Moore
October 14, 2021

By Steve YOUN, CPA, CA, From DMCL

The recent economic downturn may bring forth unexpected tax issues. As creditors become more inclined to forgive or settle debt without full or even partial repayment, more corporations may and that they are settling debt for less than the principal amount. While this may initially seem like a favourable result for debtor corporations, there are tax implications that must be considered. Specifically, debtor corporations need to consider the impact of the debt forgiveness rules so they can plan accordingly. A recap of the rules Sections 80 through 80.04 of Canada’s Income Tax Act (ITA) contain a complex and comprehensive set of rules on the treatment of debt forgiveness. In simple terms, the debt forgiveness rules apply when a “commercial debt obligation” has been settled for an amount that is less than the full amount owing (i.e., the “forgiven amount”). A commercial debt obligation is generally a debt obligation on which interest, if charged, is deductible in computing income. In other words, if interest on the particular debt is not deductible, the debt forgiveness provisions do not apply.

When reviewing the applicability of the debt forgiveness rules, it is therefore necessary to consider the relevant statutory provisions and jurisprudence regarding the deductibility of interest under paragraph 20(1) (c) of the ITA. A full review of interest deductibility is beyond the scope of this article, but the key takeaway is that the debt does not need to be interest-bearing to meet the criteria of a commercial debt obligation. If this is the case, the forgiven amount is applied to reduce certain corporate tax attributes in a specified 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:

  • Reductions of prior year losses under subsection 80(3)—i.e., non-capital losses net of allowable business investment losses (ABIL), farm losses, and restricted farm losses;
  • Reductions of ABILs and gross capital losses (grossed up by paragraph 80(2) (d)) under subsection 80(4));
  • Reductions in undepreciated capital cost (UCC) of depreciable property under subsection 80(5);
  • Reductions in resource expenditures under subsection 80(8);
  • Reductions in the adjusted cost base of capital properties under subsection 80(9);
  • Reductions in the adjusted cost base of certain shares where the debtor is the specified shareholder under subsection 80(10); and
  • Reductions in the adjusted cost bases of certain shares, debts, and partnership interests under subsection 80(11).

If a residual amount remains, 50% of any forgiven amount will be included in the debtor’s income, as per subsection 80(13) of the ITA.

In order to minimize the impact of the forgiven amount, consider transferring the forgiven amount or transferring depreciable property to a subsidiary. These practical strategies will be explored in more detail in part 2 of this article.

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