How to Effectively Utilize Tax Losses
Many business owners have heard about the great advantage of using past losses to reduce or eliminate taxes. There may even be an option to buy a company for next to nothing and use its losses to reduce your businesses’ taxes. When planned properly, this can be very effective. But be warned, the rules are complex and use of the past losses may be denied if not applied properly.
Gains from the sale of real estate are often large enough to use up significant losses whether the losses were generated from an unsuccessful business venture from a related corporation, or you have an opportunity to acquire an entity that has losses from a third party.
Loss utilization may not be limited to the use of historical losses, a company with assets that have declined in value over the cost could also create losses upon acquisition that could be used by a purchaser.
CAPITAL AND NON-CAPITAL GAINS
Consideration needs to be given to the types of losses to be used as a capital loss is only available to shelter a capital gain. For example, the loss you took on the sale of investment shares cannot be used to reduce the business income you earn on your operating business. A non-capital loss can shelter income or capital gains.
UNRELATED PARTIES ACQUISITIONS
Acquiring shares and debt of a company in order to access the losses of an unrelated party may not work the way you might expect.
First, the acquisition of control of an entity will cause a “loss restriction event”. The loss restriction event will cause the following to occur:
- A deemed year-end to the acquired corporation;
- Any assets that have inherent losses will be adjusted to the fair market value increasing capital and non-capital losses of the acquired company and reducing the cost base of transferred assets;
- Capital losses cannot be used in future years;
- If there are assets with gains an election may be used to increase the cost to the extent capital losses exist;
- Non-capital losses will only be available to income earned by the acquirer if:
- The seller’s business was carried on by the acquirer after the acquisition for profit; and
- More than 90% of the acquirer’s income was earned from similar business.
If the seller has previously discontinued its business, then the non-capital losses would likely not be deductible by an acquirer.
FORGIVEN DEBT CONSIDERATIONS – DEBT SLIDE FOR NON-CAPITAL LOSSES
An acquisition of a company that has losses from land speculation and the intention to develop may be the same business where the acquirer purchases the business to continue the development of the land along with similar projects.
It is not unusual for a company with losses or an asset with unrealized losses to have been funded through related-party loans. Depending on whether the loan is considered a commercial loan by the seller, the acquisition of debt could be subject to the forgiven debt rules. If applicable, the debt forgiveness rules may reduce certain tax attributes, including non-capital losses.
Pre-acquisition planning may be done to reduce the cost of the debt held by the seller of a target company so the debt forgiveness rules would not apply. Very generally, a “debt slide” involves the seller transferring the debt to a newly incorporated subsidiary of the target company for a nominal amount. The stop-loss rules would apply preventing the seller from claiming a capital loss on the transfer. However, after the parent and subsidiary are amalgamated the transferred debt between the parent and subsidiary would be offset and the remaining debt to be acquired would be limited to the nominal amount. There may be elections needed and other considerations that should be made with any debt slide planning.
RELATED CORPORATE GROUPS
Loss utilization between related companies is not subject to the loss restriction event rules. A loss from one business can be applied to income from a dissimilar business without restriction.
Other than charging management fees between entities which would only be deductible where the fee is reasonable, there are a few simple methods to use losses within a related corporate group.
Amalgamation between the two entities
The losses of the predecessor corporation become available to the amalgamated entity in the year immediately after the amalgamation. With an amalgamation you would want to consider:
- The timing as there is a deemed year end for each predecessor corporation;
- Legal liability as the amalgamated entity will be considered to be both predecessor corporations;
- Timing of income to which losses are to apply; and
- If the amalgamated entities are not a parent subsidiary relationship then some consideration would need to be given to the fair market value of the entities to ensure the shareholders before and after the transaction hold shares that match the ratio of value held prior to the amalgamation.
Winding-up a wholly owned subsidiary
Under either transaction preliminary planning can be done to eliminate certain shareholders or create a parent subsidiary relationship.
Acquiring new property in the loss corporation
This simply involves using the loss corporation with a new project.
Transferring asset with unrealized income or capital gains to the loss corporation
A property can be transferred to the loss corporation on a tax deferred basis prior to its sale. The transfers are subject to different provisions of the Income Tax Act (Canada) depending on what is transferred:
- A capital property may be transferred on a tax deferred basis in exchange for shares; and
- Land inventory may be transferred to a limited partnership with the limited partnership interest being then transferred to the loss corporation.
The use of rollover provisions is subject to certain limits and require elections to ensure they are not taxable.
A transfer of a property with a capital loss to a corporation with gain to be sheltered
If a capital property that is held personally is transferred into a related corporation the transferor’s loss would be deemed to be nil and the denied loss would be added to the cost of the property by the acquirer allowing a capital loss to be deducted against capital gains in the corporation.
Transferring a property with an unrealized capital loss from a corporation will generally result in stop loss rules suspending the loss in the transferor corporation until the acquirer disposes of the property.
The are other considerations with respect to the above.
- The above planning involves either transferring assets to a corporation that has existing losses or combining entities that would inherit the liabilities of the predecessor corporations. Liability considerations should be made prior to any transaction.
- Moving real property may be subject to property transfer taxes, GST/HST, and potentially certain speculation and foreign buyer taxes. (Further reading on Speculation and Foreign Buyer Taxes)
- Income tax consequences on the flow through of capital gains to an individual may result in an additional tax cost. Sheltering income gains and losses will generally provide a net benefit, however, this may not always be the case with sheltering a capital gain as the non-taxable portion of a capital gain is added to a corporation’s capital dividend account that may be paid out to an individual tax free. Combining an entity that has capital losses and a negative capital dividend account balance could result in the loss of this benefit.
As with any tax planning, each transaction will have unique aspects. Please contact a Smythe Advisor if you would like to discuss a transaction you are considering or if you have losses that you may want to use against a development or other transfer.
Aaron Dovell is a Principal in the Real Estate and Construction Group at Smythe LLP. Smythe LLP is one of the leaders in accounting and tax advisory services in the real estate and construction industries in BC. For further information, contact us at 604.687.1231 or visit smythecpa.com.
The information provided is a general overview and should not be construed as tax advice. We recommend seeking professional advice from your tax advisor in respect of your specific situation.