Turning Losses Into Gains: Private Equity Tax Strategies With Distressed Businesses

Written By Philip Ward, Andrew Young, Matthew Hunt and Doug Scully

Private equity (PE) firms play a critical role in revitalizing struggling businesses by providing, among other things, financial support and operational expertise. PE transactions are often driven by a combination of strategic growth objectives and tax planning opportunities.

In Canada, acquiring distressed companies can unlock valuable tax benefits, such as the potential to utilize non-capital loss carryforwards to offset future business income. These acquisitions are governed by strict regulatory frameworks designed to prevent abuse and ensure compliance with the Income Tax Act (Canada) (ITA). While it is possible for PE firms to utilize struggling businesses' valuable tax attributes, careful planning and a fundamental understanding of relevant tax laws is required.

Canada’s federal income tax regime, unlike many other countries, does not allow for a group of related companies to file their tax returns on a consolidated basis, meaning that losses cannot simply be shared within a corporate group by right. Each corporate entity is taxed separately and cannot, by default, utilize the losses of another entity, whether the entities are affiliated or not. However, certain strategies are available and have been accepted by the Canadian tax authorities to permit the utilization of losses within an affiliated group. In addition, Canada's tax rules permit a purchaser to utilize the tax losses of a target in certain limited circumstances intended to facilitate the turnaround of struggling businesses.

Acquisition of Control and Its Implications

There are "loss restriction" rules that seek to prevent arm's length "loss trading" in Canada. These rules are triggered on a "loss restriction event" which occurs when a purchaser acquires control of an unrelated target. Generally speaking, an acquisition of control occurs where de jure control of a corporation is acquired—meaning that ownership of sufficient shares has been acquired to grant the acquiror, or a group of persons of which the acquiror is part, the ability to elect the majority of the board of directors. The occurrence of a loss restriction event results in:

• a deemed taxation year end to the target;
• a crystallization of the target's accrued but unrealized capital losses immediately before the acquisition of control (through a mandatory write-down to fair market value of the target's tax basis in capital property);
• the ability to elect to trigger accrued gains on capital property, which can be sheltered by losses that would otherwise expire, and thereby step-up the target's tax basis in the property; and
• certain restrictions and prohibitions on the use of pre-acquisition of control losses after the acquisition of control, including the expiry of pre-acquisition net capital losses and losses from property that have not otherwise been utilized. Pre-acquisition business losses can generally be carried forward, provided that the target carries on the same business that gave rise to the losses for profit or with a reasonable expectation of profit throughout the tax year during which the losses are utilized, and provided further that the losses may only be used to shelter income from the same or a similar business.

These rules aim to strike a balance between preventing loss trading in Canada while also not discouraging the acquisition and turnaround of struggling businesses. 

Strategies for Allocating and Preserving Losses

Attempts to circumvent the loss restriction rules in the ITA are strictly monitored by the Canada Revenue Agency (CRA) and Canadian courts. In particular, a number of recent court decisions, including the Supreme Court decision in the case of Deans Knight, have closed the door on certain strategies designed to avoid the loss restriction rules. The CRA has, however, accepted certain loss utilization strategies, which can be implemented successfully by adhering to the guidelines set out in CRA policies and Canadian case law. 

On an acquisition of a distressed business, insight into which losses and other tax attributes will survive the acquisition of control, versus which will expire, may have a significant impact on financial models. If the distressed acquisition includes the restructuring or compromise of debt, the impact of Canada's debt forgiveness rules on tax losses and other attributes should be considered and managed to the extent possible. In the event there are losses that would otherwise expire, consideration can be given to the possibility of electing to trigger any accrued gains on the target's assets and thereby increase the tax basis of those assets. 

Following an acquisition of control, the purchaser and target will usually be part of an affiliated corporate group. While losses cannot be transferred within an affiliated corporate group by right, the Canadian tax regime allows corporations in an affiliated corporate group to offset certain gains in one corporation with certain losses from another corporation, provided that they operate within the boundaries prescribed by law and the CRA.

The merger or winding-up of a company with tax losses (Lossco) into an affiliated profitable company (Profitco) on a tax-deferred basis allows for the retention of non-capital losses (subject to the continuation-of-business requirements described above in the case of pre-acquisition losses). Asset transfers from Profitco into an affiliated Lossco can, subject to certain limitations, be made on a tax-deferred basis, allowing Lossco's accumulated losses to shelter income or gains on the transferred assets.

PE firms can maximize the value of expiring losses through asset sales or deferred deductions to ensure tax benefits are not wasted.

To take advantage of an affiliated Lossco's available non-capital losses, Profitco can enter into a "debt loop" transaction with the Lossco in which:

• Profitco borrows money from an arm's length lender (e.g., a bank) to subscribe for shares of Lossco;
• Lossco uses the share subscription proceeds to loan money to Profitco with interest; and
• Profitco uses the money borrowed from Lossco to repay the money borrowed from the bank.

This strategy results in (1) the creation of taxable interest income in Lossco, which is sheltered by Lossco's losses, and (2) the creation of a corresponding interest deduction in Profitco which is used to offset Profitco's income.

While the CRA has approved this strategy, care should be taken to ensure that the transaction falls within the parameters specifically approved by the CRA. For example, Profitco must be able to legitimately claim to have borrowed money for an income-earning purpose.

By implementing these and other strategies, PE firms can optimize tax efficiency while adhering to Canadian tax requirements. However, proper planning is essential to navigate the complex system of tax rules and preserve valuable tax attributes.

Limitations and Risks

In practice, compliance with the loss restriction rules on an acquisition requires that PE firms retain and continue to carry on the core business activities of the acquired company with a reasonable expectation of profit. Losses can only offset income derived from the acquired business and operations similar to those conducted before the acquisition. If a significant operational shift occurs, such as the discontinuation of key business lines, the CRA may disallow the use of carried-forward losses, regardless of profitability. Thus, business continuity and intent to retain the target's core business are necessary.

Following the Supreme Court of Canada’s decision in Deans Knight, PE firms should be cautious of strategies intended to circumvent the acquisition of control rules. Attempts to circumvent these rules, or transactions where the acquisition of tax benefits appear to the be sole or primary driver, will warrant CRA scrutiny. With that said, the acquisition of control rules, together with Canadian case law and CRA commentary, provide important goalposts for PE firms to operate within.

PE firms implementing loss utilization strategies must also be aware of the general anti-avoidance rule (GAAR) in the ITA, the scope of which was expanded in 2023 and which now includes a significant potential penalty. The CRA may deny tax benefits if a transaction is structured primarily to access tax losses without legitimate business intent. While the GAAR does not prohibit tax-efficient acquisitions and planning, it does require that transactions demonstrate clear economic substance beyond immediate tax advantages. 

In addition, PE firms should be aware that the presence in a transaction of certain hallmarks, namely contingency fees, confidential protection and contractual protection (including certain indemnities), may give rise to reporting under the Reportable Transaction rules that were introduced in 2023.

PE firms have a unique opportunity to capitalize on tax benefits through strategic acquisitions, but these gains require careful navigation of applicable tax rules. Proper planning, compliance and a focus on genuine business intent will enable firms to realize these benefits responsibly and minimize CRA scrutiny of transactions. 

Bennett Jones Private Equity and Tax Groups

The Bennett Jones Private Equity and Investment Funds group is a leader in Canada. Our clients include sophisticated financial sponsors who are looking to balance risk with expected return and who require tailored advice from the initiation of the investment phase through to exit. Bennett Jones' corporate Tax practice provides sophisticated tax planning advice and creative, incisive approaches to stewarding tax-efficient transactions and solving tax controversies.

To discuss how Bennett Jones can assist in PE tax strategies with distressed businesses, please contact one of the authors.

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