Gael Melville, Vancouver, and Winnie Szeto, Toronto
In a recent Tax Court of Canada case, the court was asked to consider whether an allowable business investment loss (ABIL) arose where a loan made to a corporation subsequently went bad. The difficulty the taxpayers faced was in convincing the court that the direct recipient of the loan, which was not itself a small business corporation (SBC), was simply a conduit for funds loaned to other corporations that were in fact SBCs. The taxpayers’ arguments were unsuccessful and serve as a reminder that close attention must be paid to structuring business transactions.
What is an ABIL?
An ABIL is a special type of capital loss that can be used more flexibly than an ordinary capital loss for a limited period of time. Unlike allowable capital losses, which may be deducted only against taxable capital gains, an ABIL may offset income from any source in the year the loss is incurred.
If the ABIL is not fully claimed in the year it’s incurred, it may be claimed as a non-capital loss that may be carried back up to 3 years and forward up to 10 years to offset income from any source. Although non-capital losses have a 20-year carryforward period, this extension does not apply to a non-capital loss resulting from an ABIL. Any part of an ABIL that is not used in the 10-year carryforward/3-year carryback period becomes a net capital loss, which may be carried forward indefinitely but can be deducted only against taxable capital gains.
An ABIL is 50% of a business investment loss. A business investment loss can only arise on the arm’s-length disposition of shares or debt of a corporation that was an SBC at any time during the preceding 12 months before the disposition. An SBC is essentially a Canadian-controlled private corporation where more than 90% of the fair market value of its assets is attributable to assets that are:
- Used principally (more than 50%) in an active business carried on primarily (more than 50%) in Canada
- Shares or debt of one or more SBCs that are connected to it (the term connected generally means the corporation owns more than 10% of the issued share capital of the other corporation); or
- A combination of the above
Facts of the case
The case involved two individuals, Mr. X and Ms. X,1 who were each denied their claims for ABILs and non-capital loss carryforwards for their 2014 and 2015 taxation years, respectively. Mr. X and Ms. X jointly held shares in a numbered company, Xco.
In 2006, Ms. X and her brother decided to launch a new fashion and furniture retail business. They set up two corporations, each of which was owned 45% by Ms. X and 55% by her brother. One corporation, Opco, would run the retail business, and the second corporation, Leaseco, would lease the business premises to Opco.
To provide their share of the financing for Leaseco and Opco, Mr. X and Ms. X used their savings, took out loans and withdrew money from their registered retirement savings plans. They then made a series of large deposits into Xco’s bank account from November 2006 to October 2007. Almost all the money deposited into Xco’s bank account was immediately transferred to Leasco’s bank account.
The loans ultimately went bad and Mr. X and Ms. X claimed business investment losses totalling nearly $850,000 in their 2014 income tax returns. In their 2015 income tax returns, they each claimed non-capital loss carryforwards relating to the unused portion of the ABILs. The Canada Revenue Agency (CRA) reassessed them and disallowed the ABIL and non-capital loss carryforward claims. Mr. X and Ms. X both appealed the decision.
Tax Court decision
The Tax Court dismissed the taxpayers’ appeals.
At trial, the taxpayers agreed that Xco was not an SBC but argued that it was merely a conduit for the loans to Leaseco and Opco. Because Leaseco and Opco were both SBCs, the taxpayers argued that their ABIL claims — and resulting non-capital loss claims — should be allowed. On the other hand, the Minister of National Revenue took the position that the transactions were straightforward — Mr. X and Ms. X loaned money to Xco, which in turn loaned money to Leaseco; since Xco was not an SBC, the initial loan to Xco could not give rise to an ABIL.
The court first considered the documentary evidence and noted that it all supported the notion that the taxpayers made a loan to Xco. For example, a schedule to Xco’s T2 corporate income tax return for the year ended July 31, 2007 showed that the corporation had loans receivable of around $800,000 and outstanding shareholder loans of around $780,000.
The accountant who designed the corporate structure for Opco’s business also prepared the corporate income tax returns. The court said that fact indicated that the accountant took the position the taxpayers loaned money to Xco, and Xco then loaned the funds to Leaseco. Furthermore, the fact that the balances in the shareholder loan and loan receivable accounts were not equal showed that different adjustments had been made to each account, which ran counter to the idea of Xco acting simply as a conduit.
At the hearing, only Ms. X gave evidence on behalf of the taxpayers and the court found her testimony in relation to Xco being a conduit unreliable. Although she asserted that it was preordained that the money flowed through Xco to the other corporations, the court did not find that these assertions were supported. The court also drew an adverse inference from the fact that the taxpayers did not call Ms. X’s brother as a witness, who was a 55% shareholder in both Leaseco and Opco and who, according to Ms. X, was responsible for the finances of the business and dealt with the accountant.
The court also listed the explanations it found to be missing from the taxpayers’ evidence, explaining the significance of each one. For example, the court noted that the taxpayers did not explain why they deposited money into Xco’s bank account rather than simply depositing it directly into the accounts of Leaseco or Opco. In the absence of an explanation, the court found it was more likely than not that the money was a loan to Xco. Similarly, the court questioned why, if Xco had merely been a conduit, the ABILs claimed were in respect of loans to Xco rather than in respect of loans to Leaseco and Opco.
In conclusion, the court found that the taxpayers lent money to Xco rather than to Leaseco or Opco, and because Xco was not an SBC, the minister was justified in denying the taxpayers’ ABIL and non-capital loss carryforward claims.
Lessons learned
As the court noted towards the end of the reasons for judgment, this was a sympathetic case where the taxpayers lost significant sums of their own money. It appears that had they structured the loans differently, they would have been able to claim ABILs (and non-capital loss carryforwards) for the losses they sustained.
As the court stated, “in [Canadian] tax law form matters.” The court must apply the law to the transactions that actually took place rather than those the taxpayer wishes had taken place.
This case is a good reminder to taxpayers to take care when structuring their business ventures and to consider possible tax ramifications.