Relief from Debt-Forgiveness Inclusions: The Basics

When a taxpayer cannot service debt because of financial distress, a creditor may forgive all or a portion of the debt. The debt forgiveness may trigger an income inclusion under subsection 80(13), but a taxpayer in financial distress may not be able to pay the tax on the inclusion. The purpose of sections 61.2, 61.3, and 61.4 is to provide relief to certain taxpayers facing subsection 80(13) income inclusions.

Section 61.2 provides a reserve on a subsection 80(13) income inclusion if the debtor is an individual (other than a trust) resident in Canada. The reserve, which is claimed net of paragraph 80(15)(a) deductions, allows the subsection 80(13) income inclusion to be deferred to future years when the taxpayer earns more income. The reserve begins to decrease at a rate of 20 cents per $1 of income earned in excess of $40,000. Therefore, the income inclusion will never be taxed if the individual never earns income in excess of $40,000, or if he or she dies in a taxation year in which the reserve is still eligible to be claimed.

Section 61.3 provides an offsetting deduction to corporations resident in Canada (unless they are exempt from part I tax) that limits the income inclusion to twice the FMV of the corporation's net assets. This offsetting deduction is aimed at ensuring that the corporation's tax liability from the income inclusion will not exceed the FMV of its net assets. As is the case for many insolvent corporations, a net asset value of zero will result in a deduction equal to the full amount of the subsection 80(13) income inclusion. Subsection 61.3(1) (for resident corporations) and subsection 61.3(2) (for non-resident corporations) function in the same manner.

The rules in section 61.3 are subject to an anti-avoidance provision. Subsection 61.3(3) restricts the deduction when property transfers are made within the 12-month period before the end of the year if it is reasonable to conclude that the reason for the property transfer was to increase the available deduction for the year under subsection 61.3(1) or subsection 61.3(2). If subsection 61.3(3) applies, the lender and the borrower referred to in the subsection are jointly and severally liable for any tax liabilities arising from a subsection 80(13) income inclusion (subsection 160.4(1)).

While sections 61.2 and 61.3 provide relief for financially distressed Canadian-resident individuals or corporations, section 61.4 allows a reserve to be claimed on a subsection 80(13) income inclusion if the debtor is any of the following (with some exceptions): (1) a non-resident person that carried on business through a fixed place of business in Canada, (2) a corporation resident in Canada, or (3) a trust resident in Canada. The section 61.4 reserve also differs in that the subsection 80(13) income is required to be included in the corporation's income at a minimum rate of 20 percent per year. Therefore, the income inclusion will be brought into income over a maximum five-year period.

Mike Ehinger
MNP LLP, Winnipeg

Canadian Tax Focus
Volume 3, Number 3, August 2013
©2013, Canadian Tax Foundation