If you owe a debt that is forgiven or settled without full payment, the Income Tax Act contains rules that may affect some tax amounts or tax attributes, or may result in an income inclusion. The main rules are summarized below.
The rules apply only if the debt is a “commercial obligation”, which basically means you used the debt (the borrowed money) to earn business or investment income. Debts used for personal purposes are not affected by the rules.
Application of the rules
If your debt is forgiven without full payment, the remaining principal amount owing (“remaining debt”) is subject to the tax treatment in the order described below. Note that some of the steps are mandatory and some are optional:
- First, the remaining debt reduces your non-capital losses and farm losses from previous years. Earlier years’ losses are reduced in the order in which they arose.
- Next, for any remaining debt, one-half of that amount serves to reduce your allowable business investment losses (ABILs) from prior years, if any. After that, one-half of the remaining debt reduces your net capital losses from prior years. The one-half rule applies here because only one-half of business investment losses and capital losses are otherwise deductible. (Note that for certain loss years, for example, most of the 1990s, the loss deduction rate was 3/4 or 2/3, so that would be the applicable fraction for those years.)
In determining the remaining debt after a portion was applied to reduce ABILs and net capital losses, you multiply the applied amount by two, and subtract that to determine whether you have a remaining debt after this step. For example, if the remaining debt was $10,000 before this step, you applied $3,000 of the debt to reduce net capital losses, the remaining debt afterwards would be $4,000 ($10,000 – 2 x $3,000).
- This next step is optional. You can elect to use any remaining debt to reduce the capital cost and the undepreciated capital cost (UCC) of any depreciable property that you own.
- The next step is also optional. Any remaining debt can be used to reduce certain resource expenses and resource pools (this is typically relevant only for corporate debtors).
- This next step is also optional, if you have fully applied steps 3) and 4) above, if applicable. Any remaining debt can be used to reduce the costs of your non-depreciable capital properties (not including personal-use properties). For properties that are shares or debt, an ordering rule provides, in general terms, that you must reduce the costs of shares or debt in corporations and partnerships in which you do not have significant holdings or to which you are not related, before you can reduce the costs of shares or debt in corporations and partnerships in which you do have significant holdings or to which you are related.
- If there is a remaining debt, and you have fully applied steps 3) through 5) where applicable (as noted, they are optional), it is applied to reduce your capital losses for the current year in excess of your capital gains for the year, if any.
- At this point, if there is any remaining debt, one-half of the amount will be included in your income. This inclusion is subject to the “eligible transferee” rule described below.
Reserve for income inclusion
If you are required to include a remaining debt amount in income under step 7) above, you may be able to deduct a reserve. The reserve is limited to the amount by which the included debt income exceeds 20% of the amount by which your net income exceeds $40,000.
For example, if your net income otherwise computed for the year is $50,000 (that is, without counting the included debt amount), and the included debt amount is $14,000, you can deduct a reserve of $12,000 ($14,000 minus 20% x $10,000). If your income otherwise computed is $40,000 or less, you can deduct the entire debt amount as a reserve. In either case, this reserve will be added back to your income in the next year, and you can claim a further reserve.
For a corporation or a trust, a different reserve mechanism generally allows the included debt amount to be spread out over five years, with a net inclusion of 20% per year.
Transfer to “eligible transferee”
Instead of including half of the remaining amount in income under step 7) above, the debtor can “transfer” it to an “eligible transferee”. The amount effectively becomes a forgiven amount for the eligible transferee, who will apply it to reduce its tax attributes under all the steps outlined above. This may be more desirable than the income inclusion for the debtor.
An eligible transferee is generally a taxable Canadian corporation or Canadian partnership that controls the debtor, or that is controlled by the debtor and/or related persons. It also includes a taxable Canadian corporation or Canadian partnership that is related to the debtor.
Death of debtor
If you have a remaining debt that is forgiven after your death, the rules will apply either to you for the taxation year of your death, or to your estate. Generally, they will apply to you in the year of death if the debt is forgiven within 6 months after your death (or such longer period as the CRA and your estate agree). If the rules result in an income inclusion, you can claim the reserve described above, which will be a final deduction since it will not be added back to your income in the next year.
If the debt is forgiven after the 6-month period (or the longer period), the rules will normally apply to your estate.
Exceptions: Where the debt forgiveness rules do not apply
There are various exceptions where the rules do not apply. Some of the main ones are as follows.
First, as noted earlier, the rules do not apply to debts used for personal purposes.
If the creditor dies, the rules do not apply if the remaining debt is settled on the death as a result of a bequest or inheritance. For example, if you owe a remaining debt and the creditor dies and forgives the debt as part of your inheritance, the rules do not apply.
The rules do not apply if the remaining debt is included in your income as a forgiven debt from your employer. Similarly, they do not apply if the remaining debt is included in your income under the shareholder benefit rules. These exceptions provide no consolation, since the remaining debt will be included in your income rather than being subject to the less onerous rules discussed above.
The rules do not apply where the debt is a debt secured by property (e.g. a mortgage) and is forgiven or settled on the transfer of the property to the creditor. In such case, you may have a capital gain or loss depending on the amount forgiven and your cost of the property. These secured-property rules will be discussed in a subsequent Tax Letter.