special reports tax planning with losses in canada planning with losses i… · tax planning with...

Tax Planning With Losses in Canada

by Steve Suarez

Unlike many other industrialized nations, Cana-da’s federal income tax regime has no system of

consolidation or group relief whereby the income orgains of group members can be offset against thelosses of other group members (or at least those inthe same country) simply by filing tax returns onthat basis. While it is possible in many cases toachieve results comparable to those obtainable un-der a formal group relief system, considerable plan-ning is required to achieve the optimal use of losseswithin a corporate group. This article reviews thebasic elements of the Canadian tax system dealingwith losses (including rules that deny recognition oflosses in some cases), describes the different sets ofstatutory rules and administrative policies thatmake up the general loss utilization framework, andoffers examples of the kind of loss utilization plan-ning undertaken in Canada.

I. Losses: Categorization andRealization

A. Types of Losses

The Income Tax Act (Canada) (ITA) distinguishesbetween items of profit (that is, income) and capitalgain. Income from a business or investment is fullytaxable, whereas only 50 percent of capital gains aresubject to tax. While distinguishing between incomeand capital gains is a highly judgmental issue thatprobably generates more disputes between taxpay-ers and the Canada Revenue Agency (CRA) than anyother, in very general terms capital gains typicallyarise from the disposition of property (capital prop-erty) acquired for producing income from holding orusing the property (for example, production equip-ment), as opposed to a property held to make a profiton reselling the property (for example, inventory).1

Losses are similarly divided between capitallosses and losses from a business or investment. A

capital loss typically arises on a disposition of acapital property when the sale proceeds are lessthan the taxpayer’s cost of the property and anyexpenses of disposition, while a business or invest-ment loss generally arises in a particular year whenthe expenses associated with the business or invest-ment in the year exceed the income it generates.

Each business or investment of the taxpayer istreated as a separate source of income with a sepa-rate computation of profit or loss. A taxpayer com-putes its overall income for the year by aggregatingthe profit (or loss) from each business or invest-ment.2 As such, a loss from one business or invest-ment is deductible against income from anotherwithin the same year.3

Each year, the taxpayer totals 50 percent of anycapital gains realized in the year (taxable capitalgains) and subtracts 50 percent of any capital lossesrealized in the year (allowable capital losses).4 If thenet amount is positive, that excess (net taxablecapital gains) is added to the taxpayer’s overallincome for the year. However, if allowable capitallosses exceed taxable capital gains, the excess is notdeductible against business or investment income incomputing overall income.5 Instead, it is treated asthe taxpayer’s net capital loss for the year, which,

1The same property can be either capital or noncapitalproperty depending on its use (for example, land acquired tobuild a production facility versus land acquired for resale).

2For Canadian residents, the income or loss from eachbusiness or investment is included, while nonresidents gen-erally include only income or losses from businesses carriedon in Canada that are not protected from Canadian tax underthe terms of a relevant tax treaty.

3Some special types of business or investment losses(losses from some farming activities and ‘‘limited partnershiplosses’’) are not freely deductible against other business orinvestment income; those special types of losses are notdiscussed.

4Again, for Canadian residents all capital gains and lossesare included. Conversely, nonresidents generally include onlycapital gains and losses from some specified forms ofCanadian-situs capital property (‘‘taxable Canadian prop-erty’’) that are not exempt from Canadian capital gains taxunder a tax treaty.

5See scenario 2 of Table 1. One particular form of capitalloss (an ‘‘allowable business investment loss’’ or ABIL) isdeductible against business or investment income. An ABILarises on some dispositions of shares or debt of Canadian-controlled private corporations all or substantially all ofwhose assets are used in active businesses carried on inCanada.

Steve Suarez is a partner with Osler, Hoskin& Harcourt LLP in Toronto.

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graphicstest

Text Box

subject to some limitations, may be applied againstnet taxable capital gains of other years as describedbelow.

If the taxpayer’s losses from businesses and in-vestments for the year exceed the sum of the tax-payer’s income from businesses and investmentsplus net taxable capital gains, that excess is the tax-payer’s noncapital loss for the year.6 The taxpayer’snoncapital loss for a particular year may be appliedagainst income (or net taxable capital gains) in otheryears, subject to various restrictions as describedbelow. Hence, the taxpayer’s net capital loss and non-capital loss can be thought of as excess losses for aparticular year that can be used in other years. Table1, on the following page, contains simplified numeri-cal examples of the operation of those rules.

The distinction between capital losses andbusiness/investment losses is an important one forvarious reasons:

• only 50 percent of a capital loss (the allowablecapital loss) is recognized by the tax system;

• capital losses are only deductible against capi-tal gains, whereas business/investment lossescan be deducted against any income or taxablecapital gain;

• excess business/investment losses for a year(that is, noncapital losses) have different rulesfor application in other years than excess capi-tal losses for a year (net capital losses); and

• as is discussed below, a corporation’s capitallosses are treated differently from its noncapi-tal losses on an acquisition of control of thecorporation.

A taxpayer’s noncapital loss for the year may becarried back and applied against the taxpayer’soverall income in any of its three immediately pre-ceding tax years or carried forward and used in anyof its 10 immediately subsequent tax years. It ex-pires if not used within that period. A taxpayer’s netcapital loss for the year may be used against thetaxpayer’s net taxable capital gains (but not busi-ness or investment income) in any of the taxpayer’sthree immediately preceding tax years or any lateryear. In both cases, unexpired losses of earlier yearsmust be used before those of later years.7 As dis-cussed below, a corporation’s ability to use its non-

capital losses or net capital losses in another yearmay be affected by a corporate reorganization or anacquisition of control of the corporation.

B. Recognition of LossesCanada’s tax system does not recognize all losses

that a taxpayer may incur. The ITA contains rulesthat deny or suspend recognition of losses or reducethe amount of the loss recognized. A brief summaryof some of the most important of those ‘‘stop-loss’’rules is useful.

1. General Requirement for Profit MotiveFor business or investment losses, the tax au-

thorities have for many years been concerned withlosses generated from activities that are not moti-vated exclusively by profit-making considerations.The classic example is a part-time farming operationcarried on by a taxpayer largely motivated by main-taining a country lifestyle rather than generating aprofit. Canadian tax authorities are concerned withallowing losses from what are essentially personalhobbies to be used to offset income from the taxpay-er’s primary business activities.

Until relatively recently, the Canadian tax juris-prudence required that, for a business or investmentloss to be recognized by the tax system, the loss-generating activity must be carried on with a ‘‘rea-sonable expectation of profit’’ (REOP). The REOPtest was meant to separate activities with at least arealistic potential to generate a profit from thosethat never will, with losses from the latter beingdenied recognition for tax purposes. A few years ago,however, the Supreme Court of Canada handeddown a pair of decisions8 that fundamentally revisedthe role of the REOP test. It ruled that, when therewas no personal element to the taxpayer’s activities,losses from those activities would be recognizedwhether or not the REOP test was met. Only whensome personal element to the activity exists will theREOP test be relevant (and only then as one factorto be considered) in considering whether the lossarises from a ‘‘business’’ or ‘‘investment’’ so as to berecognized for tax purposes.

In response to those and other judicial develop-ments, the government introduced legislative pro-posals on October 31, 2003, to limit the recognitionof losses in various circumstances.9 The essence ofthose draft proposals would have required a year-by-year analysis of whether, in each particular year,it is reasonable to expect that the taxpayer willrealize a cumulative profit from the relevant busi-ness or investment activity (that is, not only will it

6See scenario 3 of Table 1.7The rules dealing with loss carryforwards and carrybacks

are largely contained in section 111 ITA. The carryforwardperiod for noncapital losses was recently extended from 7years to 10 years. ABILs (see footnote 5) are included in thetaxpayer’s noncapital loss. If they remain undeducted at theend of the carryforward period, they are transferred to thetaxpayer’s net capital loss (which has no carryforward expi-ration).

8Stewart v. The Queen, 2002 DTC 6969, and Walls v.Canada, 2002 DTC 6960.

9See Department of Finance Release No. 2003-055.

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be profitable in the future, but all losses from earlieryears will be recouped). Losses in a year in which therelevant activity failed to meet that test would bedisallowed. Moreover, for that purpose cumulativeprofit would not include capital gains realized on theultimate disposition of property.

The tax community expressed great concern overthose proposals on the basis that they represented asignificant change in tax policy that would haveunanticipated and disruptive results.10 In response

to those concerns, the Department of Finance an-nounced in its 2005 budget that the October 2003proposals would be scaled back to ‘‘a more modestlegislative initiative’’ and that alternative proposalswould be released for comment ‘‘at an early oppor-tunity.’’ Finance reiterated that intention on May 9,2005, at the meeting of the Canadian branch of theInternational Fiscal Association, indicating that anet profit test would be proposed.

2. Loss Suspension on Affiliated PersonTransactions

A general stop-loss concept that manifests itselfin several places in the ITA is that losses on thedisposition of property should generally not be rec-ognized when the taxpayer or an affiliate continuesto own the property or an identical substitutedproperty. The basis for this principle is that no trueeconomic loss arises until the relevant propertyceases to be held within the affiliated group. Forthat purpose, the rules typically use the status of‘‘affiliated’’ persons as the relevant degree of rela-tionship. In some cases those stop-loss rules delayrecognition of the seller’s loss until neither the sellernor a person affiliated with the seller holds therelevant property. Less frequently, the rules simplydeny the loss to the seller and effectively transfer itto the affiliated purchaser as an accrued loss on theacquired property, to be realized on a subsequentdisposition.

10See, e.g., the submission of the Joint Committee onTaxation of the Canadian Bar Association and the CanadianInstitute of Chartered Accountants dated Feb. 19, 2004.Among the problems cited were that the year-by-year cumu-lative profit test denies the recognition of losses from a whollycommercial activity that has simply become unsuccessful,which is inappropriate from a tax policy perspective. Also, theyear-by-year test does not adequately take into account thatin many cases taxpayers incur multiyear obligations at theoutset of a business or investment. It is thereby inconsistentwith other provisions of the ITA that permit ongoing deduct-ibility of expenses originally incurred with a reasonableexpectation of profit. Moreover, the proposals are inconsistentwith commercial decisionmaking. For example, if a taxpayerreasonably expects that continuing an unprofitable businesswould recoup some but not all of the previous losses, the‘‘cumulative profit’’ test would deny recognition of subsequentlosses even though the taxpayer has acted in a commerciallylogical way.

Table 1

Scenario 1 Scenario 2 Scenario 3

Business 1:Income (Loss)

$100 $50 ($40)

Investment 1:Income (Loss)

($60) $20 ($100)

Subtotal: Net Business/InvestmentIncome (Loss)

$40 $70 ($140)

Capital Property 1:Capital Gain (Loss)

$80 $20 $120

Taxable Capital Gain (50%) $40 $10 $60

Capital Property 2:Capital Gain (Loss)

($60) ($50) ($20)

Allowable Capital Loss (50%) ($30) ($25) ($10)

Subtotal: Net TaxableCapital Gains (Losses)

$10 ($15) $50

Overall Income (Loss) $50 $70 ($90)

Noncapital Loss - - ($90)

Net Capital Loss - ($15) -

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The concept of ‘‘affiliated’’ persons is somewhatinvolved, but can be summarized as follows. A natu-ral person is ‘‘affiliated’’ with his spouse, but not anyother natural person (that is, children, parents, andsiblings). A corporation is affiliated with any person(including another corporation) who controls thecorporation, any member of a group of affiliatedpersons that controls the corporation, and thespouse of any of those persons. A corporation is alsoaffiliated with another corporation if: (1) each iscontrolled by the same person; (2) each is controlledby a single person and those two persons are affili-ated; (3) one is controlled by a single person, theother is controlled by a group of persons, and thesingle person is affiliated with each member of thegroup of persons; or (4) both corporations are con-trolled by groups of persons and every member ofboth groups is affiliated with at least one member ofthe other control group. For that purpose, ‘‘control’’refers to de facto control of a corporation,11 ratherthan the narrower, more typical de jure test ofhaving sufficient shares to elect a majority of thecorporation’s board of directors. Analogous rulesgovern the affiliation status of partnerships andtrusts.

While there are separate stop-loss rules dealingwith different types of property, they generally op-erate along similar lines. The operation of thoserules can be illustrated by describing the stop-lossrules applicable to dispositions of nondepreciablecapital property by a corporation, partnership, ortrust. The rules suspend recognition of the taxpay-er’s loss if some conditions apply, and (when appli-cable) go on to prescribe the circumstances in whicha suspended loss will be unsuspended and recog-nized for tax purposes. Briefly, a loss from thedisposition of nondepreciable capital property (thedisposed-of property) by a corporation, partnership,or trust (the transferor) is deemed to be nil when:

• the disposition of the disposed-of property is notan excepted disposition;12

• the transferor or an affiliated person acquires aproperty (the acquired property) within the61-day period that begins 30 days before andends 30 days after the date of the disposition;

• the acquired property is either the disposed-ofproperty itself or property identical to thedisposed-of property; and

• at the end of the 61-day period, the transferoror an affiliated person owns the acquired prop-erty.

Thus, for example, simply transferring ownershipto an affiliated person or disposing of property andbuying it (or an identical property) back within 31days will cause the loss to be suspended under thisrule. The suspended loss will be recognized at thebeginning of the first 30-day period following thedisposition in which neither the transferor nor anaffiliated person owns the acquired property or aproperty that is identical to the acquired propertyand was acquired within the 30 days preceding thestart of the 30-day period.13 Thus, the loss could beunsuspended because the acquired property hasbeen sold outside the affiliated group or because theowner of the acquired property has ceased to beaffiliated with the transferor.

3. Specific Stop-Loss Rules

In addition to the more general rules dealing withthe recognition of losses, a number of specific provi-sions reduce or deny the recognition of losses inparticular circumstances. For example:

• in some circumstances a loss realized on thedisposition of a share is reduced by the amountof particular dividends received on the share;14

and

• losses from the disposition of a debt are gener-ally denied unless the debt was acquired by thecreditor to gain or produce income or is abalance of sale owing on a disposition of capitalproperty to an arm’s-length person.15

II. Loss Transfers Between Entities

Having briefly summarized the principles appli-cable to the computation, categorization, and real-ization of losses, we now turn to the rules in the ITAgoverning the transfer of losses between entities. Asthose rules are largely directed toward the losses ofcorporations, the discussion that follows focuses on

11De facto control means effective control of a corporation,such as may occur when (for example) one large shareholderholds less than 50 percent of a corporation’s shares but theremainder are widely held among the public.

12Excepted dispositions include some dispositions deemedto occur by the ITA and a disposition by a corporation that hasundergone an acquisition of control in the 30 days followingthe disposition.

13Some events and dispositions deemed to occur under theITA (including an acquisition of control of a corporation) willalso un-suspend the loss. The rules are contained in subsec-tions 40(3.3)-(3.7) ITA and in some circumstances deem prop-erty to be identical to other property (for example, sharesacquired in certain tax-free exchanges) or deem persons toown property.

14Sections 112(3)-(7) ITA. The basic principle behind therule is that tax-free dividends that have been received on ashare represent a tax-free recovery of cost that should reducethe amount of any loss from a sale of the share.

15Subparagraph 40(2)(g)(ii) ITA. As a result, interest-freeloans can be problematic in that regard.

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corporate taxpayers, although other entities likepartnerships and trusts can be highly useful in lossutilization planning.

From the perspective of Canadian tax authorities,the fundamental distinction to be drawn betweenacceptable and unacceptable loss transfers is basedon the ‘‘affiliated person’’ concept (for that purpose,‘‘affiliated’’ is a modified version of the same ‘‘affili-ated’’ definition used in the stop-loss rules notedabove).16 In general terms, transactions that havethe effect of transferring losses between affiliatedpersons are viewed as acceptable from a tax policyperspective, while loss transfers between unaffili-ated persons are not and are much more likely to bechallenged by tax authorities.17 The basis for thatview is derived from the overall thrust of variousstatutory provisions that restrict the use of losses, inparticular:

• Acquisition-of-control rules. Those rules applyto the acquisition of control of corporations by‘‘unrelated’’ persons (discussed in detail below).Generally speaking, they crystallize accruedbut unrealized losses immediately before theacquisition of control and prohibit or restrictthe corporation’s use of pre-acquisition-of-control losses in the post-acquisition-of-controlperiod and vice versa.

• Affiliated person rules. The antiavoidance rulesin subsections 69(11)-(13) apply when a dispo-sition of property occurs at below fair marketvalue sale proceeds for tax purposes (that is, arollover) as part of a series of transactions andit is reasonable to consider that one of the mainpurposes of the series is to use the deductionsor losses of someone unaffiliated with the ven-dor on a subsequent disposition of the propertywithin three years.18 When applicable, those

rules deem the transferor to have received fairmarket value sale proceeds on the originaldisposition for tax purposes.

Loss utilization transactions designed to circum-vent the acquisition-of-control rules or the affiliatedperson restrictions described above will typically beconsidered to be avoidance transactions by the CRAto be challenged by the ITA’s general antiavoidancerule applicable to tax-motivated transactions thatresult in a misuse of specific provisions of the ITA oran abuse of the ITA as a whole. These provisions,along with related provisions that govern the use oflosses following some corporate reorganizations,such as amalgamations and windups, form thestatutory framework within which to consider trans-fers of losses between corporations.

In addition to those statutory restrictions, theCRA has a number of other administrative concernsthat it will consider in determining whether to grantan advance tax ruling on a loss utilization transac-tion (if the taxpayer has requested one) or to chal-lenge a loss utilization transaction on audit(whether under the general antiavoidance rule orotherwise). For example:

• transactions designed to effectively import intoCanada losses from outside the Canadian taxsystem are viewed very negatively;19 and

• when losses (such as noncapital losses) have aspecific time limit to be used, a transaction thatreplaces those losses with new losses withlonger time periods for use (loss refreshing) isconsidered abusive unless the new losses willbe used within the remaining life of the existinglosses (that is, the extra utilization time is notused).20

As such, loss utilization transactions must bedesigned to take into account both the various sets ofloss restriction rules in the ITA and (for taxpayers16For purposes of the rules restricting loss transfers (as

opposed to the stop-loss rules), the ‘‘control’’ element of the‘‘affiliated person’’ definition described earlier is the narrowerde jure control (that is, ownership of sufficient shares, directlyor indirectly, to elect a majority of the corporation’s board ofdirectors), not the de facto control concept relevant to theaffiliated person definition in the context of the stop-lossrules.

17Hence, while for loss realization purposes a dispositionto an affiliated person is generally denied recognition underthe stop-loss rules on the basis that it does not represent atrue realization of the loss, for loss utilization purposes onlytransfers of losses among affiliated persons are generallyconsidered acceptable by the CRA.

18For example, that rule would apply to the transactiondescribed below in Section II.C.2. and illustrated in Figure 4(Property Sale via Lossco) if Lossco and Gainco were notaffiliated, to prevent the tax-deferred transfer of the gainasset to Lossco. It should be noted that the degree of relation-ship used in the acquisition-of-control rules (‘‘related’’) is not

quite the same as that used in the loss transfer rules(‘‘affiliated’’). However, the modified version of affiliatedbased on the de jure control standard is very similar to therelated test so that, in many (but not all) cases, relatedpersons will also be affiliated. The difference between the twois less relevant in the public company context and morepronounced for family-owned corporations.

19See, e.g., the comments of a senior CRA official at the2002 Canadian Tax Foundation Annual Conference, InterestDeductibility: Where From, Where To, Where Now? 2002Conference Report, at 11:11: ‘‘If there is a way to importlosses, I would think that the tax policy would be that wewould again use whatever tools we have available to chal-lenge it.’’

20See, e.g., Income Tax Technical News, No. 25, Oct. 30,2002.

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seeking an advance tax ruling or who have lowerrisk tolerance) the nonstatutory administrative poli-cies of the CRA.21

A. Windups and AmalgamationsIt is useful to briefly summarize the rules govern-

ing the use of loss balances (that is, unused noncapi-tal losses and net capital losses from other years) onan amalgamation of two or more corporations or thewinding-up of one corporation into another. Thoserules apply in addition to any other loss utilizationrules otherwise applicable. For example, an amal-gamation (that is, merger) of two corporations toform a single corporation may also constitute anacquisition of control of one of the amalgamatingcorporations, in which case the acquisition-of-control rules described below would also apply.

1. Windups

A windup describes a corporate procedurewhereby a corporation ceases to exist and its re-maining property (after paying its debts) is distrib-uted to its shareholders on the cancellation of thewound-up corporation’s shares. Because losses at-tach to a particular entity, the loss balances of awound-up corporation are eliminated in the absenceof statutory rules to the contrary.

An exception to that general rule exists when oneCanadian corporation (the parent) owns 90 percentor more of the shares of each class of shares ofanother Canadian corporation (the subsidiary) andany remaining subsidiary shares not owned by theparent are owned by persons dealing at arm’s lengthwith the parent. In those circumstances, the parentgenerally acquires the subsidiary’s property at itstax cost (as such, inheriting any accrued but unre-alized gains and losses). Any unused loss balances ofthe subsidiary at the time of its windup may be usedby the parent in future parent tax years, beginningin the parent’s first tax year following the windup.22

The parent may not carry the subsidiary’s lossbalances back to any prewindup parent tax year.The parent is free to carry its own loss balancesforward or backward against its own income, subjectto the usual time limits.

2. Amalgamations

An amalgamation of two or more corporations is aspecific form of corporate merger, which results in

the creation of a new corporation for tax purposesthat is the successor of the two amalgamating cor-porations. An amalgamation of two Canadian corpo-rations occurs on a tax-deferred basis if the newcorporation acquires all of the property and assumesall of the liabilities of the amalgamating corpora-tions and the shareholders of the amalgamatingcorporations receive shares in the new corporationin exchange for their shares of the amalgamatingcorporations.23 As such, on a qualifying amalgam-ation the new corporation acquires the property ofthe predecessor corporations at tax cost and inheritsany accrued but unrealized gains and losses.

On a qualifying amalgamation, the new corpora-tion acquires the loss balances of the amalgamatingcorporations and may use them in postamalgam-ation tax years (subject to the same restrictions thatwould have applied to the amalgamating corpora-tion that incurred them).24 Conversely, losses in-curred by the new corporation may not be carriedback to preamalgamation tax years of any amalgam-ating corporation, with one exception. The exceptionarises when one amalgamating corporation (the topcorporation) owns all of the shares of the other (thebottom corporation). In that circumstance, the newcorporation is permitted to carry postamalgamationlosses it incurs back into the top corporation’s prea-malgamation tax years (subject to the normal three-year carryback limitation). As such, on a verticalamalgamation of the bottom corporation into the topone, the tax result is essentially the same as occurson the windup of a wholly owned subsidiary into theparent.

Amalgamations and windups are useful elementsof corporate loss planning because, if structuredproperly, they allow accrued losses and loss balancesto be moved into a profitable entity (or accrued gainsor future income to be moved into a loss entity) on atax-deferred basis. For example, a simple loss utili-zation technique might be to amalgamate a corpo-ration that has loss balances with a corporation thathas a profitable business and use the loss balancesagainst the postamalgamation income of the busi-ness. As noted above, however, it would be necessaryto consider whether on the facts, the acquisition-of-control rules or subsection 69(ii) affiliated personrestrictions create additional constraints on usingthe loss corporation’s losses. The basic rules govern-ing the use of loss balances on windups and amal-gamations are depicted in Figure 1.

21Figure 5 (Overview of Loss Utilization Rules, discussedat the conclusion of this article) attempts to visually illustratethe network of relevant provisions at a conceptual level.

22Subsection 88(1.1) and (1.2) ITA. The parent’s ability touse the subsidiary’s losses is subject to any restriction thatthe subsidiary itself was under (for example, remainingnumber of years permitted for carrying noncapital lossesforward).

23Subsection 87(1) ITA. Shares and debt of one amalgam-ating corporation held by the other are ignored for thatpurpose.

24Subsection 87(2.1) ITA. The amalgamation itself causesa deemed tax year-end, aging the loss balances by one year.

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B. Acquisition of ControlThe rules applicable to the acquisition of control

of corporations are a key element of the statutoryscheme of loss utilization restrictions. When achange in the shareholdings of a corporation (di-rectly or indirectly) meets a particular thresholddefined as an ‘‘acquisition of control,’’ a variety ofrules apply to the corporation, including rules that:(1) deem the corporation’s tax year to have ended; (2)trigger the realization (immediately before the ac-quisition of control) of its accrued losses; and (3)prohibit or restrict the use of preacquisition-of-control losses (including unused losses from (2)) inthe postacquisition-of-control period and vice versa.As such, understanding and managing the acquisi-tion of control rules is an integral part of corporateloss utilization planning.

1. Meaning of ‘‘Acquisition of Control’’The concept of corporate ‘‘control’’ is not a precise

one for Canadian tax purposes. The basic test is theownership of sufficient shares of a corporation thatgives the holder de jure control of the corporation,generally meaning the ability to elect a majority ofthe corporation’s board of directors. In some casesagreements among shareholders to vote shares aparticular way or limit the powers of the corpora-tion’s directors may also be relevant to determiningde jure control. Control can be held by a ‘‘group ofpersons’’ if the members of the group act in concertto direct the affairs of the corporation or vote theirshares jointly. In many cases (for example, withwidely held companies), no person or group of per-

sons has de jure control of the corporation. A personor group of persons that controls a corporation willalso be considered to control any corporations thatare controlled by the first corporation. Consequently,an acquisition of control of a corporation results inan acquisition of control of any other corporations itcontrols.

Not all changes in shareholdings that result in adifferent person or group of persons having de jurecontrol of a corporation constitute an ‘‘acquisition ofcontrol’’ for tax purposes. A number of rules operateto deem a transaction that would otherwise be anacquisition of control not to be an acquisition ofcontrol, in particular when the change in de jurecontrol arises because a person has acquired shareseither from a person who is related to the acquiror,or of a corporation to which the acquiror was alreadyrelated.25 As such, transactions that do not result in

25Subsection 256(7) ITA (which also deems an acquisitionof control to occur in some circumstances, such as on someamalgamations). The related test in section 251 ITA is similar(but not identical to) the modified affiliated test describedwith reference to the affiliated person loss transfer restric-tions in subsection 69(11) ITA, in particular because both arebased on de jure control. A natural person is related to his orher spouse and blood relatives (children, parents, siblings,etc.). A corporation is related to a person who controls it, toany person related to that controlling shareholder, and toeach member of a group of related persons who controls it(and to anyone related to any of those members). Two corpo-rations will be related if one controls the other, if both are

Figure 1. Permitted Use of Losses on Windups and Amalgamations

NewcoLosses

Date ofAmalgamation

AmalgamatingCorporations’

Tax Years

SubsidiaryLosses

ParentTax

Years

Parent Losses

Parent Losses

Date ofWindup

Prewindup Postwindup

Preamalgamation Postamalgamation

AmalgamatingCorporations’

Losses

Newco TaxYears

*Other than when one amalgamating corporationowns all shares of the other.

90%+-Owned Windup Amalgamation*

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an unrelated person acquiring de jure control of acorporation generally will not constitute an acquisi-tion of control of the corporation. In that sense, therelated person test plays a role in the acquisition-of-control rules similar to that of the modified affiliatedperson test in the loss transfer rules in subsection69(11) ITA and the CRA’s administrative policy, inthat the relevant loss restrictions generally will notapply on intragroup transactions.

2. Effect of Acquisition of Control

The tax year of a corporation that has undergonean acquisition of control is deemed to end immedi-ately before the acquisition of control.26 To theextent that the corporation has various kinds ofaccrued but unrealized losses (for example, on capi-tal property, inventory, or receivables, and so on),they are deemed to be realized immediately beforethe deemed tax year-end and the tax cost of therelevant property is written down to its fair marketvalue.27 In that way, accrued losses are preventedfrom being carried over to the postacquisition-of-control period and are instead crystallized before thedeemed tax year-end to be either used in the taxyear ending on the acquisition of control or (as netcapital losses or noncapital losses for that year)made subject to the rules described below governingthe carryover of losses on acquisitions of control.Note that because under many of the stop-loss rulesan acquisition of control is typically an event thatunsuspends a loss, the acquisition of control mayalso result in the effective realization of lossespreviously suspended under the stop-loss rules.

Most importantly, the acquisition of control rulesalso restrict the use of net capital losses and non-capital losses as follows:

• Net capital losses. Net capital losses of thecorporation from years before the acquisition ofcontrol cannot be carried forward and used inpostacquisition-of-control tax years. Essen-tially, they become worthless if they cannot beused in the preacquisition-of-control period.28

Similarly, net capital losses from years follow-

ing the acquisition of control cannot be carriedback and used in preacquisition-of-controlyears.

• Noncapital losses — Investments. Noncapitallosses from an investment (as opposed to from abusiness) are in the same position as net capitallosses. Preacquisition-of-control losses cannotbe carried into the postacquisition-of-controlperiod (and vice versa) and effectively expire ifthey cannot be used before the acquisition ofcontrol.29

• Noncapital losses — Business. Noncapital lossesfrom a business (the loss business) arising fromthe preacquisition-of-control period may be car-ried forward and used in the postacquisition-of-control period (and vice versa), if two conditionsare met. First, throughout the year in which thecorporation is trying to use the loss, it must carryon the loss business itself with a reasonableexpectation of profit. Second, the loss can only beused in that year to the extent of income from theloss business or from another business substan-tially all of the income from which comes fromselling similar properties or rendering similarservices as were sold or rendered in the lossbusiness.30

Thus, the acquisition-of-control rules are meantto prevent losses from one business from beingcarried forward or back through the acquisition ofcontrol and used against income from a significantlydifferent business. They also prevent investmentlosses and capital losses from being carried forwardor back through an acquisition of control at all.Figure 2 is a visual depiction of the loss restrictionrules on an acquisition of control.

C. Examples of Permissible Loss TransfersLoss utilization planning can take many forms

and a detailed discussion of all of the potentialplanning opportunities for using corporate losses isbeyond the scope of this article. However, it isinstructive to conclude by describing a couple of the

under common control, or if each is controlled by a person orgroup of persons that are sufficiently related to one another.

26Subsection 249(4) ITA.27The relevant rules include subsection 111(4) ITA (for

nondepreciable capital property), subsection 111(5.1) ITA (fordepreciable capital property), subsection 111(5.2) ITA (forcumulative eligible capital), subsection 10(1) ITA (for inven-tory), and subsection 111(5.3) ITA (for receivables). A numberof other tax attributes are subject to similar rules.

28Subsection 111(4) ITA. To alleviate some of the harsh-ness of that rule, the corporation can make a one-timeelection to effectively use any otherwise unusablepreacquisition-of-control capital losses against any accrued

but unrealized capital gains on its property that exist imme-diately before the acquisition of control, thereby increasingthe tax cost of (and reducing the accrued gain on) the gainproperty.

29Subsection 111(5) ITA. ABILs (see footnote 5) included inthe taxpayer’s noncapital loss are similarly treated.

30Subsection 111(5) ITA. Whether a business is the ‘‘samebusiness’’ as the loss business and whether property sold orservices rendered are ‘‘similar’’ to those sold or rendered inthe loss business can be a matter of some judgment. Thedifferent treatment of noncapital losses from a business andnoncapital losses from an investment makes it important todetermine whether a particular activity is a business or aninvestment. Corporations are generally presumed to carry onall but the most passive activities as a business.

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more common loss utilization techniques that exem-plify the kind of planning that can be done to effecta consolidation of losses within a corporate group.

Many loss utilization strategies rely on a fewbasic elements of the Canadian tax system toachieve the desired results. Those essential ele-ments of the loss utilization toolkit include thefollowing:

• the deduction for interest expense incurred onmoney borrowed to gain or produce incomefrom a business or investment;31

• the deduction that allows a Canadian corpora-tion to receive dividends on the shares of an-other Canadian corporation free of tax;32 and

• most property with accrued gains can be trans-ferred to a Canadian corporation in exchangefor shares of that corporation without realizingthe accrued gains when a joint election is madeunder subsection 85(1) ITA.

The two loss utilization examples described belowillustrate the use of those provisions in the context ofan affiliated group of corporations.

1. Simple Operating Loss Consolidation

When one member of a corporate group has avail-able noncapital losses, the most common form of loss

31Paragraph 20(1)(c) ITA. Interest on an unpaid balance ofsale owing on the acquisition of an income-earning invest-ment or property used in a business is also deductible.

32Subsection 112(1) ITA. There are some limited excep-tions to that intercorporate dividend deduction and, in somesituations, taxes under Parts IV, IV.1, and/or VI.1 ITA mustalso be considered.

Corporation’sTax Years

Same/similarbusiness only

Date ofAcquisition of

Control

Noncapitallosses (business)

Noncapitallosses (investment)

Net capitallosses

Same/similarbusiness only

Noncapitallosses (business)

Noncapitallosses (investment)

Net capitallosses

Preacquisition Postacquisition

Figure 2. Acquisition-of-Control Loss Restrictions

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consolidation involves a transaction between theloss corporation (Lossco) and a corporation withtaxable income (Profitco) that creates a deduction inProfitco and a corresponding income inclusion inLossco (to be offset with Lossco’s losses). Figure 3depicts a simple version of such a transaction thatthe CRA has ruled favorably on many times, whichcreates taxable interest income in Lossco and de-ductible interest expense in Profitco that effectivelytransfers Lossco’s losses to Profitco. The steps ofthat transaction (all of which occur on the same day)are as follows:

1. Profitco obtains a loan from a financialinstitution;

2. Profitco uses the borrowed funds to sub-scribe for shares of Lossco;

3. Lossco uses the share subscription proceedsto make an interest-bearing loan to Profitco;and

4. Profitco uses the money borrowed fromLossco to repay its daylight loan in 1.

The result is that Profitco pays interest to Losscoon the loan in 3 and claims a deduction from incomefor that interest on the basis that the money bor-rowed from Lossco replaced another loan (the loan in1 that was incurred to produce income (dividends onthe Lossco shares acquired with the borrowedmoney). The interest deduction reduces Profitco’sincome and the interest income in Lossco is ab-sorbed by its losses. The rate of interest on theLossco-Profitco loan reflects a commercially appro-

priate rate based on the relevant facts and is oftenstructured to be slightly less than the expecteddividends on the Lossco shares acquired by Profitcoin 2 to make clear that Profitco will earn positive netdividend income even after subtracting its interestexpense owing to Lossco. Lossco can distribute sur-plus cash to Profitco as a dividend (which Profitcowill generally receive tax-free).

There are numerous variations on this simplestructure (particularly if there are insolvency lawconcerns regarding any arm’s-length creditors ofLossco), but the basic version illustrates the essen-tial concepts.33 As noted earlier, the CRA has variousadministrative concerns (for example, loss refresh-ing and importation of foreign losses) that it willapply in scrutinizing loss utilization transactions. Inthe context of that particular form of loss consolida-tion, the CRA will also typically insist that theamount of the Lossco-Profitco loan not exceed theamount that could have been borrowed from anarm’s-length lender on an ongoing basis.34 The CRAhas also expressed concerns when Lossco has nosource of funds to pay dividends other than theinterest received from Profitco (that is, when Prof-itco is itself funding the dividends it expects to

33In a number of cases, a third corporation is included inthe structure for corporate law reasons.

34The CRA’s concern is that larger amounts meant togenerate more interest expense faster to accelerate the use ofLossco’s losses are artificial.

Figure 3. Basic Loss Consolidation

Lossco

Profitco

100%interest dividends

4

2

Lossco

Profitco

100%sharesubscription

loan

Bank

repayment

loan

3

1

Implementation Ongoing Operation

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receive on the Lossco shares it subscribed for). TheCRA greatly prefers that Lossco be able to pay itsdividends without having to use the interest re-ceived from Profitco.35

2. Property Disposition via Loss CorporationAnother form of basic loss consolidation deals

with accrued gains on property to be sold. The sale ofa property with accrued gains owned by one corpo-ration (Gainco) is routed through an affiliated cor-poration with offsetting losses (Lossco). The essenceof that structure involves a tax-deferred transfer ofthe property by Gainco to Lossco in exchange forshares of Lossco using a subsection 85(1) ITA elec-tion whereby Gainco’s proceeds of disposition andLossco’s tax cost of the property are deemed to beGainco’s tax cost of the property (that is, no gain isrealized and Lossco inherits the accrued gain).Lossco then sells to the third-party buyer at fairmarket value, thereby realizing the accrued gain.The gain is then absorbed by Lossco’s losses. Ifdesired (and assuming there are no corporate law orinsolvency law issues), Lossco can distribute the saleproceeds to Gainco as a dividend (which Gainco willtypically receive tax-free). This form of loss consoli-dation is depicted in Figure 4.

Again, while there are several variations of thebasic structure, the CRA has expressed its approvalof those transactions on numerous occasions, subjectto the general concerns expressed earlier on lossutilization transactions (for example, the subsection69(11) affiliated person restrictions).36 In addition toany corporate or insolvency law issues that may berelevant to any particular situation, considerationmust also be given to whether the additional dispo-sition to Lossco creates any incremental sales ortransfer tax issues.

III. ConclusionIt is by now apparent that many restrictions

govern the recognition and use of losses in theCanadian tax system. Indeed, the tax regime inCanada governing losses can best be thought of as anumber of distinct sets of rules overlaid on oneanother, producing a loss utilization system that islargely but not entirely consistent.37 Indeed, theremay be multiple layers of relevant loss utilizationrestrictions in any situation. Figure 5 attempts to

35The concern is whether Profitco can legitimately claim tohave borrowed money for an income-earning purpose (asrequired for a paragraph 20(1)(c) ITA interest deduction)when the income to be earned is dividends that can only befunded with the very interest Profitco will pay on the bor-rowed money.

36If Gainco and Lossco were not affiliated, subsection69(11) ITA would prevent the tax-deferred transfer of the gainproperty to Lossco in the first step, crystallize the gain inGainco, and defeat the plan.

37For example, the use of the affiliated standard (based oneither de facto or de jure control) in some provisions and therelated standard in others. That reflects the development andenactment of the various different sets of rules at differenttimes, rather than as a unified and comprehensive scheme.

Gainco

Buyer

Gain

AssetLossco

100% $

$

Lossco

GaincoBuyer

100%GainAsset

LosscoShares

$

GainAsset

Gain

Asset

Figure 4. Property Sale via Lossco

1. 2. Asset Drop-Down and Sale

1

1 2

2

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visually depict the principal sets of rules that mustbe considered in Canadian loss utilization planning.

Making optimal use of losses in Canadian taxplanning is not a simple matter because of thenumerous rules in the ITA (and CRA administrativepolicies) that are potentially relevant and the ab-sence of a formal loss consolidation regime. How-ever, loss utilization planning is an accepted andimportant part of the Canadian tax system, in

particular within an affiliated group (since Financeand the CRA have both expressed a willingness toaccommodate planning that replicates the resultsthat may be had under a formal group relief systemelsewhere in other countries). With a good under-standing of the rules, appropriate planning, andcareful execution of the relevant transactions, excel-lent results can be achieved. ◆

Figure 5. Overview of Loss Utilization Rules

Specific Rules Applicable to Particular LossUtilization Transactions- §20(1)(c) interest expense deduction- §112(1) intercorporate dividend deduction- transaction-specific CRA policies

Capital/Noncapital LossApplication and Carryforward/backRules- capital losses only usable against

capital gains- carryforward/carryback time limits

Stop-Loss Rules- denied when no profit motivation- denial/suspension when property

remains in affiliated group- specific stop-loss rules

LossRecognition/Application

Rules

Loss Utilization

CRA Administrative Policies- loss refreshing- importation of losses

General Antiavoidance Rule- transactions recharacterized on

misuse or abuse of specificprovisions or ITA as a whole

Anti-avoidance

Rules

Acquisition-of-Control Rules- deemed realization of accrued

losses- prohibition or restriction on

carrying losses forward or backacross acquisition of control

Amalgamation/Windup Rules- amalgamations: losses carried

forward but not back- windups: subsidiary’s losses

carried forward; no parent losscarryback to subsidiary

Affiliated Person Rules (§69(11))- rollover denied when purpose of

series is to take advantage ofunaffiliated person’s deductionsor losses within three years

Loss Transfer Rules

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