once these are eliminated, half of the remaining balance is included in the income of the debtor, turning an otherwise innocent-looking transaction among related companies into a surprise tax bill.
Fortunately, there is some relief available.
One avenue arises where a debtor is insolvent. There is an ITA provision which permits a deduction from the income inclusion discussed earlier. This deduction is equal to the amount of the income inclusion minus two times the fair market value of the net assets of the debtor. If the net value of the assets is nil, then the deduction will be equal to the inclusion and no tax will arise.
Another option is to transfer the tax owing to related company that qualifies under the rules. For this to apply, the related company has to agree to the transfer.
The final method is to claim a reserve, allowing the income inclusion to be arise over five years instead of all at once.
There are further issues around debt settlement that are beyond the scope of this note. For example, unless strict requirements are met, the loss to the lender company on the debt settlement may be denied. This kind of uneven tax treatment, with tax issues to one entity and no benefit to the other, can be avoided with careful tax planning prior to entering into a debt situation.
If you are looking for tax advice on intercorporate debt or other matters relating to your business, please do not hesitate to contact the author at firstname.lastname@example.org or 604.678.4459, or visit our homepage at wrightlegal.ca.