A guarantor becomes the creditor when a guarantee payment is made
According to the Federal Court decision in Abrametz v. The Queen, when a taxpayer makes a payment under a guarantee for a corporation's indebtedness, it is generally regarded that the taxpayer has acquired the rights of the creditor concerning the debt at the moment of payment. When a guarantor makes a payment under a guarantee for a corporation's indebtedness, it establishes an account receivable against the corporation. If the account receivable becomes uncollectible, it leads to a bad debt, which can be treated as either a capital loss or an allowable business investment loss (ABIL).
In the case of M.N.R. v. Steer the Supreme Court of Canada determined that the loss is classified as a capital loss if it occurred while fulfilling a guarantee on a loan negotiated by a company in which the guarantor held an equity interest. However, the Tax Court of Canada judgment in Armstrong v. The Queen states that an ABIL can be claimed by a guarantor who makes a payment under a guarantee, provided that subsection 39(12) of the Income Tax Act is complied with. Nevertheless, referring back to Abrametz, it was established that a guarantor can claim an ABIL without satisfying subsection 39(12) as long as paragraph 39(1)(c) of the Income Tax Act has been met. It is important to note that the ABIL tax treatment can only be considered once it has been confirmed that the guarantor has made a payment.
What is an ABIL
An allowable business investment loss is half of a taxpayer's business investment loss, which refers to a capital loss resulting from the disposal of shares in a small business corporation or debt owed to the taxpayer by an SBC. Under paragraph 39(1)(c) of the Income Tax Act, the disposition can occur in two ways:
- It can be made to an arm's-length person.
- It can fall under the application of subsection 50(1) of the Income Tax Act.
Unlike capital losses that are only deductible against capital gains, an ABIL can be deducted from all sources of income and is first applied in the tax year it arises. If an ABIL cannot be fully deducted in the year it is incurred, it is treated as a non-capital loss, which can be carried back for three years or forward for up to ten years. Any remaining loss not deducted within the ten-year carryforward period is considered a net capital loss, which can be carried forward indefinitely.
A business investment loss occurs when there is a capital loss resulting from the actual transfer to an arm's length individual, meaning someone unrelated to you or without a shared interest with you, of:
- A share of the capital stock in a small business corporation, or
- Debt in a Canadian-controlled private corporation (CCPC) that falls under one of the following categories:
- It is a small business corporation.
- It becomes bankrupt and was a small business corporation when it became bankrupt.
- It is a corporation that was both insolvent and a small business corporation at the time a winding-up order was issued for the corporation.
A CCPC is defined in subsection 125(7) of the Income Tax Act and generally refers to a Canadian private corporation that is not controlled by non-residents or public corporations or any combination of the two.
Apart from an actual disposition, subsection 50(1) of the Income Tax Act allows for a deemed disposition. This means that the taxpayer is considered to have disposed of a share or debt at the end of the taxation year for no proceeds and immediately reacquired the property at zero cost. Generally, a deemed disposition can occur if the taxpayer makes an election for a specific year in relation to:
- A debt that is owed to the taxpayer at the end of the taxation year and is determined to be a "bad debt" (i.e., uncollectible) during that year, or
- A share in a corporation that is owned by the taxpayer at the end of the year, in cases where:
- The corporation becomes bankrupt within the year,
- The corporation is insolvent, and a winding-up order is issued in the year, or
- The corporation is insolvent, does not conduct business, the fair market value of the share is zero, and there is a reasonable expectation that the corporation will be dissolved or wound up without future business operations.
Pro tax tips - the guarantor only becomes a creditor once a payment has been made
The tax treatment discussed above only applies to a guarantor once he acquires the rights as the creditor by making the payment. Under certain conditions, a guarantor could also realize a non-capital loss from honoring a guarantee. This would occur if the guarantee was given in the ordinary course of the taxpayer's business with the intention of earning a continuous and increasing income stream, as seen in the Tax Court case Lachapelle v. M.N.R. Therefore, it is highly recommended for a taxpayer to consult with an experienced Canadian tax lawyer to understand all the potential tax consequences before making any personal guarantee.
What are the tax treatments of a guarantor who makes a personal guarantee on behalf of a private corporation?
A guarantor becomes a creditor of the corporation once payments concerning the guarantee have been made. Depending on the circumstances, the debt the corporation owed to the guarantor as the new creditor may be claimed as capital losses or an ABIL.
What is an ABIL?
An allowable business investment loss is half of a business investment loss, which can be incurred via the disposition of SBC shares or a bad debt in two ways:
- The disposition is made to an arm's-length person.
- The disposition is elected under subsection 50(1) of the Income Tax Act.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.