Tax & Trusts
Comparing US and Canadian Rules for Debt Forgiveness
Published: 10/05/2009
By Lorne H. Saltman In the current recession, some North American businesses facing difficulty in meeting their debt obligations may consider the implications of restructuring their debt in Canada or the US. The rules in the two jurisdictions have some similarities, but also some significant differences that should be examined in any such restructuring.
In Canada, the debt forgiveness rules are, in some ways, the opposite of the American rules, in that an income inclusion is the last, not the first, consequence of debt forgiveness. In the US, the general rule outside a bankruptcy of the debtor is that cancellation or repurchase of the debt (“COD”) for less than its face amount (or “adjusted issue price”) results in taxable income to the debtor. However, if the debtor is insolvent, COD income is not taxable to the extent of such insolvency. In such a case, the debtor must apply the COD to reduce specified tax attributes.
The first determination in Canada is whether the debt is a “commercial debt obligation.” One needs to ask if interest is, or would be, deductible on such debt in computing the income of the debtor. If the answer is affirmative, the debt is considered a commercial debt obligation.
The second determination is whether there is a “forgiven amount,” because the debt is being settled or extinguished for an amount that is less than the lesser of (a) the principal amount of the debt and (b) the amount for which the debt was originally issued.
In some cases, the debt may be deemed to have been settled, resulting in a forgiven amount. For example, where a commercial debt obligation becomes a “parked obligation” and the cost at that time to the holder is less than 80 per cent of the principal amount of the obligation, the obligation is deemed to have been settled for a payment equal to the cost of the obligation to the holder. In general terms, a parked obligation is a “specified obligation” which is owned by a “significant shareholder,” or a person who does not deal at arm's length with the debtor. A significant shareholder is a person who, if the debtor is a corporation, together with another person with whom the person does not deal at arm's length, owns 25 per cent or more in votes or in value of the shares of the debtor. A specified obligation includes an obligation (a) which is acquired by the holder from a person unrelated to the holder, or (b) if, at any previous time, a person who owned the obligation either dealt at arm's length with the debtor, or if the debtor is a corporation, did not hold a significant interest in the debtor.
Third, the forgiven amount is applied to reduce specified tax attributes in the following order:
• non-capital and farming losses
• capital losses
• capital cost of depreciable property and undepreciated capital cost of property of a prescribed class of assets
• cumulative eligible property (goodwill)
• resource pool balances
• adjusted cost base of capital property.
After the forgiven amount is applied and, only if a residual balance remains, will one-half of the balance be included in the income of the debtor. There is no relief if the income inclusion renders the debtor insolvent or bankrupt. However, it may be possible for the debtor to elect to transfer the forgiven amount to related corporations, so as to reduce their specified tax attributes and, thus, avoid the income inclusion itself.
Where a Canadian corporation becomes bankrupt, its tax attributes, such as non-capital losses, will be lost if the debtor corporation obtains a bankruptcy discharge. It seems the only way of avoiding such a consequence in Canada is to have the bankruptcy annulled under the Bankruptcy and Insolvency Act (“BIA”). In the US, on the other hand, it may be possible to implement a reorganization of a bankrupt corporation under Section 368(a)(1)(G) of the Internal Revenue Code, and still preserve such tax attributes as net operating loss carryovers.
In a share-for-debt exchange in Canada, the debtor will realize a forgiven amount to the extent that the fair market value of the shares issued is less than the lesser of (a) the principal amount of the debt and (b) the amount for which the debt was originally issued. In a US stock-for-debt exchange, the rules are similar in that COD income will be equal to the excess of (a) the adjusted issue price of the old debt over (b) the fair market value of the stock issued.
It may be possible in Canada to avoid debt forgiveness, however, if the fair market value of other shares held by the same creditor has increased as a result of the exchange.
In a Canadian debt-for-debt exchange, there will be no forgiven amount if the principal amount of the new debt is equal to the principal amount of the old debt. There is no requirement here that the fair market value of the new debt be at least equal to that of the old debt. In a US debt-for-debt exchange, however, COD income will be equal to the excess of (a) the adjusted issue price of the old debt over (b) the issue price of the new debt.
It may be possible in Canada for a debtor to avoid debt forgiveness by issuing “distress preferred shares.” The debtor must be in default or can reasonably be expected to default on debt held by an arm’s length creditor; the debt must be issued for a term not exceeding five years; the debt must be issued as part of a court-approved proposal to, or arrangement with, creditors under the BIA; and the debt must be issued at a time when all or substantially all of the debtor’s assets are under the control of a receiver or trustee in bankruptcy. If these conditions are met, there will be no debt forgiveness when the shares are issued, but when the shares are redeemed or repurchased, a determination will have to be made as to whether the amount paid results in a forgiven amount.
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