Taxation of Shareholder Loans – Canadian Tax Lawyer Analysis

Introduction–Shareholder Loans

Shareholders of a corporation can legitimately extract funds from their corporation in a variety of ways, including via salary, dividends, management fees, returns of capital and, if they qualify as an independent contractor, business income. Shareholders can also draw funds out of their corporation via shareholder loans. The Canadian Income Tax Act contains numerous provisions relating to the tax treatment of shareholder loans, many of which are designed to prevent their abuse by shareholders. Our team of top Canadian tax lawyers can advise you on the tax implications of each type of distribution to shareholders and what makes the most sense for your business.

As an owner-manager of a corporation you can compensate yourself by way of salary, dividends, management fees or by a shareholder loan. Though, generally, any distribution from your company is subject to taxation, each type of distribution has different tax implications and needs to be properly documented.

However, the use of shareholder loans has important tax saving implications in certain circumstances. The general rule is that if a withdrawal from a corporation, designated as a shareholder loan, is repaid within one year from the end of the taxation year of the corporation, that is the taxation year in which the loan was made, it will not be included in the income of the borrower. So, for example, if the year-end for the corporation is December 31, 2011 and you borrowed from the corporation in June of 2011 you have until December 31, 2012 to repay the loan.

If the loan recipient fails to repay the loan within the one year after the year-end, the full value of the loan is included in the income of the recipient back to the date of advance under subsection 15(2) of the Income Tax Act. This is to prevent the abuse of shareholders loans; without this rule a taxpayer could repeatedly withdraw amounts as loans from his or her corporation without paying any tax on the transactions.

If you run afoul of the one-year after the year-end rule and as a result the loan amount is included in income you can repay the loan at a later date and then deduct the amount of the repayment from your income in the year it is made under paragraph 20(1)(j) of the Income Tax Act. This presents certain tax deferral and income-splitting opportunities.

Income Inclusion and Exceptions

Under subsection 15(2) of the Income Tax Act, withdrawals from corporations by non-corporate shareholders and taxpayers connected with such shareholders are fully included in the recipient’s income if the withdrawal is characterized as a shareholder loan. The reason for this is that if the amount was not included in income shareholders would take non taxable loans out of a corporation rather than taxable income and would never have to pay tax on withdrawals from their corporation.

Subsection 15(2.6) of the Tax Act contains the most widely-used exception to this general rule, which is that if the loan is repaid within one year from the end of the taxation year of the corporation in which the loan was made, it will not be included in the income of the borrower. For example, if a corporation has a July 31 tax year-end and a shareholder borrows from that corporation on August 1, 2017, the shareholder has until July 31, 2019 to repay the loan. If the recipient of the loan fails to repay the loan by that date, the full amount of the loan plus interest will be included in the individual’s income for the 2017 taxation year. If a shareholder fails to abide by the “repayment within one year of corporate year end” rule and the income is included in their income via 15(2), a deduction is available under paragraph 20(1)(j) for the year in which repayment is eventually made. Even if repayment is made with one year of the corporation’s year end, there may still be a deemed interest inclusion at the prescribed rate (currently 1%) in the shareholder’s income if a market rate of interest is not charged by the corporation on the loan.

Subsection 15(2.4) contains several exemptions from the income inclusion in subsection 15(2) of the Tax Act that relate to loans made to shareholder employees of a corporation when certain conditions are met. Paragraph 15(2.4)(a) authorizes corporations to loan funds to employee shareholders, for any purpose, so long as the employee is not a “specified employee”. A specified employee is defined in the Income Tax Act as a non arm’s length specified shareholder which, in turn, is a shareholder who owns, directly or indirectly, 10% or more of the issued shares of any class in the capital stock of a corporation.

Paragraph 15(2.4)(b) of the Tax Act allows for a corporation to loan funds to a shareholder employee or his or her spouse for the purpose of enabling or assisting the employee in the purchase of a dwelling.

Paragraph 15(2.4)(c) of the Income Tax Act gives corporations the ability to issue employee shareholders, or shareholder employees of corporations to which the corporation is related, loans for the purpose of enabling or assisting the employee shareholder in the purchase of previously unissued, fully-paid shares in the capital stock of the corporation or a corporation related to the corporation, as long as the shares are to be held by the specific employee shareholder for his or her benefit.

In addition, paragraph 15(2.4)(d) allows shareholder employees to receive loans from the corporation for the purpose of acquiring a motor vehicle for use in the performance of the employee’s office or employment.

Conditions of the Exemptions

All of the exemptions contained in subsection 15(2.4) of the Tax Act are subject to two conditions. First, under paragraph 15(2.4)(e) any loan to an employee shareholder must be made as a result of the recipient’s employment, or “qua employee”, and not as a result of any person’s shareholdings, including the employee’s, in order to qualify for the exemptions set out in subsection 15(2.4). In CRA’s view, a loan will be considered to be made qua employee if the loan “can be considered part of a reasonable employee remuneration package”. In Mast v. The Queen, 2013 TCC 309, the Tax Court of Canada found that a $1 million dollar interest-free loan to the sole shareholder was on account of the recipient’s shareholdings and not made on account of his employment of the corporation. In Mast, the large quantum of the loan, the fact that the loan represented a substantial portion of the corporation’s retained earnings, the flexible and favourable terms of the loan and the corporation’s own characterization of the loan as a shareholder loan all influenced the decision of the Tax Court.

The other condition that must be met by a loan for any of the exemptions in 15(2.4) to apply is found in paragraph 15(2.4)(f) of the Tax Act, which states that at the time the loan was made, bona fide arrangements have to have existed to allow for repayment of the loan within a reasonable time.

In Barbeau v The Queen,2006 TCC 126, The Tax Court of Canada interpreted 15(2.4)(f) to mean that at the time the loan was made to the recipient employee shareholder, there must have existed evidence that would allow one to have ascertained when the loan was going to be repaid, including the existence of specific terms and conditions of repayment. Loans to employee shareholders always attract close scrutiny during a CRA tax audit and our experienced Canadian tax law firm can maximize your chances of successfully withstanding such an audit with proper planning and documentation and in particular a loan agreement.

Tax Tips

1) Repay Shareholder Loans Within Two Corporate Year-ends

As discussed above, the consequences of running afoul of the shareholder loan provisions in the Income Tax Act, chief of which is having the full amount with interest retroactively added to the shareholders income for the year of advance, can be devastating. However, arranging for repayment of shareholder loans within two corporate year ends is a foolproof way of avoiding the application of subsection 15(2) of the Tax Act. These repayments can be by way of salary or dividends. Quite simply, if you are withdrawing significant amounts of funds from your corporation, you cannot afford to not have proper accounting methods in place to keep track of draws from, and deposits into, your corporation.

2) Reward Employees with Automobile and Housing Loans

The Income Tax Act specifically allows corporations to enter into bona fide loans with employees for the purpose of purchasing of a home or vehicle. As long as such arrangements are properly documented, they can be an excellent way to incentivize key employees of the business because loans from the corporation can be obtained on much favourable terms than from a typical lending institution. Speak with one of our leading Toronto tax lawyers to discuss flexible mechanisms to reward key employees of your corporation.

Income Splitting Strategies Jeopardized by Proposed Changes

The exception in subsection 15(2.6) of the Income Tax Act has traditionally presented opportunities for tax deferrals and income splitting to small corporations. For example, a family-owned corporation could make loans to adult children in university, when such children are presumably subject to little or no tax. The adult child would not repay the loan within one corporate year end and thus have the full amount of the loan included in his or her income for the year in which the loan was made. The adult child could eventually choose to repay the loan during a year in which they earned a higher income and thereby obtain a deduction under subsection 20(1)(j) of the Tax Act, sheltering income that would otherwise be subject to higher marginal rates.

The Department of Finance’s proposed changes to section 120.4 of the Income Tax Act would serve to eliminate the benefits of this widely-employed strategy. Amounts included in the income a “specified individual”, which would include the a child of the owner manager of a corporation regardless of age, as a result of section 15 of the Tax Act will be taxed at the highest marginal federal tax rate, completely eliminating any tax advantage to such a strategy. If your corporation has traditionally taken advantage of income splitting strategies, our experienced tax lawyers can determine whether such strategies would run afoul of the coming changes to the Canadian Tax Act.

Conclusion

Although there are myriad ways for shareholders, particularly owner-managers, to withdraw compensation from a corporation, in certain circumstances it may be beneficial to characterize shareholder draws from a corporation as shareholder loans. The rules in the Income Tax Act relating to shareholder loans can be very complex and if shareholders are not careful, they can be subject to an income inclusion for the full amount of the loan plus interest under subsection 15(2) of the Tax Act. In order to successfully navigate subsection 15(2) of the Income Tax and its many exceptions, proper planning is essential. Our expert Toronto tax lawyers can properly document shareholder loans so your corporation is prepared for a CRA tax audit.