In today’s business and social environment, more and more owner-managers are struggling to keep their businesses alive. Many find it necessary to inject capital, including personal funds, into their companies. These funds might come from mortgaging their home, drawing on personal credit lines, or even friends and family. But investing in a business when there is an increased risk of struggle or failure requires that any investment should be planned with potential future loss in mind. Where such investments are made to private corporations, the investors or owner-managers may be entitled to a special type of loss known as a business investment loss (BIL). A BIL is a type of capital loss with one important advantage.
Advantage to claiming a BIL
Unlike regular capital losses, which may only be applied against capital gains, a BIL may be applied against any source of income. The deductible portion, which is equal to 50 per cent of the loss, is called an allowable business investment loss (ABIL). If the loss exceeds other sources of income for the current year, the remainder becomes a non-capital loss for that year, and may be carried back three years and carried forward ten years. If it cannot be deducted within that time frame, it becomes a net capital loss and may be applied against future taxable capital gains.
When does a loss become a BIL?
A BIL occurs when a taxpayer disposes (or is deemed to dispose) of either of the following types of qualifying property:
- debt owed by a small business corporation (SBC)1; or
- shares of an SBC.
BIL – actual disposition
A BIL includes a capital loss from a disposition to an arm’s-length person of:
- a share of the capital stock of an SBC; or
- debt in a Canadian-controlled private corporation (CCPC) that is1:
- an SBC;
- bankrupt and that was an SBC at the time it became bankrupt; or
- a corporation that was insolvent and an SBC at the time a winding-up order was made in respect of the corporation.
Generally, an SBC is a CCPC in that all or substantially all of the fair market value of its assets is attributable to assets used principally in an active business carried on primarily in Canada by the corporation or by a corporation connected to it, or debt or shares in other SBCs. The Canada Revenue Agency interprets “all or substantially all” as usually meaning 90 per cent or more. Although these criteria can be met at the time of the disposition of the shares or debt of the corporation, the corporation can also qualify as an SBC if it meets the criteria at any time in the 12 months preceding the disposition of the shares or debt.
A BIL can also occur when a taxpayer is required to repay a debt of a corporation resulting from a guarantee made by the taxpayer. The loss will qualify as a BIL only where the lender was an arm’s-length party and the corporation was an SBC both at the time the debt was initially incurred and at any time during the 12 months before an amount first becomes payable under the guarantee.
BIL – deemed disposition
In addition, a loss on a “deemed disposition” of the debt or shares, does not require an arm’s length party in order to qualify as a BIL. As long as a taxpayer makes a prescribed election in their tax return, a deemed disposition will occur in respect of:
- a debt owing to the taxpayer at the end of a taxation year that is established to be a “bad debt” (it is wholly uncollectable) in the year; or
- a share in a corporation owned at the end of the year, where:
- the corporation has become bankrupt during the year;
- the corporation is insolvent and a winding-up order has been made in the year; or
- the corporation is insolvent, neither the corporation nor a corporation controlled by it carries on business, the fair market value of the share is nil, and it is reasonable to expect that the corporation will be dissolved or wound up and will not carry on business again.
When a taxpayer makes this election, there will be a deemed disposition of the qualifying property for $nil proceeds, which will result in a capital loss on the share or debt, leading to the BIL.
ABIL – reduced by previous capital gains exemption claimed
The amount of an individual’s ABIL is reduced to the extent that the individual previously claimed the capital gains exemption. That exemption allows an individual to receive tax-free capital gains of up to $883,384 for 2020 ($441,692 for taxable capital gains) during their lifetime from disposition of certain types of property, such as qualified SBC shares.
The reduced BIL remains a capital loss, one-half of which is an allowable capital loss that may be deducted against taxable capital gains.
Procedure for claiming a BIL
BILs must be recorded on a taxpayer’s income tax return for the taxation year in which the business ceased active operations. In addition, for a deemed disposition to occur, the taxpayer must file an election stating that the taxpayer wants the deemed disposition rules to apply. The election should be filed with the income tax return on time to avoid relying on the Minister’s discretion to accept a late-filed election. Be careful not to wait too long when deciding whether to file the election. The election deems the loss to have occurred at the end of the claimant’s taxation year; if the business ceased active operations more than 12 months prior to that deemed date, the BIL will be denied.
The CRA tends to audit BILs regularly. It is thus important to maintain proper supporting documentation. A BIL requires that the loan be made for the purposes of earning income. One way to ensure this requirement has been met is to charge an appropriate rate of interest on the loan. It is prudent to have that stipulation documented in writing in a loan agreement or other contract, along with supporting documentation showing the actual cash advance.