ABILs

Given the economic climate, it’s not surprising that we are receiving a lot questions about allowable business investment losses (ABILs). Nor is it surprising that many taxpayers find it difficult to claim ABILs, given the many pitfalls.

For example, to claim an ABIL on a loan, a taxpayer must sustain a capital loss for tax purposes. A taxpayer sustains such a loss, however, only if he or she advances funds for the purposes of gaining or producing income (see subparagraph 40(2)(g)(ii) of the Income Tax Act). Unfortunately, small business owners and their relatives often fail to charge interest on the advances they make to the corporations that own their businesses. The result is that their ability to claim even a capital loss—never mind an ABIL—is put at risk.

All is not lost if the lender is also a shareholder of the borrower: see Byram v. The Queen, [1999] D.T.C. 5117, [1999] 2 C.T.C. 149, 1999 CanLII 7428 (FCA). In that case, the Court held that, in some cases, the prospect of dividends is enough to create a “nexus” between the advance of funds (at no interest) and an income-earning purpose.

But what if wife loans money to a corporation of which her husband is the sole shareholder? The Tax Court has held in a number of cases that the wife is out of luck: see for exampleService v. The Queen, 2004 TCC 592, and Elliott v.The Queen, 2005 TCC 35. Justice Rip (as he then was), in Elliott, wrote the following:

[21] Ms. Elliott’s problem is not unusual, unfortunately. There are many people who lend money and guarantee loans to small businesses to corporations in which their spouses own shares but they do not. Many of these people are not sophisticated in tax matters. They do what they feel is important for the economic well‑being of the family. They do not do consult lawyers or accountants who may advise how to structure the loan or guarantee so, if something goes wrong, then, for tax purposes, they could deduct at least a portion of the money they may lose. Many of these people and their spouses are hard‑working people of modest means. They do what they think is right; they are optimistic. They do not foresee possible failure. When failure does come, they lose everything. On the other hand, a more sophisticated person may impose a rate of interest on the loan to the spouse’s corporation or acquire shares in that company and in the case of a loan guarantee, charge the corporation for the guarantee. In the latter cases, if the loan goes bad or the person must honour the guarantee, because income was a consideration for the loan or guarantee, the person would be eligible to deduct a portion of the amount lost as an ABIL. Our senior courts have told us there is no equity in a taxing statute and as the Act is written, there is not much I can do to help Ms. Elliott. Parliament may well wish to consider the unique situation of family controlled small business corporations and the possibility of permitting family members to deduct a portion of the amount of loans and guarantees made by a shareholder’s spouse for the benefit of such a corporation when the loans go bad or guarantees are exercised. As the law now stands, such taxpayers are not even entitled to claim a capital loss on such misadventure.

[22] The loans made by Ms. Elliott to Construction were not made by her for purpose of earning income for herself as a taxpayer. Her counsel’s submission that she was the beneficial owner of her husband’s shares of Construction is not tenable on the evidence.

Ms. Elliott did not go away empty-handed however. She had given a guarantee of a portion of her husband’s corporation’s debts, and she was required to honour the guarantee. Justice Rip allowed an ABIL in an amount equal to what was paid under the guarantee as follows:

[27] In income tax, persons often become liable for tax as a result of a transaction or legal result that they did not intend. For example, what a person intends to be a capital transaction may turn out to be a transaction on income account, or what a person intends to be a tax free event is held to be a taxable event. While Ms. Elliott’s purpose in paying off the bank was not to earn income—she may not have even been aware of her rights to be subrogated in the rights of the bank—the result of paying the bank entitled her to claim interest from the bank’s debtor, Construction. The purpose of the loan she inherited from the bank was for an income earning purpose. When Ms. Elliott took over the bank’s loan to Construction, she was entitled to claim interest; she became a creditor of a potential income‑producing loan. Had Construction paid her interest on the subrogated loan amount, the interest would be included in her income; once the loan became bad in 1998, she incurred a capital loss that is a business investment loss, and she ought to be entitled to claim an ABIL on the amount she paid to the National Bank.