Chapter 5 - Limitation of shareholder tax losses

5.1 The limited partnership rules contain loss limitation rules which prevent the flow-through of losses in any income year to limited partners in excess of the actual investment of the limited partner. A limited partner’s tax loss is restricted if the amount of the loss exceeds the carrying tax value of that partner’s investment. Disallowed losses in any year may be carried forward to future years.

5.2 This rule applies only to limited partners because they are not exposed to any risk of loss greater than the amount of their investment in the limited partnership. In contrast, general partners have unlimited liability and therefore exposure to the risk of loss.

5.3 Currently, the flow-through of LAQC losses to shareholders is subject to “at risk” rules in sections GB 45 to GB 48 and section HA 27 of the Income Tax Act. However, these rules do not prevent the flow-through of losses in excess of a shareholder’s equity in the LAQC, which is the treatment under the limited partnership loss limitation rules.

Proposed loss limitation rules

5.4 As no loss limitation rules similar to those for limited partnerships apply in the current LAQC regime, an LAQC shareholder can deduct losses in excess of their equity in the LAQC. The amount of losses may not be commensurate with the level of financial risk that the shareholder faces. Therefore, officials propose implementing loss limitation rules for the new qualifying company regime, similar to the rules applying to limited partnerships. These rules would allow shareholders to offset, for tax purposes, net tax losses only to the extent of the shareholder’s investment in the qualifying company.

5.5 If the allocated losses exceed the value of the shareholder’s investment in the qualifying company for tax purposes, the excess losses may be carried forward by the shareholder until, for example, the shareholder’s investment in the company increases. The basis for measuring a shareholder’s investment in a qualifying company is discussed later in this chapter.

5.6 Tax losses of a qualifying company will be allocated to shareholders and treated as those of the shareholders themselves. Therefore, losses may be offset without any special restrictions against other income, just as if the losses had been the shareholder’s directly.

Policy rationale

5.7 The rationale behind restricting a shareholder’s tax losses in any given year is to ensure that the tax losses claimed reflect the actual level of that shareholder’s economic loss.

5.8 Shareholders have limited liability in relation to their interest in the qualifying company, so do not have exposure to losses greater than the amount of their investment in any year. As shareholders cannot lose more than the amount of their investment, it is not appropriate for shareholders to take a deduction for a greater amount. Therefore, it is the correct policy result to allow shareholders to offset, for tax purposes, only those tax losses they have exposure to.

5.9 In the absence of such rules, qualifying companies would provide opportunities for taxpayers to receive tax deductions in excess of the expenditure they personally have at risk in the qualifying company. The absence of such rules may therefore distort efficient decision-making and efficient resource allocation, by encouraging investors to enter arrangements or schemes whereby small amounts of capital are invested to get access to larger net tax losses. This could result in abuse of the new qualifying company rules and in actions that are contrary to their intent.

5.10 It is international practice to limit the flow-through of losses of a transparent entity to its members where their liability is limited. This occurs, for example, in the United States and Australia (such as for venture capital limited partnerships).

Membership basis

5.11 A shareholder of a qualifying company will only be able to offset allocated losses to the extent of their investment in the company. To measure a shareholder’s level of investment in the company, officials propose to adopt a qualifying company membership basis similar to the “partner’s basis” in section HG 11 which applies for limited partners. This would include the share of any debt guaranteed by the shareholder.

5.12 If a tax loss exceeds a shareholder’s basis because the shareholder has insufficient equity in the qualifying company, the tax loss would not be included in the shareholder’s annual total deduction. In other words, it cannot be offset against the shareholder’s other income. Instead, it can be carried forward by the shareholder to use in a future year if the shareholder has sufficient basis in the qualifying company to offset the loss.

Anti-avoidance

5.13 Section HG 11(9) of the Income Tax Act provides that any investment into a partnership within 60 days of the end of the year which is subsequently reduced within 60 days after the year end will be disregarded for the purposes of calculating a shareholder’s membership basis. This is an anti-avoidance rule that prevents an artificially high basis around the end of the income year, in order to increase the flow-through of losses. Officials propose a similar anti-avoidance rule for the new qualifying company rules.