In the February 2019 Tax Letter, we discussed the debt forgiveness rules under section 80 of the Act. As discussed, when a debt used for income-earning purposes is forgiven or otherwise settled, certain tax attributes of the debtor are reduced, such as previous years’ loss carryforwards and the tax costs of some properties. If some of the debt remains outstanding after the reduction of the tax attributes, one-half of the remaining amount is included in the debtor’s income.
In the February Letter, we also noted that a debtor corporation can normally claim a reserve, which effectively allows it to spread out the income inclusion over five years, with a 1/5th inclusion each year.
However, another reserve may apply, under section 61.3 of the Act, if the debtor corporation is insolvent, or more particularly, where the remaining debt exceeds two times the corporation’s net assets. (The net assets for this purpose are computed using a formula in the Act.)
In such case, the reserve deductible from the debt income inclusion is the amount by which the remaining debt exceeds twice the net assets. (In the extreme, if the net assets are zero or negative, the entire remaining debt can be deducted.) As noted by the Department of Finance in its explanatory notes to the provision, since the tax rate of a corporation does not exceed 50%, the net income inclusion after this reserve will not result in the corporation’s liabilities exceeding the fair market value of its assets.
In practice, an insolvent corporation usually has losses and is no longer paying tax, so this reserve may not be of any use.