Many Canadians make investments in private companies, either by buying shares or by lending money to the company. Although we all hope that our investments will “pan out” and show profitable returns, sometimes the company fails and we lose our investment. Losing money is never good, but if the business invested in is a “small business corporation” it may be that the loss is not a total loss.
The Canadian Income Tax Act contains special rules that may permit the investor to deduct one half of the loss from other sources of income when determining taxable income for the year. The special rule treats the loss as an “Allowable Business Investment Loss” or ABIL. This treatment is better than a capital loss since capital losses can be deducted only against capital gains.
An example faced by some of our clients is where a loan was made to a private company that became insolvent and unable to repay the loan. In order to qualify for tax treatment as an ABIL, the borrower company must be:
- a Canadian-controlled private corporation;
- the assets of the business must be used principally in carrying on an “active business”;
- the active business must be carried on primarily in Canada
There are certain timing issues and documentation issues to consider when claiming an ABIL. Firstly, the loss must be incurred within 12 months after the date that the business ceased or became insolvent.
ABIL’s have come under intense scrutiny by CRA in recent years since CRA’s objective is to collect income taxes, not allow tax deductions. We have found that formal documentation assists us in presenting a case to CRA that will substantiate the loss.
The documentation that we recommend includes:
- if the investment is in shares of the company, a copy of the cheque written for the subscription in shares; and
- a copy of the share certificate;
- if the investment is a loan to the company; copies of cheques written to the company indicating that the amount is being loaned;
- a promissory note or notes indicating the amounts lent and owing;
- PPSA registration of the promissory notes;
- documentation that repayment of the note(s) has been demanded;
- documentation from the company that the debt is uncollectible;
- formal collection attempts (i.e. lawyer’s demand letter)
We have also found that it is beneficial if the promissory note(s) contain a requirement to pay or accrue interest at a nominal rate of 1% per annum. This is because loans usually bear interest and CRA may consider a non-interest bearing loan to not have “an income producing purpose” and therefore not be a bona-fide loan.
Although the Tax Courts have interpreted the income tax act more broadly in recent years, our approach is to have the ABIL qualify rather than incur unnecessary professional fees to fight CRA in court.
In a recent tax case, a father guaranteed a line of credit of his son’s company. The son’s company had a loan payable to the father’s company. There was no guarantee fee charged. The son’s business failed and the father had to settle the line of credit since he had provided his guarantee. He claimed an ABIL, but CRA rejected it since their position was that there was no “income producing purpose” for the guarantee. The tax court however accepted that the guarantee was made to protect the inter-company loan and found that to be an adequate purpose. Although successful, the father had to incur quite a lot of professional fees to win this case.
A bit of a twist in the claiming of an ABIL is that the loss is reduced by any capital gains deductions claimed in previous years, and net capital gains qualifying for the capital gains deduction are reduced by ABIL’s incurred since 1985.
The Final Word
The “take-away” is that you should consult your Professional Chartered Accountants before the investment is lost to ensure that everything is documented well enough to confirm the eligibility for an ABIL in the event that the investment is lost.
We encourage you to contact us to review your situation and determine if changes should be made to meet your objectives.
Please contact us with your questions.