Loan money for a business? Do it right to save tax

It was Shakespeare who wrote, in Hamlet, “Neither a borrower nor a lender is; For lending often loses both himself and a friend, and borrowing dulls the edge of agriculture.” Every time the words “boring” and “husband” are used in the same sentence, my wife, Carolyn, sits up and takes notice – as if there is a cure for such a problem. Shakespeare, however, wrote about the folly of lending money to friends.

Let’s face it: Loans like this happen all the time. How many friends have helped other people who had good business ideas, only to see those ideas fail? I’m not going to suggest that you avoid making these types of investments, but make sure you structure them properly so that you at least get some tax relief if things go wrong. An April 21 Tax Court of Canada decision tells the story of an individual who could have done things differently and saved thousands in taxes had he done so.

The case

Osborne Barnwell and Nicholas Austin had met in the early 1980s, were both from the island of St. Vincent and lived in Canada when they met. They have developed a relationship over the years. When they first met, Mr Austin ran a business called Carib-Can, which published children’s books.

Mr. Austin was well known in the local Caribbean community, successful and passionate about his work. Any well-meaning and reasonable businessman and friend might see fit to lend Mr. Austin money to start what seemed like a good idea: a magazine targeting commercial airline passengers.

Between 2007 and 2009, Mr. Barnwell loaned Mr. Austin approximately $73,000 for the new venture. The I’s were dotted and the T’s were crossed out in the sense that the advances were evidenced by promissory notes. Although Mr. Austin had established a corporation to operate the business, Mr. Barnwell’s loans were made directly to Mr. Austin.

In 2009, things were not going well for the new company. It became clear that Mr Barnwell was unlikely to receive repayment of the loans he made. In 2011, Mr Barnwell claimed an “allowable business investment loss” on his tax return for the debt gone bad.

The Tax Court of Canada (Osborne G. Barnwell v. The Queen, 2015 TCC 98) dismissed his ABIL claim, costing him approximately $17,000 in lost tax dollars. A simple loan modification could have put those dollars back in his pocket.

CAPAC

So here’s the deal: our tax law will allow an investor in many cases to claim an ABIL if they have suffered a loss by lending money or investing in the shares of a small business. An ABIL is different from your usual capital loss. A capital loss can generally only be set off against capital gains. An ABIL, on the other hand, receives more favorable treatment and can be applied to any source of income.

What exactly is an ABIL? Simply put, an ABIL is half the money you could have lost by lending money or investing in the shares of a small business that went bankrupt or became insolvent.

It is important that, if you make a loan or invest in shares, the loan or shares are those of a “small business” under our tax laws (this includes most small companies which are private corporations under Canadian control where all of the company’s assets are used in a business carried on primarily in Canada), rather than lending money to an individual. That was Mr. Barnwell’s problem. He loaned the funds directly to Mr. Austin rather than to the company operating the business.

Similarly, Mr Barnwell could have invested in shares of Mr Austin’s company, rather than making a loan, and if it was a small business, there could have been tax relief under the form of a PDTPE.

There are a few other points to note here: First, virtually all ABIL applications are reviewed by the tax authorities. So expect to receive a letter from the Canada Revenue Agency if you make a claim. It’s okay as long as you’ve dotted the I’s and crossed out the T’s, so make sure you get tax advice before making a claim. Finally, if you used part of your Lifetime Capital Gains Exemption in the past, all or part of your ABIL may be denied and converted to a capital loss instead.

Tim Cestnick is managing director of Advanced Wealth Planning, Scotiabank Global Wealth Management and founder of WaterStreet Family Offices.

Troy M. Hoffman