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Canada: No ABIL for loans to Canco

Tuesday, 17 March 2015   (0 Comments)
Posted by: Author: Marlene Cepparo
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Author: Marlene Cepparo (KPMG LLP, Toronto)

In Coveley (2014 FCA 281), the FCA upheld the TCC’s decision (2013 TCC 417) that the taxpayers were not entitled to claim allowable business investment losses (ABILs) of approximately $25 million for loans for unpaid remuneration, cash advances, and corporate expenses.

Mr. and Mrs. C were co-founders and employees of Canco. Mrs. C was also Canco’s sole shareholder. Mr. and Mrs. C made loans to Canco for remuneration, cash advances, and corporate expenses that they paid on behalf of Canco with their personal credit cards. Payments of Mr. and Mrs. C’s salaries constituted the majority of the loans.

During the years under appeal, Canco did not generate significant revenues; its operating funds came from SR & ED credits and from third-party investors. Mr. and Mrs. C believed that Canco would be successful and profitable, and Canco continued to operate after December 31, 2005; on that date, Mr. and Mrs. C determined that the debts owed to them by Canco had gone bad.

Mr. and Mrs. C claimed ABILs on their 2005 tax returns and non-capital loss carryforwards on their 2006 returns arising from the ABILs. The CRA disallowed the ABILs claimed on Mr. and Mrs. C’s 2005 income tax returns (of about $1.7 million and $770,000, respectively) and denied each of them the related non-capital loss carryforward for the 2006 taxation year.

The TCC said that Mr. and Mrs. C were not entitled to the ABIL claims because they could not establish that the debts owing to them had become bad debts in 2005, as required under paragraph 50(1)(a). The TCC also found that Mr. C did not incur the debt for the purpose of gaining or producing income from a business or a property because he was not a shareholder of Canco, and it denied Mr. C’s ABIL claim under subparagraph 40(2)(g)(ii); Mr. C’s earning of income from employment did not fulfill the technical requirements of the provision.

In deciding whether the TCC had made a palpable and overriding error, the FCA opined solely on whether the debts in question had become bad debts in 2005, as required under paragraph 50(1)(a). The FCA agreed with the TCC’s analysis of Rich (2003 FCA 38) and said that the principles outlined in Rich have become the governing authority in assessing the eligibility of a taxpayer’s ABIL claim. In particular, a taxpayer who claims an ABIL must show, among other things, that he or she honestly and reasonably determined that his or her debt became bad during the year in question. The FCA found that the TCC’s decision was supported by evidence at that time. At the end of 2005, business developments were encouraging, and the taxpayers continued to work for Canco and to lend it further funds.

The FCA also confirmed that a taxpayer should not use hindsight to determine whether a debt had become bad. The relevant time for determining whether the debt has become bad is the end of the particular taxation year (December 31, 2005, in this case). Therefore, the FCA concluded that the TCC did not err in its decision.

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