A Canadian Tax Lawyer’s Guide to Business and Personal Tax Debt Forgiveness from CRA

Overview of the debt forgiveness rules

Sections 80 to 80.04 of the Income Tax Act contain the rules governing the tax consequences of debt forgiveness. These rules are designed to prevent a windfall tax benefit where a taxpayer is relieved of its obligations without recognizing income. A windfall refers to a significant and often unexpected sum of money received by an individual or business.

Forgiving the debt an individual or business owes can be taxable. These rules exist to stop debt holders from forgiving debt for the purposes of a tax advantage: using debt forgiveness to lower their taxes elsewhere. The Income Tax Act tries to prevent individuals and businesses from partaking in artificial transactions simply for the purpose of a tax advantage. The debt forgiveness rules ensure that debt forgiveness is not used solely to obtain a tax advantage and is grounded in a legitimate commercial rationale.

In essence, these provisions apply when a commercial debt obligation is extinguished for less than its principal amount, resulting in a “forgiven amount.” A debt qualifies as commercial if the interest payable on it, had it been charged, would have been deductible in computing income. Thus, where the interest on a debt is not deductible, the debt forgiveness rules are generally inapplicable.

To determine whether a debt is a commercial obligation, it’s necessary to assess whether interest would be deductible under paragraph 20(1)(c) of the Income Tax Act. While an exhaustive review of interest deductibility is outside the scope of this article, it is important to note that a debt can be considered commercial even if no interest was actually charged.

The concept of commercial debt is complex and often difficult to interpret. Due to the complexity of commercial debt, consider consulting a top Canadian tax lawyer to help you navigate the rules and avoid potential pitfalls.

When applicable, the forgiven amount must be applied to reduce the debtor’s tax attributes in a strict statutory order. Any remaining amount that is not offset is partially included in income.

Application of the Forgiven Amount on tax pools

If the rules are triggered, the forgiven amount reduces the debtor’s tax pools in the following sequence:

1. Subsection 80(3): Non-capital losses (net of allowable business investment losses, farm losses, and restricted farm losses);
2. Subsection 80(4): Business investment losses and gross capital losses (with capital losses grossed up under paragraph 80(2)(d));
3. Subsection 80(5): Undepreciated capital cost (UCC) of depreciable property;
4. Subsection 80(8): Resource expense pools;
5. Subsection 80(9): Adjusted cost base (ACB) of capital property.
6. Subsection 80(10): ACB of shares where the debtor is a specified shareholder.
7. Subsection 80(11): ACB of certain shares, debts, and partnership interests.
8. Subsection 80(13): Once all applicable tax attributes have been reduced, any leftover forgiven amount results in an income inclusion equal to 50% of what is left.

A top Canadian tax lawyer can help you navigate through these rules and ensure you are applying the debt forgiveness rules properly.

Tax Tip: Sections 61.3 and 61.4 as relief

If the provisions above do not apply, debtor corporations still have access to relief under sections 61.3 and 61.4 of the Income Tax Act, which can lessen or delay the impact of an income inclusion under subsection 80(13).

Section 61.3 is aimed at insolvent corporations. It allows a deduction that caps the income inclusion to twice the fair market value of the corporation’s net assets at the end of the year. In most cases where the corporation has no meaningful assets, this means the income inclusion can be fully offset.

This relief applies to both resident and non-resident corporations, provided they are subject to Part I tax; Part I tax is the general tax applied on individuals, businesses, and trusts. However, anti-avoidance rules under subsection 61.3(3) may deny the deduction if there’s evidence that property was shifted around in the year to inflate the deduction.

On the other hand, section 61.4 offers a timing benefit. Rather than eliminate the inclusion, it allows solvent corporations to spread it over up to five years, requiring at least 20% to be included annually. This reserve mechanism helps manage the cash flow impact and may align income recognition with future profitability. It’s available to resident corporations and trusts, and non-residents with a permanent establishment in Canada.

FAQ:

1. Do the debt forgiveness rules apply to individuals or only corporations?

The debt forgiveness rules can apply to individuals, partnerships, and trusts, provided they have commercial debt obligations. However, certain provisions (such as the 61.3 deduction) are available only to corporations.

2. Does the debt forgiveness regime apply to shareholder loans?

Potentially, if the loan qualifies as a commercial debt obligation (i.e., interest would be deductible if charged). However, if the shareholder loan is caught under the shareholder benefit provisions of section 15, the debt forgiveness rules may be displaced by those specific rules.

3. What happens if the debtor and creditor are non-arm’s-length?

If the debtor and creditor are not dealing at arm’s length, and the debt is settled for less than 80% of its principal amount, the obligation may be classified as a “parked obligation” under subsection 80.01(7), which automatically triggers the forgiveness rules.

Disclaimer: This article provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of an expert Canadian tax lawyer.