Novation and Its Impact on Debt Forgiveness

What is Novation?


Novation is a concept that can be important in the context of shareholder benefits, debt forgiveness, deemed income on loans to non-residents, and exemptions from withholding tax. According to the Oxford Dictionary, novation is defined as the substitution of a new contract in place of an old one. A novation ordinarily arises when a new individual assumes an obligation to pay which was incurred by the original party to the contract. It can be distinguished from the situation that occurs when another individual makes a guarantee that a debtor will pay what they owe to a creditor; in the case of a novation, the original debtor is totally released from the obligation, which is transferred to someone else.


In National Trust Co v Mead, the Supreme Court of Canada set out the following test for determining what constitutes a valid novation:

    1. The new debtor must assume the complete liability;
    2. The creditor must accept the new debtor as principal debtor and not merely as an agent or guarantor; and
    3. The creditor must accept the new contract in full satisfaction and substitution for the old contract.


General Rule

The Canada Revenue Agency’s (CRA) view is that novation occurs when the debtor is legally changed in respect of a debt obligation. The reason is that the debtor is considered to be so fundamental to the holder’s economic interest in the property that it will create a disposition resulting in novation. However, it should be noted that the courts consider the establishment of novation to be a question of fact. Thus, there is a distinction between cases where it is a question of fact whether acceptance of a new party to a contract has created a novation situation and cases involving the interpretation of a contract itself to determine whether its terms allow for substitution of a contracting party.


The Exception

The CRA recognizes that there is an exception to the general rule that a change to the debtor in a debt obligation contract results in novation, in cases where the degree of change is minimal and of little importance. An example of this would be in the case of an amalgamation, where the debtor is entitled to the rollover provisions of sections 87 and 88 of the Income Tax Act (the “Act”). Here, the debtor would be eligible to a rollover at an amount equal to the adjusted cost base when the obligation of an amalgamating corporation becomes the obligation of the amalgamated entity on identical terms, and will not apply when a third party undertakes with a debtor to change the debtor’s responsibilities under an obligation, while the debtor’s liability to the holders is unaffected. However, take note that the rollover provisions referred to above are only available to qualified amalgamations under the Act and would not apply to amalgamations taking place merely under corporate law principles.


Consequences of Novation

The CRA states that when a taxpayer receives an amount to accept the substitution of a new contract for an existing one between the same or different parties (novation), there is a disposition of the rights under the former contract. In such cases, the taxpayer may either realize a capital gain or be in receipt of ordinary income. Whether it is a capital or income receipt will depend on the nature of the rights disposed of as a result of the novation of the contract.

Note that with respect to the novation of a debt obligation contract, there will be a deemed disposition triggering the debt forgiveness rules in section 80 of the Act. Pursuant to section 80, debt forgiveness applies when a commercial obligation is settled for an amount less than the principal amount of the obligation. As a result, the forgiven amount is applied to reduce the debtor’s tax balances or included in the debtor’s income.

If you would like more information around the concept and consequences of novation, please contact one of our tax lawyers for a consultation.