Written by Cindy Collins | Taylor Leibow LLP
Forgiveness is a noble trait, but be forewarned of the potential tax consequences that can result from such forgiveness.
Often when purchasing or acquiring a new business, existing debt of that corporation may either be forgiven or included in the purchase at a discounted price.
In addition to other considerations that will arise from the acquisition of control of a corporation, a purchaser should be cognizant of the debt forgiveness and debt parking rules in Sections 80 and 80.01 of the Income Tax Act (Canada) (“the Act”).
Debt Parking Rules:
The debt parking rules of section 80.01 of the Act were first introduced in 1995 to prevent income tax deferral or avoidance on any differences between the amount paid for a debt and its principal amount, in certain circumstances, by deeming a debt to have been settled for tax purposes even though it may remain legally outstanding.
A debt could become a “parked debt” if:
- it is acquired by a party that does not deal at arm’s length with the debtor or owns shares having more than 25% of the votes OR value of all the issued shares of the debtor; and
- its “specified cost” is less than 80% of its principal amount.
Once it is determined that a debt is considered to have become a “parked obligation”, the forgiven amount (the difference between the specified cost and the principal amount) will be considered to be settled and will be taxed according to the debt forgiveness rules.
Debt Forgiveness Rules:
Section 80 of the Act may allow a corporation to reduce certain corporate tax attributes before potentially including a portion of any forgiven amount in taxable income. The tax attributes, and the order in which they can be reduced, are as follows:
- Reduction of non-capital losses;
- Reduction of capital losses;
- Reduction in undepreciated capital cost (“UCC”) of depreciable property;
- Reduction in resource expenditures;
- Reduction in adjusted cost base of capital properties;
- Reduction in adjusted cost bases of certain shares where the debtor is specified shareholder; and
- Reduction in adjusted cost bases of certain shares, debts and partnership interests.
If a portion of the forgiven amount remains after making all allowed tax attribute reductions noted above, one-half of the remaining amount will be included in taxable income to the debtor.
There are some relieving provisions in the Act which can reduce the income inclusion based on the amount of the Taxpayer’s net assets. For example, some relief may be available pursuant to section 61.3 of the Act if the debtor meets Canada Revenue Agency’s (“CRA”) definition of being “insolvent”. Where the insolvency test is met, the general rule under section 61.3 of the Act would allow the debtor to claim a deduction that equals the debt forgiveness income included under subsection 80(13) in excess of twice the fair market value of the corporation’s net assets at the end of the year.
In addition, if the debtor ultimately repays some or all of the forgiven debt, they may be entitled to a deduction from income.
One point to consider when structuring a share purchase transaction is that the capital loss carry-forward balance of the purchased corporation will disappear upon an acquisition of control. Accordingly, it may be beneficial to use the debt forgiveness rules to utilize any capital loss carryforward balance prior to the acquisition of control, since the benefits of those losses will not be available post-acquisition anyway.
The debt parking and debt forgiveness rules are complex and may unintentionally apply. Where debt is being acquired or assumed on the purchase of a business you should consult your tax advisor on these rules.