What tax applies when debt is forgiven as a buyer cleans up the balance sheet?

A buyer who inherits a heavy balance sheet may try to clean it up. Creditors agree to take less, a lender writes part of a loan off, or a debt is swapped for shares. For the company that owed the money, each can look like a gain, and the Income Tax Act has specific debt-forgiveness rules for it. The rules are written around the debtor, the party that issued the debt, so the result lands in whichever company owes it, which may not be the buyer personally.

Which debts the rules reach

The rules apply to a “commercial obligation”, which for an ordinary debt means a “commercial debt obligation”: a debt where interest paid or payable on it under a legal obligation was, or if interest had been payable would have been, deductible in computing the debtor’s income, subject to stated exclusions. A debt with no stated interest can therefore still be caught. The rules are triggered when the obligation is settled or extinguished, other than by bequest or inheritance or in exchange for certain excluded shares, so an outright forgiveness can be covered. Our page on forgiving a vendor take-back note applies the same rules to a seller-financed note.

What happens to the forgiven amount

The forgiven amount is applied in a set order. It first reduces the debtor’s non-capital and farm losses, then an applicable fraction of the remainder reduces net capital losses, and then, to the extent the debtor designates on a prescribed form filed with its return, the cost of depreciable and certain other property. Part of whatever remains is added to the debtor’s income. Because the designation is made with the return, the accountant should model the result before a debt is settled, not after.

Debt swaps and formal compromises

A clean-up can replace a debt instead of cancelling it. Where a corporation issues a share to settle a debt owed to the holder, the Act deems the amount paid to equal the share’s fair market value, unless the share is an excluded security, so if the shares are worth less than the debt, a forgiven amount can remain. A creditor can also be bound without agreeing. The Superintendent of Bankruptcy describes a Division I proposal as a compromise between a commercial debtor and its creditors that becomes legally binding once the creditors and the court approve it, and the Bankruptcy and Insolvency Act sets out whom it binds.