Article written by STEVE YOUN, CPA, CA DE DMCL in the quarterly overview of Canadian news, a newsletter published by the Canadian member firms of Moore North America. This article on debt forgiveness is part of our mission to become your partner in success by keeping you informed.
The recent economic slowdown could lead to unforeseen tax problems. While creditors seem increasingly inclined to agree to debt forgiveness or settlement, or even partial repayment, many companies could settle debt for less than the principal amount. While this may appear, at first glance, to be advantageous for debtor companies, there are certain tax implications that need to be taken into account. In particular, debtor companies need to assess the impact of debt forgiveness rules so that they can plan accordingly.
With regard to the rules governing debt forgiveness, can we really talk about forgiveness?
As a reminder, sections 80 to 80.04 of the Canadian Income Tax Act contain a complex and comprehensive set of rules on the treatment of debt forgiveness. In other words, the rules governing debt forgiveness apply when a “commercial debt” has been settled for less than the total amount due (i.e. the “forgiven amount”). A commercial debt is generally a debt on which interest, if applied, is deductible from income. In other words, if interest on a particular debt is not deductible, the debt forgiveness provisions do not apply.
To determine the applicability of debt forgiveness, it is therefore necessary to examine the relevant statutory provisions and case law relating to the deductibility of interest under paragraph 20(1) of the Income Tax Act. A full examination of interest deductibility is beyond the scope of this article, but the key point is that the debt does not have to be interest-bearing to meet the criteria of a commercial debt. If so, the remitted amount is applied to reduce certain corporate tax attributes in a specific order, with the remaining unapplied amount included in the debtor’s income. These tax attributes, presented in the order in which they can be reduced, are as follows:
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- previous year’s loss reductions under subparagraph 80(3) – i.e., non-capital losses, net of allowable business investment losses (ABIL), farm losses and restricted farm losses;
- reductions in ABILs and gross capital losses (calculated on a gross basis in paragraph 80(2) ) subparagraph 80);
- reductions in the capital cost of depreciable property under subparagraph 80(5);
- reduction in resource expenditures under subparagraph 80(8);
- reductions in the adjusted cost base of capital assets under subparagraph 80(9);
- reductions in the adjusted cost base of certain shares and debts if the debtor is the holder specified under subparagraph 80(10);
- reductions in the adjusted cost base of certain shares, debts and partnership interests under subparagraph 80(11).
If there is a residual balance, 50% of any amount remitted will be included in the debtor’s income, in accordance with subparagraph 80(13) of the Income Tax Act.
To minimize the impact of the amount forgiven, consider transferring this amount or the depreciable property to a subsidiary. These practical strategies will be explored in greater detail in Part 2 of this article.
