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Canadian Tax Planning and COVID-19: Opportunities Amidst Uncertainty

Posted on May 11, 2020
Colleen Ma
Colleen Ma
Carolyn Hogan
Carolyn Hogan
Ron Choudhury
Ron Choudhury

Ron Choudhury is a partner with, and leader of, the commodity tax group of Miller Thomson LLP in Toronto, and Carolyn Hogan and Colleen Ma are associates with Miller Thomson in Calgary.

In this article, the authors outline Canadian federal income and sales tax planning opportunities that may help taxpayers during the COVID-19 pandemic.

These are uncertain times. The world is faced with a pandemic and resulting lockdown that have no parallels in living memory. Humanity, having lived through natural disasters, wars, and various other catastrophes, has been stopped in its tracks. However, trade and commerce carry on even during a lockdown and so do taxes and tax planning. Whether it be a recession or a depression caused by a global pandemic, economic downturns provide unique opportunities for tax planning that may not be as available, prevalent, or feasible during times of plenty. This article considers a few such Canadian federal income and sales tax planning opportunities that may provide greater flexibility and optimization in the future.

Debt Restructuring

A global downturn leads to unique challenges for debtors and creditors. While liquidity crunches and business downturns may force debtors to seek to borrow further, the same liquidity crunches and business downturns may render lenders reluctant to lend. Nontraditional debt — for example, rental payments to landlords — are also affected when payers struggle to make payments. Debt restructuring can become an important component of planning at such times.

Debt restructuring can take many forms. An outright forgiveness of debt, while a lucrative proposition in a recession or depression, is not always realistic. Canada’s Income Tax Act1 penalizes the debtor on a forgiveness of debt through a reduction of tax attributes (in a specific order laid out in the ITA) and thereafter, an income inclusion. Debt parking, the transfer of a debt at a deep discount to a non-arm’s-length person with significant interests in the debtor, leads to similar consequences.

Given these punitive consequences, a restructuring of debt may sometimes be favorable to outright forgiveness. Restructuring can take the form of refinancing, deferral, or conversion. However, each may also have its own tax consequences.

When refinancing indebtedness, it is important to ensure that the debt obligation has not been disposed of. A disposition of debt may lead to debt forgiveness and its attendant consequences. It is also important to ensure that the debt has not been novated (a new debt created) or the disposition of the old debt may also lead to debt forgiveness. Generally, fundamental changes to a debt obligation lead to novation.2 Examples include a change from interest-bearing to interest-free, a change in repayment schedule or maturity date, a change in the principal amount, or a change in the debtor or creditor.

A deferral of debt can also have tax consequences, particularly if the deferred amount is subject to Canadian federal sales tax (goods and services tax/harmonized sales tax). The Excise Tax Act (ETA) deems consideration for a supply to be payable at a specific time and the GST/HST on that consideration to be payable at that time.3 In the context of rent, for example (viewed here as a nontraditional debt obligation), the ETA states that consideration under a lease, license, or similar arrangement, is due on the day the lessor/tenant is required to pay that consideration under an agreement for the same (generally, the rental agreement).4 The rent is due on the day on which the tenant is required to pay it under the rental agreement and the GST/HST is payable on that day unless the rent is paid earlier.5 If such debt is deferred without appropriate structuring, the GST/HST will remain payable on the due date of the original payment instead of the date of deferred payment. This can lead to unintended consequences and cash flow problems.

A conversion of debt to equity is often the most favorable option during an economic downturn. A conversion of debt into shares of the debtor can be completed on a tax-deferred basis under ITA section 51. The adjusted cost base of the converted debt becomes the adjusted cost base of the shares issued on the conversion. The debt forgiveness rules will also not apply if the fair market value of the shares issued in the exchange equal the FMV of the exchanged debt. Care must be taken to ensure that if the terms of the debt do not contain a conversion right, minimal terms are changed such that the debt is not disposed or novated. Generally, the addition of a conversion right does not lead to a disposition of the debt in and of itself.

The issuance of equity can also take the form of distress preferred shares. Corporations may issue distress preferred shares (generally, preferred shares that are excluded from many of the rules in the ITA that tax distributions on preferred shares) under bankruptcy or receivership situations, and when default is imminent because of financial difficulty.6

Financial difficulty offers relative flexibility in structuring debt conversions. The issuer of shares can do so when it is in financial difficulty as opposed to in receivership or bankruptcy. Also, such difficulties with a related corporation resident in Canada allow an issuer to issue these shares. However, distress preferred shares can only be issued when the issuer or a related corporation resident in Canada is in default or could reasonably be expected to default on a debt owed to an arm’s-length person.

Distressed preferred shares are also subject to the debt forgiveness rules in the ITA. The rules treat these shares as debt if they are redeemed or canceled for an amount less than their FMV. However, the debt can be converted into distress preferred shares on a tax-deferred basis.7

Corporate Reorganizations

Taxpayers considering corporate reorganizations may benefit from decreased market values driven by the fallout from COVID-19. Such reorganizations, often done on a tax-deferred basis under the ITA, can be valuable planning tools in an economic downturn when reduced values of assets allow for the tax liability on the reorganizations to be low. Reorganizations done on a taxable basis are likely to be simpler to execute, involve less administrative compliance, and may not be as susceptible to challenge or audit as a tax-deferred reorganization.

Some reorganizations are typically conducted on a taxable basis and are potential candidates for completion during downturns. One situation in which a taxable reorganization could be considered is in the case of a foreign investment. Although the ITA contains various provisions that allow tax-deferred dispositions (also known as rollovers) applicable to Canadian entities, if a taxpayer wishes to move an asset from one foreign entity to another, it usually must be done on a taxable basis. For example, a Canadian member of a foreign partnership that wishes to transfer assets to a foreign corporation will likely realize a taxable event for Canadian tax purposes on the transfer, even if the reorganization may be done on a tax-deferred basis under the applicable foreign law. Given the declining market values resulting from COVID-19, taxpayers wanting to reorganize their foreign holdings should consider doing it now while values are low and taxes may be minimized.

Another situation in which tax savings may be realized through reduced market value is the split-up of a business that does not otherwise qualify for a tax-deferred reorganization under the ITA; for example, a reorganization that requires a corporation to distribute property directly to its shareholders. Another example is a corporate reorganization that does not otherwise qualify as a tax-deferred “butterfly” reorganization under ITA 55(3)(a) or 55(3)(b). A “butterfly” reorganization is so named because the steps of the transaction, when illustrated, resemble a butterfly. This might occur when parties wish to split up a business, but do not qualify for a “related party butterfly” under paragraph 55(3)(a) because they are dealing with each other at arm’s length. This might also occur in the case of siblings, who are deemed by paragraph 55(5)(e) to be dealing with each other at arm’s length for purposes of section 55. An unrelated party butterfly under paragraph 55(3)(b) is also possible, but may not be desirable because it requires each party to receive its pro rata share of each type of property — if one party wants the business assets of a corporation and one party wants the investment assets of a corporation, and the parties are not related, a butterfly reorganization would not allow the parties to achieve their desired results. If the parties nonetheless wish to split up their business and go their separate ways, it will likely have to occur on a taxable basis. If so, then the best method to reduce taxes payable is to complete the reorganization when as gains are as low as possible.

Tax Losses

Most noncapital losses may be carried back three years and forward 20 years. Businesses that anticipate realizing noncapital losses because of COVID-19 should consider how those losses may be realized going forward. Planning opportunities may be available that will allow businesses to use these losses within a corporate group.

In circumstances in which one entity within a corporate group will incur losses in the year while another is expected to be profitable, consideration should be given as to whether the separate corporate existence of the two entities is necessary for business purposes. If the entities can be amalgamated, the income of one may be offset with the losses of the other (assuming that the amalgamation does not lead to the application of specific “stop-loss” rules in the ITA). The timing of such amalgamation must be carefully considered, however, to ensure the losses can be used as intended. Then the amalgamated corporation may deduct the noncapital losses of the predecessor corporations on a go-forward basis.

It also may be possible to adopt strategies to transfer income within a corporate group so that losses may be used by a related corporation (subject to legal issues and risk factors being considered). Consideration could be given to the payment of management fees or other intercorporate fees to shift income from a profitable corporation into one that expects to incur losses. However, such management fees may be deductible by the profitable corporation only if they are incurred to gain or produce income from business or property. The payer entity should therefore ensure that it is actually receiving services from the payee entity, and that the management services should actually relate to the payer’s business.

The use of intercompany loans may also be a valuable planning strategy. The Canada Revenue Agency generally considers such strategies implemented within a related group of companies to be in accordance with the scheme of the ITA, provided that the goal is not to shift income among provinces or to refresh losses beyond their carryforward limit.8 In general terms, these strategies involve a corporation in a loss position lending funds to a profitable corporation within a related corporate group, that in turn uses those funds to invest in the loss corporation. If done properly, the profitable corporation will receive a deduction from the interest payments made to the loss corporation, which will offset its taxable income, while the loss corporation will have an income inclusion that it may offset with its noncapital losses. The effective result is to transfer income and lower the overall taxes payable within a corporate group. For these strategies to be successful, the interest must be deductible to the profitable corporation; therefore, care should be taken to ensure that the borrowed funds are used for earning income from a business or property.

Crystallization of capital losses may offer another planning opportunity. When a taxpayer disposes of capital property, the difference between the taxpayer’s proceeds of disposition and adjusted cost base of the property is either a capital gain or a capital loss. If a taxpayer realizes a capital gain, half of the gain is included in the taxpayer’s income. If the taxpayer realizes a capital loss, however, half of that capital loss may be used to offset a capital gain. Generally, capital losses can only be used to offset capital gains. Capital losses may be carried back three years and may be carried forward indefinitely.

If a taxpayer has realized a capital gain in the past three years, consider whether a capital loss could be triggered that can be carried back against the previous capital gain. If a taxpayer is looking to trigger a capital loss, the superficial loss rules and the stop-loss rules in the ITA should be carefully reviewed to ensure that triggered losses may be claimed as intended.

Drop in Valuation and Freeze Transactions

Canada does not have a gift or estate tax like other jurisdictions. However, one does not fully escape tax at death. Generally, immediately before death, a deceased person is deemed to have disposed of each capital property held for an amount equal to its FMV. This includes shares held in a private corporation. This provision effectively forces a person, immediately prior to death, to realize accrued capital gains.

A strategy to minimize the tax liability that arises at death is to “freeze” the value of shares held in a private corporation and shift any future growth to another person, often the next generation. This transaction can generally be completed on a tax-deferred basis. A typical tax plan involves the “freezor” exchanging common shares for fixed-value preferred shares with an aggregate redemption amount equal to the FMV of the shares on the effective date of the transaction (the freeze shares). After this exchange, common shares are issued to new common shareholders for a nominal amount. The tax liability that arises on the freezor’s death is then limited to the value of the freeze shares.

Generally, a lower valuation at the time of the freeze transaction results in a lower tax liability at death. The current depressed market may be the opportune time for individual shareholders to consider this type of tax planning. Further, if a freeze transaction was implemented in the past but the aggregate redemption amount of the freeze shares exceeds the total value of the corporation (that is, the freeze shares are underwater), a refreeze transaction may be implemented to lower the value of the freeze shares. This may decrease the tax liability that arises at the freezor’s death.

Deferral of Federal Sales Tax Remittance

On March 27 Canada’s Department of Finance announced that businesses could delay to June 30 remitting federal GST/HST, including installment payments, due on or after March 27, without interest.9 This is welcome news for businesses of all sizes, individuals, and nonresident registrants that are finding themselves in cash flow trouble during the COVID-19 pandemic.

Generally, a registrant is required to charge GST/HST on taxable supplies made in Canada and remit that amount to the CRA monthly, quarterly, or annually. Delaying when registrants are required to remit the tax gives them more time to collect outstanding accounts receivable without being out of pocket. Further, if the tax had been collected, registrants can use the funds for other expenses, such as rent or payroll, until June 30.

Businesses that use amounts collected as GST/HST to supplement their cash flow need to remember this measure is only a deferral. GST/HST must still be remitted June 30. Generally, amounts collected as GST/HST are deemed to be held in trust in favor of the Crown.10 This deemed trust can be extended, in some circumstances, to a secured creditor that is paid ahead of the Crown, potentially making the secured creditor a collection target.11 Secured creditors should be aware of the extended trust rules when discharging the security and take mitigation steps.

This government measure is an excellent opportunity for businesses that have been affected by the economic fallout of COVID-19. However, businesses that treat collected GST/HST as an interest-free loan should remember there are significant penalties for late or nonremittance.12

Creating Liquidity and Federal Sales Tax

The phrase “cash is king” rings very true in this COVID-19 environment. Businesses should consider strategies to minimize their GST/HST burden to create liquidity.

GST/HST is remitted on a net tax basis. Generally, this is determined by the formula A–B in which A is the total of all amounts that became collectible in the reporting period and B is the total of all input tax credits (ITCs) claimed in the reporting period.13 If net tax is positive, the registrant must remit the amount. However, if net tax is negative, the registrant is entitled to a refund issued by the CRA “with all due dispatch” after the filing of a GST/HST return.

Registrants due refunds should file their GST/HST returns promptly after the end of their reporting periods (although the lockdown may affect the timing of payments). Businesses may consider whether their expected refunds can be used as collateral for borrowing. Provisions in the ETA allow the CRA to set off refunds against other amounts owing. While this may stifle much-needed cash flow, it may also be used to offset other tax liabilities.

A registrant may generally claim ITCs within two or four years. A business may want to delay its claims for ITCs when the amount of GST/HST collectible in a reporting period exceeds the amount of ITCs it can claim, to avoid potentially being selected for an audit.

GST/HST that is charged must be added to the net tax calculation, whether or not the tax was actually collected. Effectively, in circumstances in which GST/HST is remitted before collection, the registrant is extending credit to the customer. If the debt has become uncollectible, a registrant may be entitled to make a bad debt adjustment claim to recover the GST/HST that was previously remitted.14 This may be a good time to review receivables to determine if they are collectible and to make appropriate adjustments.

FOOTNOTES

1 Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended.

2 See General Electric Capital Equipment Finance Inc. v. The Queen, 2002 DTC 6734 (FCA).

3 Excise Tax Act (Canada), RSC 1985, c. E-15.

4 Section 152 ETA.

5 Section 168 ETA.

6 Para. (e) of the definition of “term preferred share” in subsection 248(1) ITA.

7 Subsection 80.02(3) ITA.

8 Canada Revenue Agency, 30 Income Tax Technical News (May 24, 2004).

9 Department of Finance Canada Backgrounder, “Additional Support for Canadian Businesses From the Economic Impact of COVID-19” (Mar. 27, 2020).

10 Section 222 ETA.

11 See, e.g., Canada v. Toronto-Dominion Bank, 2018 FC 538.

12 Nothing in this article should be construed as advice to use funds otherwise collected in trust for the crown. The discussion is of a generic nature only and not intended to be applicable to specific situations.

13 Sections 225 and 228 ETA.

14 Section 231 ETA.

END FOOTNOTES

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