Tax Deductions for Bad Debt Under Section 22
When selling a business, your assets may include accounts receivable that include bad debts, for which there is no expectation for recovery. The CRA is sympathetic to vendors for any loss that occurs due to debts that will never be repaid by providing a remedy through section 22.
When can a S.22 Election Occur?
Section 22 applies, on election by the vendor and a purchaser, when the vendor sells all or substantially all of the assets of a business that it carried on in Canada to a purchaser that proposes to continue the business. The business assets that are sold must include all the accounts receivable of the vendor that are outstanding at the time of the sale.
The requirements for making an election under section 22 include the following:
1. The vendor carried on a business in Canada;
2. All or substantially all of the property that was used in carrying on the business must be sold. Therefore, the section does not apply to a disposal by way of gift;
3. The sold property must include all the outstanding debts that are included in the vendor’s income for the year of sale or previous year;
4. If the business was moneylending, the sold property must include all the outstanding loans;
5. The purchaser must propose to continue the business;
6. The vendor and the purchaser must jointly execute an election in prescribed form. The election must specify the consideration that is paid for the accounts receivable and loans.
It is important to bear in mind that the amount stated in the election to be the consideration for the accounts receivable is final for tax purposes as far as the vendor and the purchaser are concerned, and cannot be altered later. However, the amount is not necessarily binding on the CRA, and may be questioned on assessment if it is considered not to reflect the facts of the sale.
Impact of Section 22 for the Vendor
Section 22 allows the vendor to deduct a portion of the debt that is has not been fully recovered by the consideration received on the sale of his business.
So, how much of a deduction can the vendor hope to claim through section 22? The deduction is the difference between the face value of the debts and the consideration received for them. Through section 22, the vendor thereby obtains relief for the face value of the accounts receivable that has not been realized.
In other words, where the accounts receivable are sold at a discount from the face amount, the Vendor should be entitled to claim a deduction equal to the amount of the discount. The effect of the election is to enable Vendor to deduct an amount that would otherwise have been deductible under paragraphs 20(1)(l) or 20(1)(p) had the accounts receivable not been sold.
Impact of Section 22 on the Purchaser
The amount that the vendor is allowed as a deduction in the year of sale must be included in the purchaser’s income in the year of purchase. In other words, the Purchaser will be required to include an amount in income equal to the difference between the face amount of the accounts receivable and the allocated portion of the purchase price paid to acquire them, since that would be a gain and hence income.
For example Acme Construction purchased the accounts receivable from Green Homes Build for $7000, however its face value was determined to be $10,000. Green Homes Build as the vendor can claim a deduction for $3000 under section 22. When the purchaser is eventually paid the $10,000 through accounts receivable, he must claim the $3000 as income since he has collected more than he paid.
Conversely, if Acme Construction is only able to collect $8000 of the accounts receivable, the purchaser can claim a deduction in the year of acquisition on account of doubtful or bad debts associated with the purchased accounts receivable pursuant to either paragraph 20(1)(l) or paragraph 20(1)(p), other than amounts claimed by Vendor as a bad debt in respect of those accounts receivable.
What happens when you do not use Election S. 22?
Without an election under section 22, when the vendor sells his accounts receivable for less than the face value, the “doubtful debt reserve,” an amount in reserve against a percentage of bad accounts for which a vendor does not expect to be repaid, must be included in the vendor’s income in the year of sale. Furthermore, the discount from the face value is a capital loss in the hands of the vendor, only 50% of which is deductible against capital gains.
For this reason, it is beneficial for the vendor and purchaser to make a joint election under section 22, which will allow the vendor to claim 100% of the difference between the face value of the debt and the consideration received. This deduction also eliminates the inclusion of the doubtful debt reserve in income. The election has the effect of converting a transaction of capital account into one of income account for both parties.
How to file under section 22
When filing under section 22, both vendor and purchaser make a joint election and sign Form T202. Two copies must be completed and sent to the vendor’s and purchaser’s tax centre for the tax year that includes the date of the sale.
Making an election under section 22 of the Income Tax Act is a indispensable tool for both vendors and purchasers in dealing with any loss incurred from bad debt. It is important to know if you qualify and to maximize the benefits that can be gained under section 22. Contact one of our lawyers at Kalfa Law Firm to discuss how you can use section 22 to your advantage.
FAQ’s:
-Shira Kalfa, BA, JD, Partner and Founder
Shira Kalfa is the founding partner of Kalfa Law Firm. Shira’s practice is focused in corporate-commercial and tax law including corporate reorganizations, corporate restructuring, mergers and acquisitions, commercial financing, secured lending and transactional law. Shira graduated from York University achieving the highest academic accolade of Summa Cum Laude in 2012. She graduated from Western Law in 2015, with a specialization in business law. Shira is licensed to practice by the Law Society of Ontario. She is also a member of the Ontario Bar Association, the Canadian Tax Foundation, Women’s Law Association of Ontario, and the Toronto Jewish Law Society.
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