A company, as a debtor, borrows money from a bank or another company. However, it fails to repay the debt in full. In such cases, the creditor may choose to forgive a portion of the debt (the “settlement amount” is lower than the “principal amount plus interest”). But does this mean that the forgiven debt simply disappears from the debtor company’s books?
Certainly not, because Income Tax Act comes into play.
Simply put, if the debtor company has been making payments and paying interest on the debt, the interest portion can be deducted as an expense from the company’s operating costs. In other words, when the debtor incurs expenses related to the debt, it can receive certain tax benefits.
Conversely, if the debtor company benefits from the debt (by not having to repay the full amount), it will face increased tax obligations.
s.80 ITA provides specific provisions on how the forgiven portion affects the debtor’s tax burden. These provisions essentially form a “pecking list.”
In other words, the forgiven amount will be used to impact the following tax factors, which originally could have provided tax benefits to the debtor:
- Reduce the debtor company’s Allowable Business Investment Loss (ABIL);
- Reduce the undepreciated capital cost (UCC) of depreciable property owned by the debtor company;
- Reduce the adjusted cost base (ACB) of capital property owned by the debtor company;
- Reduce the ACB of shares held by the debtor in another company;
- Reduce the ACB of shares in the debtor’s own company.
- If the residual still remains, 50% of any forgiven amount will be included in the debtor’s income and subject to taxation.
