It may not seem intuitive, but there are certain situations where it is possible for a creditor to recoup some of their lost loan from a non-arm's length debtor in the form of a capital loss or, if the debtor is a small business corporation, a business investment loss (for further information on allowable business investment losses, please read our Tax Notes series on ABIL Claims Part I and Part II).
Is it a bad debt? The first step in claiming a bad debt expense under section 50 of the Income Tax Act (Canada) (the "Act") is to determine that the debt has, in fact, gone bad such that the creditor is entitled to make an election pursuant to subsection 50(1). The creditor must conduct an honest and reasonable assessment of the debt's collectability. This means the creditor cannot choose to ignore facts, and it cannot be evident that the creditor could reasonably have collected the debt if some proactive steps had been taken to collect it.
The Federal Court of Appeal in Rich v R, 2003 FCA 38, discussed additional factors to be considered when determining whether a debt has gone bad, including:
- The history and age of the debt;
- The financial position of the debtor; and
- The past experience of the taxpayer with writing off bad debts.
(For the complete, non-exhaustive, list of factors, please refer to paragraph 13 of the decision.)
The Court in Rich indicated that the non-arm's length relationship with the debtor may also be relevant in some cases, potentially requiring further scrutiny of the debt; however, the non-arm's length relationship alone cannot lead to a finding that the creditor did not honestly and reasonably determine the debt to be bad.
Does subparagraph 40(2)(g)(ii) apply? Subparagraph 40(2)(g)(ii) of the Act provides that a capital loss resulting from a bad debt claimed under section 50 of the Act on a non-arm's length debt is reduced to nil unless the debt was acquired for the purpose of gaining or producing income from a business or property.
Since it is not unusual for a non-arm's length loan to carry little or no interest, there is often concern that the loan will not be considered to have been made for the purpose of gaining or producing income. However, the test is not for the primary purpose of the loan, but merely for a purpose, and it has been determined that the potential to generate dividend income satisfies this test. Therefore, a non-interest bearing loan can still be considered to have been issued for the purpose of gaining or producing income.
It may even be possible for a non-arm's length creditor that does not directly own shares of the debtor to be entitled to recognize the loss, so long as the potential to earn dividend income is not too remote.
Overall, it is possible for a non-arm's length debt to generate a bad debt expense for a creditor, but guidance should be sought prior to the debt's issuance to ensure the potential bad debt would qualify.
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.