Stop Loss Rules for Corporations

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(Thursday, January 21, 2010)

Summary

The Canadian income tax system has many provisions that are designed to stop someone deducting a loss in certain specified circumstances. Collectively, these are known as “Stop Loss” rules. The most familiar, and for many taxpayers, perhaps the most important, trigger of these rules is the acquisition of control of a corporation.

When control of a corporation is acquired by an unrelated party, capital losses, business investment loss and losses from property cannot be carried forward or back across the acquisition of control. Non capital losses and certain other items can be carried across the acquisition of control, but only against income from the same or a similar business.

These rules are intended to stop “selling” of losses, whereby one corporation would acquire another purely in order to utilize the accumulated losses to offset current tax liabilities. They are not intended to stop the consolidation of losses within an affiliated group of companies, or consolidation of unrelated companies in the same line of business.

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When control of a corporation is acquired by an unrelated party, there are restrictions in the Income Tax Act that apply to stop losses from being deducted in most circumstances. As a summary, the following rules apply on acquisition of control:

· The corporation’s tax year is deemed to end immediately before control is acquired, and a new taxation year is deemed to start on the date of acquisition of control. This year end counts for the 3 year limit on all losses carried back and the 10 and 20 year limits for non capital losses and farm losses carried forward.

· No capital loss occurring prior to the acquisition of control can be carried forward to taxation years after the acquisition of control, and no capital loss occurring after the acquisition of control can be carried back to taxation years occurring before the acquisition of control.

· Non capital and farm losses may only be carried forward to years after the acquisition of control and applied against income from the same business or a similar business, and only if the business is carried on with a reasonable expectation of profit. Business losses and farm losses incurred after the acquisition of control may only be carried back to years before the acquisition and applied against the same business or a similar business, and only if the business was carried on with a reasonable expectation of profit.

· Losses from property (rental losses, for instance) and business investment losses cannot be carried forward or back over the acquisition of control.

· Investment tax credits earned before or after the acquisition of control may be carried back three years or forward ten years, but can only be applied again tax on income earned from the same business or from a similar business to that which earned the credit.

As well, the corporation is forced to recognize certain unrealized losses immediately on the acquisition of control. These are:

· Where non depreciable capital properties (usually land) have an Adjusted Cost Base (ACB) or book value in excess of the fair market value, a capital loss results. The corporation can chose to recognize any unrealized capital gain on other properties (land, buildings, and equipment) to offset the loss.

· Where a depreciable capital property (buildings, equipment) or eligible capital property (licenses, trademarks) has a book value in excess of the fair market value, the difference is required to be deducted as an expense in the year ended by the acquisition of control.

· No amount is deductible as a reserve for doubtful accounts in the tax year ended by the acquisition of control. If the face amount of accounts receivable exceeds the fair market value, the difference must be deducted as a bad debt. If the bad debt is subsequently recovered, it will be included in the corporation’s income in the year it is recovered.

· Any amount of Part 1.3 tax credit (federal capital tax credit) for a year prior to the acquisition of control cannot be deducted in a year after the acquisition, except against the tax attributable to the same or a similar business. Similarly, no Part 1.3 tax credit for a taxation year ended after the acquisition of control can be carried back except if it is applied Part 1.3 tax attributable to the same or a similar business.

If you are contemplating buying or selling control of a corporation, make sure you consult your tax accountant to cover any potential issues with the stop loss rules.