Often a distressed target business will have significant liabilities on its balance sheet including bank debt, shareholder loans or other related party debts.
Transactions frequently result in payouts, settlements or restructuring of the target’s debt and could have undesirable tax consequences to the target if not structured with timing and responsibility for tax exposures in mind.
Section 80 of the Canadian Income Tax Act (Act) governs the tax treatment of situations where a ‘commercial debt obligation’ is forgiven. A debt is forgiven when it is wholly or partially settled for an amount less than the outstanding principal balance, which generally includes any accrued but unpaid interest amounts.
A ‘commercial debt obligation’ for tax purposes is generally an obligation incurred for the purposes of gaining or producing income and on which interest charged would be deductible and therefore could include a noninterest bearing loan.
The difference between the settlement value and the principal amount is referred to as the ‘forgiven amount’ and will reduce various tax attribute pools of the debtor in the following order:
- Noncapital losses and farm losses
- Net-capital losses
- The capital cost and undepreciated capital cost (UCC) of depreciable property as designated by the debtor in prescribed form
- Resource expenditures
- Adjusted cost base (ACB) of capital properties
- ACB of certain shares where the debtor is specified shareholder
- ACB of certain shares, debts and partnership interests
For a debtor other than a partnership, where the forgiven amount cannot be fully applied to the above tax attributes and no exceptions apply; 50 per cent of the remainder is included in income.
Settlement for less than principal
The simplest type of debt forgiveness occurs where a company settles its obligations, using cash or other assets, for less than the outstanding principal amount. In the context of a transaction, this may occur where the agreement requires the target to be ‘debt-free’ on acquisition and often, there are insufficient assets available to satisfy all amounts owing. While it may be difficult to settle arm’s length debt at less than the principal amount, non-arm’s length debt or shareholder debts may frequently be settled at less than face value resulting in debt forgiveness.
Replacement, restructuring or refinancing may give rise to debt forgiveness in certain circumstances such as when the principal amount of the ‘new’ debt is less than the principal amount of the ‘old’ debt.
In a transaction context, it is not uncommon for a target business to be recapitalized or existing debt to be replaced with new borrowing. By comparing the principal amount of the old and new debts rather than their fair market values (FMV), the rules effectively allow for replacement of debt, facilitating changes in the repayment and commercial terms as well as the interest rates without triggering the debt forgiveness rules. It is important to consider any tax implications, including debt forgiveness, particularly if the principal amounts differ.
Debt to equity conversions
In some instances, creditors will opt to convert their debt into equity of the debtor corporation. In contrast to debt-for-debt exchanges, debt to equity conversions are valued for debt forgiveness purposes at the FMV of the shares issued.
Often in the context of a private company transaction, shareholders or other non-arm’s length creditors will convert all, or a portion of debt to equity prior to sale. Accordingly, a forgiveness event may occur where the FMV of the equity issued is less than the principal amount of the debt settled. Acquisition of control implications should be considered, and where a non-resident is involved, the thin capitalization rules and withholding tax may apply.
Distressed preferred shares can be issued to lenders only where the company is in receivership, bankruptcy or is expected to default on its obligations. These shares may be issued in settlement of debt without the application of the forgiveness rules, but must be structured properly to avoid inadvertent tax consequences.
Where a non-arm’s length party acquires a commercial debt obligation from the debtor for less than 80 per cent of its principal amount, the debt may become a ‘parked obligation’ giving rise to a debt forgiveness event. Originally, this legislation was intended to capture situations where arm’s length debt was acquired by a party related to the debtor at a discount and with no intent to settle. The application in practice is much broader and can extend to transactions where a buyer assumes the position of creditor in the target business at a discounted value, regardless of the buyer’s intention to settle.
Planning for debt forgiveness
In most instances, distressed businesses will have beneficial tax attributes such as operating losses and capital losses the purchaser is expecting to inherit. The impact of acquisition of control and debt forgiveness rules should be considered as part of the tax due diligence process to ensure attributes are utilized prior to closing when required.
If a forgiven amount still remains after reducing the tax attributes, an insolvency deduction may be available, limiting the income inclusion to two times the fair market value of net assets. This deduction may be of limited use in a transaction context where a positive net asset value can readily be determined due to value attributed to unrecorded assets such as goodwill.
Any remaining unapplied forgiven amount may be eligible for inclusion in income over a five-year period by claiming a reserve or transferred to a related corporation once all tax attributes of the debtor have been exhausted. In a transaction context this may permit sellers to transfer the forgiven amounts pre-closing to a related company outside of the transaction perimeter.
Consideration of a target’s existing debt is common to almost every private company acquisition. The impact of any transaction or structuring on those liabilities should be considered as part of the tax due diligence process. Working with a tax professional well-versed in M&A transactions will ensure any tax consequences can be appropriately addressed in the most efficient manner.