Using Losses in a Group of Companies: Loss Consolidation Overview – Tax
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Corporate taxation in Canada is not consolidated at group level. This means that planning is necessary to deal with situations where one company in one group has losses and another has profits, since the losses will not automatically offset the profits of the other company in the group for tax purposes. .
There are a number of planning techniques that can be used for this purpose. A basic structure consists of an interest-bearing loan from the loss-making company (“LossCo“) to the profitable company (“ProfitCo“). ProfitCo then uses the loaned funds to purchase LossCo preferred stock. The interest income that ProfitCo pays to LossCo may be offset against the losses of LossCo. From Profitco’s perspective, interest paid on the loan and intercompany dividends on preferred shares may generate deductions.
As shown in a recent decision discussed in more detail below, loss consolidations can vary in their structure and complexity. Depending on the structure, the relevant considerations may vary somewhat. However, there are certain factors that are relevant in most loss consolidation scenarios. Key examples, although not exhaustive, of these considerations include ensuring that
- interest on the loan will be deductible under paragraph 20 (1) (c) of the Income Tax Act(“ITA“);
- dividends will be deductible under subsection 112 (1) of the ITA and this Part IV tax will not apply;
- and the general anti-avoidance rule will not apply.
Like other transactions that are believed to have specific tax implications, loss consolidation transactions must represent real and legally effective transactions.
There are also specific considerations regarding the relationships between companies that may undertake loss consolidations. Remember that the purpose of loss consolidation transactions is to prevent one member of a corporate group from paying tax while another member of the corporate group has a loss. As such, companies must be part of the same group of companies. In particular, the companies concerned should generally be related, affiliated or both (see paragraph 1.71 of the Income Tax folio, S3-F6-C1 – Interest deductibility).
Once it is clear that the companies in question are part of a group of companies, the transaction should be structured to meet the requirements of the arrangements necessary to achieve the intended results. As noted, interest deductibility is generally an important part of loss consolidation agreements. It is therefore important that the requirements of paragraph 20 (1) (c) for the deduction of interest be met. One of these requirements is that the borrowed money be “used for the purpose of earning income from a business or property”. In order to meet this requirement, preferred stocks which are generally part of loss pools would have a right to a dividend which serves as a source of income. However, this is not the only consideration to keep in mind when consolidating losses. The CRA is of the opinion that the dividend yield should be greater than the interest owed on the loan (paragraph 1.73 of the Income Tax Folio, S3-F6-C1 – Interest Deductibility). In this case, the income is more than the amount spent to generate it, which is consistent with an income generating goal. The other requirement, whether the amount is paid or payable within the year under a legal obligation to pay interest, must also be met.
The requirements of the relevant dividend provisions must also be fulfilled. For example, for dividends to be deductible, the requirements of subsection 112 (1) must be met. Most often, this means ensuring that the company paying the dividend (usually LossCo) is a taxable Canadian company. Corporate groups considering loss consolidation will often want to take steps to prevent the application of Part IV tax on dividends as well. This will eliminate the need to monitor and ensure that the refundable tax is actually refunded. Preventing the application of Part IV generally means ensuring that the company that pays and the company that receives the dividend are linked by reason of controlling or meeting the 10% vote and value test.
The considerations mentioned above are common factors that will be relevant in most loss consolidations. Subsection 55 (2) and section 69 are other examples of provisions that may need to be considered. Depending on the particular transaction undertaken, other provisions of the ITA may also be relevant and this list is not exhaustive.
A recently released CRA ruling, 2020-0847681R3, provides an example of a more complex loss consolidation arrangement where other provisions of the ITA were also relevant. At a high level, the proposed transactions addressed in the decision involved multiple profit-and-loss companies as well as a limited partnership with the profit-generating companies as limited partners. Loans from loss-making companies were then made to the limited partnership rather than directly profitable companies. The limited partnership then subscribed for preferred shares of new companies formed for this purpose. The new companies then used the subscription funds to lend money to the original loss making companies. This allowed loss-making companies to use the new loans to repay the initial third-party funding that they had used to make the loans to the limited partnership. Loss-making companies have also pledged to fund new companies so that they can meet their dividend obligations. The limited partnership could then use the dividends to pay interest to loss-making companies. Other provisions that became relevant in this scenario included subsections 103 (1) and (1.1) which deal with income distribution agreements between partners.
As the example of the decision shows, loss consolidation agreements can be useful when one or more companies in a group of companies suffer a loss and another makes a profit. There are different structures ranging from simple to relatively complex and the optimal structure will depend on the specific circumstances. The deductibility of interest and dividends will generally be factors. However, this article is a high level overview of loss consolidation. This is not an exhaustive list of issues that should be considered.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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