LANGIND E DOCNUM 2011-0393561E5 REFDATE 110613 SUBJECT Debt forgiveness SECTION 80, 20(1)(p), 39(1)(c), 40(2)(g)(ii), 61.3 Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA. Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'arc. PRINCIPAL ISSUES: What are the tax consequences to a debtor and a creditor in a debt forgiveness transaction. POSITION: General information provided. XXXXXXXXXX 2011-039356 V. Srikanth June 13, 2011 Dear XXXXXXXXXX : Re: Corporate Returns This is in response to your correspondence dated January 6, 2011 wherein you requested a technical interpretation on the application of the debt forgiveness rules to a particular scenario. Specifically, you have described a situation wherein there is an inter-corporate loan. You state that each corporation is solely owned by individual spouses, who are now divorced. Further, the debtor corporation is in the process of winding-up. You would like our views on the tax consequences to both the debtor and creditor corporations in the event the amount of the outstanding loan is forgiven. Our Comments This appears to be an actual situation. It should be noted that written confirmation of the tax implications inherent in actual proposed transactions is given by this Directorate only where the transactions are the subject of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, entitled Advance Income Tax Rulings dated May 17, 2002. This Information Circular and other Canada Revenue Agency ("CRA") publications can be accessed on our website at http://www.cra-arc.gc.ca. Your request was not submitted as an advance income tax ruling request, however, as stated in paragraph 22 of IC 70-6R5, we do provide written opinions on general enquiries and we are prepared to provide you with the following comments. Section 80 of the Income Tax Act (the "Act") applies when a commercial obligation of a debtor, with the exception of an excluded obligation, is settled or extinguished for an amount less than the principal amount of debt. Where section 80 applies, the forgiven amount is applied to reduce 'tax balances' or is included in the debtor's income as provided in subsections 80(3) to 80(13) of the Act. For the purposes of section 80, a commercial obligation is basically an obligation on which interest paid or payable is deductible in computing
- 2 - income, or would be, if interest had been paid or payable in respect of the obligation. An "excluded obligation" is essentially an obligation (or part of an obligation) not taken into account for the purposes of applying section 80 because it is taken into account for purposes of the Act, apart from the rules in section 79 and 80. For example, an "excluded obligation" as defined in subsection 80(1) of the Act includes a loan that has been recognized as assistance for income tax purposes under any one of a number of provisions of the Act (e.g., paragraph 12(1)(x) or subsection 13(7.1)) and, amounts payable that have been otherwise included in computing the debtor's income (e.g., subsection 15(2)). The forgiven amount is also defined in subsection 80(1), and with some adjustments, can generally be described as the principal amount of the obligation less the amount paid in satisfaction of the principal amount. The terms 'settled' and 'extinguished' are not defined in the Act. However, paragraph 6 of Interpretation Bulletin - 293R, entitled 'Debtor's Gain on Settlement of Debt', states that: "For a debt or obligation to be "settled or extinguished" all liability for payment must be terminated. Payment, cancellation, set-off, substitution of debtors and release are examples of some possible means of settlement. A debt or obligation is not settled where a creditor abandons his right to enforce payment or becomes statute-barred from enforcing his right to payment." Further, paragraph 80(2)(b) of the Act provides that for the purposes of subsection 80(1), interest that had been deducted by the debtor in computing his income or that would have been deductible "but for subsection 18(2) or (3.1) or section 21", is deemed to be a principal amount equal to such interest. Paragraph 80(2)(b) of the Act is a deeming clause, and, in essence, it provides that for the purposes of subsections 80(1) and (3), an amount of interest in respect of a debt shall be deemed to be a debt issued by a taxpayer that has a principal amount. Therefore, subsections 80(1) and paragraph 80(2)(b) of the Act, read together, apply both to the principal amount of a debt in its ordinary sense and the amount of the debt that is made up exclusively of interest deducted or deductible by the debtor. In the given scenario, no description of the debt was provided, so we have assumed that the debt is otherwise a debt to which section 80 of the Act would apply, i.e., that as defined for purposes of section 80, the debt is a commercial obligation that is not an excluded obligation. You have indicated in your letter that the creditor corporation is likely to forgive the amount of the outstanding loan. Assuming that section 80 applies to the given situation and the debt is settled or extinguished for an amount less than the principal amount of the debt, the forgiven amount would be the outstanding principal amount that has been settled. Accordingly, pursuant to paragraph 80(2)(c) of the Act, the forgiven amount is applied to reduce the tax attributes of the debtor in the numerical order specified, namely, subsections (3) to (5) and (7) to (13) of the Act as described below. Pursuant to subsections 80(3) and (4), the forgiven amount is applied to reduce the carryover losses of the debtor. The application of the forgiven amount to the tax losses under these subsections is mandatory and is carried out in the following order:
- 3 - (i) (ii) (iii) (iv) and, (v) non-capital losses [paragraph 80(3)(a)], farm losses [paragraph 80(3)(b)], restricted farm losses [paragraph 80(3)(c)], allowable business investment loss (ABIL) [paragraph 80(4)(a)] net capital loss [paragraph 80(4)(b)]. After the mandatory application of the forgiven amount, as explained above, the debtor may elect (in a prescribed form), to apply the remaining forgiven amount to reduce the capital cost of the following, in any order, pursuant to subsections 80(5) and (7) to (11) of the Act: a) capital cost and undepreciated capital cost of depreciable property [subsection 80(5)], b) cumulative eligible capital [subsection 80(7)], c) resource expenditures [subsection 80(8)], d) adjusted cost bases of capital properties [subsection 80(9)], e) adjusted cost bases of certain shares and debts [subsection 80(10)], f) adjusted cost bases of certain shares, debts, and partnership interests [subsection 80(11)] The prescribed form for this purpose is form T2154, entitled 'Designation of Forgiven Amount by the Debtor - Subsections 80(5) to 80(11)'. As noted on form T2154, "the designation is not valid unless you file this form with your income tax return for the taxation year in which the debt is forgiven." Subsection 80(12) of the Act treats the unapplied portion of a forgiven amount in respect of a commercial obligation of a debtor settled in a year, as a capital gain of the debtor for the year from the disposition of capital property, to the extent of the lesser of the amount of the remaining unapplied portion and the amount of the debtor's net capital losses for the year. This subsection is applicable only after maximum designations have been made under the elective provisions of subsections 80(5) and (7) to (11). Subsection 80(13) of the Act includes an amount in computing the income of a debtor for the taxation year in respect of the remaining unapplied portion of the forgiven amount in respect of a commercial obligation settled in the year. Such amount as determined under subsection 80(13) is added to the income of the taxpayer by virtue of paragraph 12(1)(z.3). Basically, for a corporation, any remainder of the forgiven amount is included in income, generally at the capital gains inclusion rate. In summary, pursuant to paragraph 80(2)(c) and subsection 80(13) of the Act, a subsection 80(13) income inclusion will result when there remains
- 4 - an unapplied portion of a forgiven amount following: * the mandatory application of subsections 80(3) and (4) of the Act, * the optional designations made as allowed by subsections 80(5) to 80(11) of the Act, if any, and * the application of subsection 80(12) of the Act, if applicable. Relief under subsections 61.3(1) and section 61.4 Subsection 61.3(1) of the Act provides a deduction for corporations resident in Canada (other than corporations exempt from tax under Part I of the Act) with respect to amounts included in income under subsection 80(13) because of the application of the debt forgiveness rules. In general terms, section 61.3 requires a debtor corporation to compute the amount of its net assets (i.e., the fair market value of its assets, net of its liabilities) at the end of a taxation year. Subsection 61.3(1) allows an offset against the income inclusion under subsection 80(13) equal to the amount of that income inclusion minus two times the net asset amount. The effect of the offset is that a corporation will be required to recognize income as a consequence of subsection 80(13) only to the extent of twice the corporation's net assets. Accordingly, in a situation where there are no assets, the deduction under subsection 61.3(1) should equal the income inclusion under subsection 80(13) of the Act. It should be noted that subsection 61.3(3) is an anti-avoidance provision, which provides that the deduction under, inter alia, subsection 61.3(1) is not available to a corporation for a taxation year if property was transferred (or the corporation became indebted) in the 12-month period preceding the end of the year and one of the reasons for the transaction was to increase the amount that the corporation would be entitled to deduct under, inter alia, subsection 61.3(1). Thus, in the given situation, it is possible that any amount that may be included in the income of the debtor corporation, pursuant to subsection 80(13), may be offset by the application of subsection 61.3(1), subject to the application of subsection 61.3(3). Further, section 61.4 allows a taxpayer to deduct an amount as a reserve with respect to an income inclusion, inter alia, under subsection 80(13). The application of section 61.4, along with section 56.3, results in the reserve being bought into income over a period of five years. No reserve is allowed for corporations that are winding-up in circumstances to which subsection 88(1) does not apply. For the purposes of section 61.4, the original income inclusion referred to above is determined net of deductions claimed by the taxpayer under section 61.3 in respect of the income inclusion. Section 80.04 Section 80.04 is a mechanism whereby unapplied portions of forgiven amounts may, in effect, be transferred by a debtor to certain (basically related) corporations and partnerships (referred to as an 'eligible transferee', as defined in subsection 80.04(2)). The provisions of this section allow a debtor to enter into an agreement with an eligible
- 5 - transferee in order for the debtor to minimize its tax consequences under section 80 of the Act. Accordingly, the amount so transferred will be treated as a forgiven amount to the eligible transferee and the transferor, i.e., the debtor, can avoid the income inclusion under subsection 80(13) of an otherwise unapplied portion of the forgiven amount. Based on the information you provided, we are unable to determine if the provisions of this section are applicable to your situation. Tax consequences to the creditor corporation A debt obligation is a property of a creditor and it may be held by a creditor on capital or on income account. Pursuant to subsection 248(1) of the Act, disposition includes, inter alia, "any transaction or event by which,...where the property is a debt or any other right to receive an amount, the debt or other right is settled or cancelled". Accordingly, when a debt is forgiven, it is generally considered a disposition to the creditor. Where the disposition is on account of income, the creditor may be able to claim a bad debt expense deduction pursuant to paragraph 20(1)(p) of the Act provided it is a debt owing to the taxpayer that is established to have become bad in the year and has been included in computing the taxpayer's income for the year or a preceding year. If the debt is determined to be on account of capital, the debtor may incur a capital loss. Further, the resulting loss may qualify as a business investment loss if the requirements in paragraph 39(1)(c) of the Act are met. However, it is to be noted that, pursuant to subparagraph 40(2)(g)(ii) of the Act, a taxpayer's loss arising from the disposition of a property is nil unless the debt had been (i) acquired by the taxpayer for the purpose of gaining or producing income from a business or property (other than exempt income); or (ii) acquired as consideration for the disposition of capital property in an arm's length transaction. It is a question of fact whether a particular debt was acquired for the purpose of earning income from a business or property. In order to make such a determination, it is necessary to review all the relevant facts and documents surrounding a particular situation. In the given instance, we do not have enough information to make this determination. Again, the facts of a particular situation will determine which of the above-noted provisions will apply. We trust our comments will be of assistance to you. Yours truly, R.A. Albert, CA For Director Financial Industries Division Income Tax Rulings Directorate Policy and Legislation Branch