What are the tax consequences of forgiving a vendor take-back note?

A seller sometimes forgives some or all of a vendor take-back note, because the business is struggling, the relationship has changed or a settlement is easier than a dispute. Forgiveness is not a neutral act for tax. The buyer who owes less and the seller who collects less each face rules that do not mirror each other, so the effects should be mapped before anything is signed.

The buyer’s side: the debt-forgiveness rules

The Income Tax Act treats an obligation as settled when it is settled or extinguished, which covers a forgiveness. For a commercial debt obligation, meaning a note on which interest is payable under a legal obligation or, had interest been payable, would have been deductible, the Act works out a forgiven amount. That amount is applied in a set order to reduce the buyer’s tax attributes, such as loss balances and, to the extent the buyer designates it, the tax cost of property, and part of any remainder is added to the buyer’s income.

The seller’s side: proceeds and losses

The CRA explains that a capital gains reserve is built around the portion of the proceeds not yet received. If the unpaid balance is forgiven, that part of the price is never collected, so the seller should work out with an accountant how the reserve and the gain originally reported are affected. The CRA says a reserve claimed in the previous year is included in the capital gains calculation for the current year. A loss on giving up a debt is also not automatic. The Act denies a loss on disposing of a debt unless the debt was acquired to earn income, or as payment for capital property sold to an arm’s-length person.

Clean up the security and the paperwork

A forgiveness should be recorded in a signed release that says exactly which amounts are forgiven. Where the seller registered security for the note, that registration should be discharged too. In Ontario, the Personal Property Security Act allows a registration to be discharged by registering a financing change statement; other jurisdictions have their own registration rules. How a vendor take-back is taxed is a useful companion to this page.