Forgiving and Forgetting: Debt Addition

I came across an article the other day about the Canadian investor and entrepreneur who was on Dragon’s Den, Vincent Guzzo. The article related to his cinema chain business  “Cinemas Guzzo Inc.”. The cinema business has fallen on hard times since Covid and Cinemas Guzzo Inc. owes CIBC $38m, Equitable Bank roughly $28m and some unpaid property taxes all past due. CIBC has now applied to the courts to place Cinemas Guzzo Inc. into bankruptcy and wants to liquidate the company. Liquidating the company is just selling off all the assets in the hope that there is enough value to repay all of the debt. If there is, the remaining about will go to the shareholders.

For those interested in the court order you can read it here. You should have google translate nearby as it is in French.

This got me thinking about the debt forgiveness tax rules for companies undergoing hard times found under Section 80 of the Income Tax Act. These rules say that when you settle a debt for less than the total amount outstanding, you receive some type of benefit/advantage as you did not have to repay the full amount. The tax rules try to offset this advantage which I’ll explain how in this post using Guzzo’s $66m debt outstanding.

Qualifying Rules

In order for the debt forgiveness rules to apply, there are 3 rules that must exist:

1)    The debt must be a commercial obligation.

2)    The debt must be settled or extinguished

3)    There must be a forgiven amount.

For Guzzo’s debt outstanding, since there was interest paid previously (I’m assuming there most likely was) this means it was a commercial obligation. Even though CIBC wants to do a liquidation and not restructure the debt, let’s assume for the purposes of this article that all the debt outstanding will be settled for $30m. This means Guzzo will pay $30m to settle the $68m in debt, which means criteria #2 is met. Therefore, the forgiven amount is now $68m less $30m for a total of $38m forgiven.

There can be instances where the debt is settled using a share for debt exchange The company would issue new shares in exchange for the debt and the debt would then be extinguished. But to keep this example simple we will just assume they paid $30m to forgive the $68m in total debt.

Guzzo’s and Lenders Tax Implications

The lenders would recognize a capital loss of $38m. That is pretty straightforward.

So what would this mean for Cinemas Guzzo? Since the forgiven amount is $38m, Cinemas Guzzo must use this 38m automatically against any of their prior years’ non-capital losses, farm losses, restricted farm losses, allowable business investment losses and net capital losses. Out of the 5 it would probably be any non-capital losses and net capital losses that existed, especially since they probably have been in loss positions the past few years if they can’t repay their debt.

Let’s assume they have $15m in non-capital losses. This would wipe out some of the forgiven amount to $23m ($38m - $15m). Now what?

There are 3 options they can use for the remaining $23m:

Option #1 – Make a T2154 Filing

By filing a T2154, Guzzo could use the remaining amount against any UCC balances of depreciable property and any ACB’s of capital property they own. This has the affect of having less tax depreciation to shield from taxes or creating a larger gain when the capital properties are sold. If a forgiven amount is still remaining after that they could use it against any CURRENT year capital losses. If any amount is still leftover, it will just be included into income for the year.

If they are going this route, because there is more than one commercial obligation outstanding (CIBC and Equitable Bank), they would have to file form T2153 to indicate the order of which the commercial obligations were settled.

Option #2 – Current year’s capital losses

Guzzo could apply the remaining amount against any net capital losses in the current year and then the remaining amount would have to be included into their income at 50%.

Option #3 – Transfer the forgiven amount

After amounts are used against UCC of depreciable property and ACB’s of certain properties and shares it holds, Guzzo could transfer this unapplied amount to an “eligible transferee” if it qualifies. This would allow Guzzo to not have to reduce certain tax accounts or put the amount into income if it came to that but transfer it to another company. If this other company had losses, it could then be used against the remaining amount.

Other liabilities

If Guzzo has other liabilities like accounts payable to suppliers and the suppliers are willing to take less than face value, just because these are not commercial obligations does not mean they won’t fall under the debt forgiveness rules. Under 248(26), these would also be considered applicable to the debt forgiveness rules.

What if Guzzo issues shares to the lenders?

Sometimes when a company is undergoing a restructuring, the lenders will take over the company and become the business owners, eliminating the debt. Or sometimes a company will issue new shares in exchange for some of the debt to be forgiven, called a debt for equity conversion. If Guzzo were to issue $30m of shares to settle the $68m liability, there is still $38m in debt forgiveness that would have to be applied the same as the above options go over.

If the lender is also a shareholder and this transaction takes place it can be a bit more complicated and is beyond the subject of this post.

Wrapping Up

 Just some quick notes on items relevant to these rules.

• Personal debts that are forgiven do not fall under these rules.

• Convertible debt does not fall under the debt forgiveness rules as well.

• If amalgamating two companies to wipe out one company’s inter-company debt, the rules do not apply.

• The rules are roughly the same for partnerships but because the non-capital and net capital losses flow through to the partners in prior years, there is generally no balance in these accounts when it comes to debt forgiveness situations. There are different types of planning that could be used.

• If you have purchased a company in an acquisition of control that came with losses and now your company is in distress, those losses can only be used to offset the forgiven amount provided that debt was outstanding PRIOR to the acquisition of control.

The debt forgiveness rules can be a complex place. Any debt forgiveness transaction needs to be consulted with by your tax advisor to ensure the proper sequence of forgiveness and options are available.

 I’ll be following this case closely to see if they can ultimately restructure the business or if a full on liquidation takes place.

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