If you have a loan or debt that is forgiven or cancelled, you may be subject to adverse income tax consequences. The “debt forgiveness” rules under the Income Tax Act may apply to reduce some of your tax attributes or tax costs in a detrimental way, and in some cases, they may result in an income inclusion.
The debt forgiveness rules apply only if interest on the debt was or would have been deductible for you for income tax purposes. Basically, this means that the rules can apply to forgiven debt that was used for income-earning purposes, such as to earn investment income like interest, dividends or rent, or if the debt is used in a business. Personal debt such as student loans, or loans to purchase a personal-use car or property or to finance a vacation, are not caught by the rules.
The rules can apply to both the forgiven principal amount of your loan and the forgiven interest on the loan, if any.
How the rules work
The forgiven amount is applied to reduce certain tax attributes or tax costs. There are various steps in the process. The main steps, in order, are as follows (the steps are set out in general terms; the specific mechanics are quite complex):
1. First, the forgiven debt reduces your non-capital losses (i.e., business losses) and farm losses from previous years, if you have any. The previous years’ losses are reduced in the order in which they arose.
2. Next, one-half of the remaining forgiven debt reduces your allowable business investment losses (ABILs) from prior years. After that reduction, if any, one-half of the remaining forgiven debt reduces your net capital losses from prior years. The one-half rule applies here because only half of business investment losses and capital losses are otherwise deductible.
3. This rule is optional: You can elect to use any remaining forgiven debt to reduce the capital cost and the undepreciated capital cost of any depreciable property that you own. Any remaining forgiven debt can then be used to reduce certain resource expenses and resource pools (this latter rule is typically relevant only to corporations).
4. This step is also optional, but only if you have applied the rules in step 3 to the extent they can apply. You can use the remaining forgiven debt to reduce the costs of certain non-depreciable capital properties, such as investment properties. For properties that are shares or debt, you reduce the costs of shares or debt in corporations and partnerships in which you do not have significant holdings or to which you are not related.
5. If you have fully applied step 4, you can normally apply any remaining forgiven debt to reduce the costs of shares or debt in corporations and partnerships in which you have significant holdings or to which you are related.
6. Any remaining forgiven debt is deemed to be a capital gain, but only to the extent of your actual capital losses for the current year in excess of your actual capital gains for the year. The deemed capital gain can then be offset by those excess capital losses, meaning that you will not have a further taxable capital gain under this step. But this step only applies if you have applied the rules in steps 3 and 4 to the extent they apply (as noted above, those steps are optional).
7. If, after the application of the above steps, there is still a remaining forgiven debt, one-half of the amount is included in your income. As noted below, this inclusion is subject to the “eligible transferee” rule. Also, as noted below, a reserve may allow you to defer or spread out the income inclusion over time.
If you (the debtor) have an “eligible transferee”, you can forego the income inclusion in step 7 to the extent you allocate the remaining forgiven debt to that transferee. The eligible transferee would then apply the allocated amount under the above steps to its tax attributes or tax costs. An eligible transferee includes a taxable Canadian corporation or Canadian partnership that you control, alone or along with one or more related persons. An eligible transferee also includes a taxable Canadian corporation or Canadian partnership that is related to you.
To the extent you do not allocate the remaining forgiven debt and therefore have an income inclusion under step 7, you may be able to deduct a reserve, which could partly or wholly offset the inclusion. Generally, the reserve equals the amount by which the remaining forgiven debt exceeds 20% of your income otherwise determined in excess of $40,000. Therefore, for example, if your income otherwise determined is $40,000 or less, you can deduct the whole forgiven debt amount as a reserve. Obviously, if your income otherwise determined is quite high, you might not get any reserve.
If you claim a reserve in the year, you add it back into income the next year, although you might qualify for another reserve in the next year under the same formula. The reserve is optional.
Example
One half of your remaining forgiven debt this year is $20,000 and is included in your income under step 7 above. Your income otherwise determined for the year (i.e. not counting the $20,000 remaining forgiven debt inclusion) is $70,000. You can deduct a reserve of $20,000 minus (20% of $70,000 - $40,000), which equals $14,000.
In the next year, you will include the $14,000 amount back in income. Depending on your income for that year, you may be eligible for a reserve once again.
The reserve mechanism is different for a corporation. In very general terms, a reserve applies where the remaining forgiven debt exceeds 2 times the corporation’s net assets, if any, which are computed using a specific formula in the Income Tax Act. If the net assets are zero or below zero, the entire forgiven debt qualifies for the reserve. To the extent this reserve does not apply, e.g. because the corporation has significant net assets, an optional reserve is allowed, which generally allows the corporation to spread out the income inclusion over five years.
