Due to the recent economic shock of the COVID-19 pandemic, many businesses are considering various options to weather the economic shock. One commonly considered option is to ask existing creditors to forgive all or part of a debt. However, this strategy is subject to a complex regime commonly known as the “debt forgiveness rules”. These rules can trigger important income tax implications that should be considered in evaluating such a strategy.
These debt forgiveness rules can ultimately cause an amount to be included in the taxpayer’s income. Before seeking to have all or a portion of your debt forgiven or discharged, you should consider the applicability and implications of the debt forgiveness rules, summarized below.
When do the debt forgiveness rules apply?
The debt forgiveness rules generally apply where a commercial debt obligation of a debtor is wholly or partially settled (i.e. forgiven). The amount of this forgiveness is referred to as the “forgiven amount”. Summarily, the forgiven amount is calculated as the debt’s current principal amount, minus amounts that are either paid on settlement or to the extent such amount would be otherwise included in the income of the debtor (e.g. forgiveness of a shareholder loan). Where the debtor is bankrupt, there is no forgiven amount.
With some exceptions, a commercial debt obligation is a debt obligation in which the associated interest expenses would be deductible for income tax purposes or would theoretically be deductible if a no-interest loan charged interest. Very generally, interest on a loan is deductible where the loan is obtained for the purposes of earning income. Note that outstanding unpaid interest on commercial obligations are deemed to be commercial debt obligations themselves.
The debt forgiveness rules can also apply where a commercial debt obligation becomes a parked obligation. Briefly, a parked obligation is a commercial debt obligation that was acquired for less than 80% of its principal amount by a person closely related to the debtor (such as a related person or a significant shareholder). These rules can apply to a wide range of transactions and are designed to prevent a debtor from getting around the typical debt forgiveness rules by having the creditor transfer the debt to a related person of the debtor (such as a parent corporation) and then having that subsidiary never act on or collect the debt.
If a commercial debt obligation becomes settled or parked, and there is a resulting forgiven amount, the forgiven amount is applied against various other beneficial tax attributes of the debtor in a specific order. These tax attributes include valuable attributes such as cost base in capital property and accumulated capital and non-capital losses. If there is any remaining forgiven amount after all of the applicable tax attributes have been reduced to zero, then 50% of the remaining forgiven amount (100% if the debtor is a partnership) will be included in the taxpayer’s income for the tax year. Corporations and trusts can usually claim a reserve to spread this income inclusion over five years.
What can be done to mitigate their impact?
Depending on the circumstances, there are ways to mitigate or avoid application of the debt forgiveness rules in some contexts. One commonly used method to avoid an income inclusion is for debtors to transfer any remaining unapplied forgiven amount to an eligible transferee, such as a parent or subsidiary company. This transfer is only available if a debtor has reduced its own tax attributes to the maximum extent permitted and an election form is prepared and filed.
Relief from the debt forgiveness rules exists for financially distressed or limited persons. Some examples of financially distressed persons include bankrupt entities, corporations with relatively low net assets and natural persons that earn modest income. These provisions may effectively eliminate the income inclusion if the debtor is insolvent, or may spread the income inclusion out over a number of years. These rules do not typically affect financially healthy going concerns.
The debt forgiveness rules are complex and can apply in a wide range of contexts. If you have any questions or are considering entering into a transaction or arrangement that relates to transfer, the settlement or forgiveness of debt, please feel free to reach out to a member of our Tax Group for further advice to see how the impacts of these rules can be mitigated.
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