Foreclosures in Canada and developments in loss trading

Executive summary

This article describes how recent case law and legislation trigger loss restriction events, barring loss trading in circumstances beyond legal control.

Recently, foreclosures and bankruptcies have impacted brick and mortar businesses in Canada, and thereby the commercial real estate sector. According to Statistics Canada, bankruptcies filed by retail trade businesses in 2023 increased by 46.4% from 2022. Notably, Canadian retailer Best Buy announced its plans to close 10 to 15 stores in 2024, and the Hudson’s Bay Company also announced its third key department store closure since the Spring of 2020. In April 2023, Bed Bath & Beyond closed all 54 Canadian stores.

In the current economic environment, both retailers and commercial lessors will be contemplating the benefit of accrued losses to prospective acquirors or new investors. However, the tax benefits resulting from accrued losses of a business may be limited if new parties are introduced as shareholders. In particular, the Income Tax Act (Act) contains provisions that restrict the deductibility of operating losses and capital losses, as well as the use of certain tax credits, following a purchaser acquiring legal control (or a certain fair market value) of a target. In addition to loss streaming, there are other tax consequences related to an acquisition of control, some of which are outlined here.

This article focuses on new developments in the realm of loss trading, and circumstances where utilizing the accrued operating losses of an acquired entity may be permissible. It also highlights recent case law developments, notably in Deans Knight Income Corp. v. Canada and subsequent Tax Court of Canada (TCC) rulings where the General Anti-Avoidance Rule (GAAR) of the Act applied to deny the benefit of loss-trading transactions that were undertaken to avoid loss deductibility limitations.

Continuity (or lack thereof) of operating losses or capital losses

The carryover of losses to reduce net income is generally only available for the taxpayer that suffered the loss. Accordingly, certain provisions in the Act restrict the deductibility of operating and capital losses when a loss restriction event has occurred, sufficiently changing the taxpayer’s identity. A loss restriction will occur where there is either an acquisition of legal control or an acquisition of 75% of the fair market value of shares of a corporation by a person or group of persons. However, a loss restriction may also occur if the ‘functional equivalent’ of legal control has been acquired and the GAAR has been applied, as detailed below. An acquisition of legal control differs from that of factual control, the latter being based on myriad factors that determine who has control of a corporation from a factual standpoint.

Importantly, if a loss restriction event has occurred, there is a carve-out within the Act for purchasers that continue to operate the same business as the corporation they have acquired, following the loss restriction event. If this carve-out applies, then accrued losses may be utilized following the investment that caused the loss restriction event. Determining whether the same or similar business is carried on ‘with a reasonable expectation of profit’ is circumstantial.

The determination of whether a business is continued is not necessarily confined to its parts, such as management, employees, machinery, premises, and products. Instead, courts have emphasized that one must discern the “essence” of the business to determine continuity. For example, in the Tax Court of Canada (TCC) judgement Crystal Beach Park Limited v. The Queen (Crystal Beach), a recreational site was redeveloped from an amusement park to a marina and condominium buildings. The TCC considered the marina and condominiums to be extensions of the same business, the essence of which continued to be the exploitation of a recreational site.

Accordingly, taxpayers looking to make use of accrued losses will need to assess the nature of the target’s business to understand whether it can be considered to be continued after their acquisition or significant investment. For example, for acquisitions of commercial lessors, it will be important to consider if the use of any relevant land is altered, the analysis of which may even have similarities to the Crystal Beach case.

Recent case law developments

The continuity of a business is important where a loss restriction event occurs. However, where taxpayers avoid triggering a loss restriction event through a series of transactions in conjunction with a business acquisition, the CRA may intervene and deny the resulting tax benefit (i.e., the use of losses or tax attributes) by applying the GAAR.

In Deans Knight, the Supreme Court of Canada (SCC) determined the GAAR applied to deny the use of tax attributes, where a third party had achieved the functional equivalent of legal control of the taxpayer (which had accrued losses and other tax attributes) for the benefit new shareholders. The SCC assessed the rationale of subsection 111(5), the relevant provision limiting the ability to use non-capital losses (operating losses) following a loss restriction event.

The SCC found the rationale of subsection 111(5)–its ‘why’–was to prevent an acquired corporation’s losses from being used against the income of a new business to benefit new shareholders. Broadly, the SCC considered that an investment agreement giving a third party the ability to elect the board of directors of the relevant loss corporation produced the “functional equivalent” of legal control and was therefore contrary to the rationale of subsection 111(5).

In subsequent “loss-trading” cases at the TCC, taxpayers argued to no avail that a “functional equivalent” of legal control (similar to Deans Knight) was not present, despite employing varying methods to work around subsection 111(5). The TCC noted that when determining whether the rationale of loss trading provisions have been frustrated, one must not get bogged down by the facts of the relevant transactions: i.e., it is unnecessary to compare the specifics of transactions in Deans Knight with those of each new taxpayer. Instead, the proper approach is to assess the result of the transactions against the rationale of subsection 111(5).

It is important to consider that analyzing a provision's rationale in this manner is only appropriate in the context of a GAAR determination. Outside that context, loss restriction provisions generally continue to apply the test as it is contained in the Act, namely a legal control or fair market value test. That said, Deans Knight and subsequent judgements now form part of key considerations when structuring a transaction, particularly where the target has accrued losses or tax attributes, and legal control (or sufficient fair market value) will not be acquired.

Takeaway

Generally, a loss restriction event limits the use of operating losses of a target entity unless the same or a similar business is carried on. This consideration may be brought to the forefront of investors’ minds given recent store closures and bankruptcies on the rise in Canada. Further, recent case law on the GAAR has created new important principles on loss trading. In particular, where legal control is not formally acquired one must still consider, following the relevant transactions, whether the resulting structure and use of operating losses frustrates the rationale of provisions that seek to prevent loss trading.