Debt forgiveness rules, is all really forgiven? (part 2)
BY STEVE YOUN, CPA, CA, FROM DMCL for the Canadian Overview of Q4 2021. A newsletter published by Canadian member firms of Moore North America. These articles are part of our mission to become partner of your success by keeping you informed of the news.
Debt forgiveness rules, is all really forgiven (part 2)
MINImizing the impact of the forgiven amount
The following practical strategies can minimize the forgiven amount under the debt forgiveness rules:
Transfer the forgiven amount
If there is a residual forgiven amount remaining after applying subsections 80(3) to (10), section 80.04 allows the debtor corporation to transfer the balance of the forgiven amount to reduce the tax attributes of any related corporation or partnership, referred to as an “eligible transferee.”
Transfer depreciable property to a subsidiary
Piggybacking off the section 80.04 designation, consider a scenario in which a debtor corporation has a forgiven amount of $100 and does not want the application of subsection 80(5) to grind down its UCC pool. By chance, the debtor corporation has a sister company (“LossCo”) with non-capital losses of $100 that can’t be used, and an amalgamation isn’t feasible for commercial reasons. The debtor corporation can incorporate a subsidiary (“SubCo”) and transfer the depreciable property to SubCo before applying the debt forgiveness rules. By doing this, the debtor corporation can make a section 80.04 election and assign the forgiven amount to LossCo without triggering a reduction to SubCo’s UCC pool.
The reason for this, as noted in the rules recap, is that the debtor corporation must apply the forgiven amount to the tax attributes in subsection 80(3) to 80(10) before a section 80.04 election can be made. If the debtor corporation decides to retain its depreciable property, the section 80.04 election will not be available.
Preserve discretionary deductions
The debt forgiveness rules dictate that the forgiven amount must first be applied to reduce non-capital and capital loss balances, respectively. _e debtor corporation may then designate an amount to be a reduction of UCC or a capital cost balance. Since it is a designation, this reduction is not mandatory. Instead, the debtor corporation may simply take the subsection 80(13) income inclusion of 50% of the unapplied forgiven amount. The latter choice can be advantageous when, instead of grinding the tax attributes by 100% of the forgiven amount, the debtor corporation can take a discretionary deduction, such as a capital cost allowance, to reduce the subsection 80(13) 50% income inclusion and thereby preserve the remaining tax attributes for future years.
Note that if the creditor attempts to transfer the commercial debt obligation to a related person of the debtor for less than 80% of its principal amount, the debt may be considered a “parked obligation,” as defined in subsection 80.01(7) of the ITA, to which the debt forgiveness rules would apply.
Relieving provisions from the income inclusion rule
If none of the above planning opportunities are applicable, the debtor corporation may want to consider the relieving provisions under sections 61.3 and 61.4 of the ITA to help contend with subsection 80(13)’s income inclusion rule.
Section 61.3 provides a deduction for certain insolvent corporations that effectively limits the debt forgiveness income inclusion rule under subsection 80(13) to twice the fair market value of the corporation’s net assets at the end of the year. In its technical notes to the provision, the Department of Finance explains that—assuming a tax rate of 50% or less—this rule ensures that the corporation’s liabilities will not exceed the fair market value of its assets at year-end. An insolvent corporation will most likely have a net asset value of nil, resulting in a full deduction against the subsection 80(13) income inclusion rule.
Note that relief under section 61.3 may apply to both resident corporations and nonresident corporations as long as they are not exempt from Part I tax. In addition, when claiming the section 61.3 deduction, debtor corporations should consider the anti-avoidance provision in subsection 61.3(3), as this provision restricts the deduction when: a) properties are transferred within a 12-month period (during a given year); and b) it is reasonable to assume that one of the reasons for the transfer was to increase the deduction under Section 61.3.
For solvent corporations, section 61.4 allows for a reserve to defer the subsection 80(13) income inclusion over a maximum five-year period (a minimum balance of 20% per year). This is available to a corporation or trust resident in Canada, or a non-resident person carrying on a business through a fixed place of business in Canada, during the year.
The debt forgiveness rules are extensive and quite complex, and we are likely to see them being applied more regularly as British Columbians continue to deal with the economic impact of the COVID-19 pandemic. Thankfully, there are many planning strategies and opportunities available to minimize the income inclusion to the debtor corporation.