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Tax Planning in a Downturn (Part II)

 

By: David Louis, J.D., C.A., Tax Partner.
Minden Gross LLP, a member of MERITAS Law Firms Worldwide.

(*This release is based on an article published in Tax Notes # 555, April 2009, CCH Canadian Limited)

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This article – my second in recent months devoted to this topic[1] - is based on a number of recent presentations by the Minden Gross tax group to members of the accounting profession.

Asset Securitization

Asset securitization procedures, which often accompany other tax and estate planning structures[2], are one of the most important planning strategies in a downturn.  One of the biggest problems is timing: the more acute creditor issues have become by the time these strategies are undertaken, the less successful they are likely to be.  In fact, some eleventh-hour procedures might even expose professional advisors to liability.  So the best time to implement asset protection strategies is long before there are potential concerns - and the longer the structure is in place before a potential problem, the greater chances of success. 

The typical strategy will be to interpose a Holdco (if necessary), pay a large dividend to it, and lend it back to the operating company on a secured basis.  Some advisors think that the size of this dividend and loan-back is restricted to the operating company’s retained earnings, so that deficits cannot be created.  In fact, corporate solvency tests are typically based on the net realizable value of the company’s assets (so as the company grows in value, additional dividends could be paid).   Having said this, one issue for many businesses is that this procedure will wreak havoc on a company’s balance sheet, which could be particularly problematic where financial information is required by third parties.  In addition, the dividend will usually render Holdco liable for unpaid income taxes of the operating company.  However, multiple holding company structures may alleviate these issues.

Refreezes – The "Reset Button"

One of the most important elements of an estate and succession plan is an estate freeze, a manoeuvre that limits the shareholder’s death tax exposure to the value of the corporation at the time of the freeze, with future growth in value passing to the next generation.

If the value of the company has decreased relative to the freeze value, it is possible to "refreeze" at the lower value.  If this is done, the death tax exposure will be "reset" at this lower value; otherwise, the original freeze value will prevail if the value of the company "reflates" to the freeze value[3].  So a refreeze can be a simple manoeuvre that can save considerable tax. 

If the growth shares have been held by a family trust, it will usually be advisable to distribute these shares before the 21^st anniversary of the trust in order to avoid adverse tax consequences.  While not necessary, a refreeze can involve the formation of a new family trust, so that the 21-year period is also "reset".[4] 

Accessing Losses

A company or its shareholders may have made loans that have gone bad.  More often than not, such losses will be treated as capital losses, so that tax relief is restricted to situations where there are capital gains, including in the previous three taxation years.

In some cases, allowable business investment loss (ABIL) status may be available – where one-half of the actual loss is deductible against all sources of income, not just capital gains.  This can arise where the bad investment has been made in a "small business corporation" – basically, a Canadian-controlled private corporation whose assets have been devoted to Canadian active business activities[5].  While ABIL treatment will not be available to non-arm’s length inter-company loans, it could be available to other bad loans or equity investments.  (An ABIL can be triggered either by a disposition to an arm’s length person, or where subsection 50(1) of the Act applies in respect to bad debts or worthless shares[6].)  It is also possible to take an ABIL for a guarantee of a small business corporation’s indebtedness[7]; however, where guarantor is not a shareholder of the corporation at least[8], it is advisable to ensure that adequate guarantee fees or other consideration are received. 

If ABIL claims are to be made, it is important that there is no undue delay.  Generally, a corporation must qualify as a small business corporation within the twelve months preceding the time at which the investor triggers the ABIL claim.  This timeframe could be problematic for investors, especially since information from companies which are in financial difficulty - and typically in various stages of winding down - may not be readily forthcoming.[9]

As many readers will be aware, ABIL claims are regularly followed by a detailed questionnaire from the CRA. It is a good idea to review the questionnaire before a claim is made, in order to ensure that satisfactory answers can be given (most accountants have copies of the questionnaire).  Remember also that ABILs claimed in the year or prior years will block capital gains exemption claims[10].

Besides ABILs, there may be circumstances where a fully-deductible business expense can be claimed for a bad loan.  One of these is by a taxpayer whose ordinary business includes money lending; however, meeting this requirement is unusual.  Otherwise, the case for fully-deductible expense claims will be "factually driven" – i.e., considering the circumstances and purpose of the loan.  For example, a bad loan to a subsidiary or related company could perhaps be deductible if the purpose is to protect or preserve existing goodwill or maintain a continuing source of revenue[11].  While these opportunities may be unusual, they should not be overlooked. 

Tax Loss Selling

As the triggering of tax losses is usually done at year-end, I discussed this topic in the November and December issues of Tax Notes.  For this year’s tax season in particular, the big issue may be whether the losses can be filed as fully deductible.  As mentioned in my December article, one possibility is an investor with a managed account, where the manager makes a great many trades.  Fully-deductible loss treatment may also be available to a person whose trading activities amount to a business (e.g., a day trader); it may also be possible for stockbrokers and other professional investment advisors.  Interested readers should obtain a copy of Interpretation Bulletin IT-479R[12], which delineates the CRA’s policies on securities trading (available on the CRA’s website www.cra-arc.gc.ca).  Among other things, the CRA suggests that transactions may be presumed to be on income account (i.e., fully deductible) if it is apparent that the taxpayer has used special information not available to the public[13].  It is also suggested that gains and losses made by a corporation whose "prime activity" is trading in securities will be considered to be on income account[14].  As I mentioned in the fall, taxpayers who wish to claim fully-deductible losses should be prepared for a possible review by the CRA, as well as being held to income treatment if there are future gains, and even the possibility of a reassessment for prior years. 

Another possibility for tax-loss selling relates to real estate investments that have declined in value.  Even if the investment is "on capital account", it may be possible to trigger a terminal loss on a building.  Because of applicable "stop-loss" rules, the sale must be to a non-affiliated transfereee[15].  Also, land transfer tax should be considered where applicable.  In Ontario, for example, the land transfer tax may be quite material in relation to the tax benefits (particularly within Toronto)[16]. 

If real estate is held as inventory, it may be possible to simply write it down[17]; however, if a property increases in value, it will be necessary to write the property back up to its original cost; this can be prevented if the loss is triggered by transferring the property to another entity[18].

Default Procedures

One of the most overlooked tax planning opportunities relates to default proceedings, and more specifically, minimizing the adverse tax effects that may occur.  In many cases, debtors may have no control over how creditors exercise their default remedies; however, a creditor may often be willing to work together with the debtor; after all, if the debtor’s tax liabilities are minimized, there may be more assets available to the creditor.

Basically, there are two regimes for defaulting debtors, which can have very different tax results.  Foreclosures and other procedures involving the actual surrender of property to a creditor result in proceeds of disposition of the surrendered asset based on the amount of debt.  These rules (in section 79 of the Act)) are intended to sweep-in related debt in respect of the surrendered asset, for example, debts having priorities, as well as debts to third parties if they cease to be owing.

The other regime relates to powers of sales and similar remedies, e.g., where a creditor causes a sale of the secured asset to a third party and scoops the proceeds.  In this case, the proceeds of disposition of the asset is based on the actual sale pricee[19].  Generally, powers of sale are preferable to foreclosures if the value of the asset is less than the associated debt.  Under power of sale, the excess of the debt over the sale proceeds is not necessarily forgiven, so that the debt forgiveness rules (see below) may not apply. 

Most default proceedings are based on power of sale rather than foreclosure.  However, the "foreclosure rules" can apply if the debtor surrenders the property to the creditor as a consequence of failure to pay part or all of a debt, e.g., he or she makes a deal with the creditor to transfer over the asset, or there is a "quit claim". 

Another group of tax rules come into play when a debt is forgiven by a creditor (i.e., settled or extinguished).  These rules are among the most complex in the Income Tax Act.  Basically, though, they reduce various tax accounts, and there are ordering rules as to which tax accounts are reduced[20].  The highest on the list are loss carry-forwards.  Next in the pecking order are so-called "elective deductions": undepreciated capital cost, as well as resource and eligible capital balances.  It may be possible to "manage" these accounts in order to minimize the effect of the debt forgiveness rules.  For example, tax losses can be used up by transferring assets at a profit in the taxation year before the debt is forgiven[21].  Similarly, assets which involve "elective deductions" can be moved around prior to the time of forgiveness.  Other planning opportunities relating to debt forgiveness that come to mind include the utilization of the deduction for insolvent corporations[22], and strategies to avoid the "debt parking rules"[23], which may otherwise result in debt forgiveness.  The latter may arise, for example, where debt of a company is acquired at a discount of more than 20%, e.g., on a takeover[24].

Special thanks to Joan Jung, Michael Goldberg and Samantha Prasad, of the Minden Gross Tax Group, for their presentations on which this article is based.