David Rotfleisch on Shareholder Loan Taxation: A Canadian Tax Lawyer's Analysis

Introduction: Loans to Shareholders

In order to legally extract money from their organization, shareholders of a company may do so in a number of ways, including through salaries, dividends, management fees, capital returns, and, if they meet the requirements for independent contractors, business income. Additionally, shareholders may borrow money from their organization through shareholder loans. Many of the restrictions in the Canadian Income Tax Act that deal with the taxation of shareholder loans are aimed at preventing shareholders from abusing them. The tax repercussions of various distributions to shareholders and which option is best for your company can be discussed with our team of highly qualified Canadian tax lawyers.

You can receive money as the owner-manager of a corporation by taking a salary, receiving dividends, collecting management fees, or taking out a shareholder loan. Each sort of distribution has a unique tax impact and needs to be properly documented and accounted for, even though generally speaking, any distribution from your firm is subject to taxation.

Therefore, in some situations, using shareholder loans might result in significant tax savings. The usual rule is that a withdrawal from a corporation that is designated as a shareholder loan that is repaid within one year of the end of the corporation’s taxation year, or the taxation year in which the loan was made, will not be included in the borrower’s income. So, for instance, if the corporation’s fiscal year ends on December 31, 2022, and you borrowed money from the company in June 2022, you have until December 31, 2023 to pay back the loan with no tax implications.

According to subsection 15(2) of the Income Tax Act, the full amount of the loan is included in the recipient’s income back to the advance date if the loan recipient does not repay the loan within a year after the corporation year-end. Without this provision, a taxpayer might regularly take money as loans from his or her company without having to pay taxes on the withdrawals. These rules discourage the misuse of shareholder loans. If you violate the one-year after-the-year-end rule and the loan amount is retroactively added to your income, you may repay the loan at a later date and then deduct the amount of the repayment from your income in the year it is repaid in accordance with paragraph 20(1)(j) of the Income Tax Act. There are tax planning opportunities in certain narrow circumstances using these rules.

Inclusion of Income and Exceptions

In compliance with subsection 15(2) of the Income Tax Act, withdrawals from corporations made by non-corporate shareholders and taxpayers associated with those shareholders are entirely included in the recipient’s income if the withdrawal is accounted for as a shareholder loan. Through these rules, shareholders would withdraw non-taxable loans from corporations rather than taxable income, and they would never be subject to tax on those withdrawals.

The most frequently utilized exemption to this general rule is found in subsection 15(2.6) of the Tax Act, which states that if a loan is repaid within a year after the end of the corporation’s tax year in which it was made, it will not be included in the borrower’s income. If a company, for instance, has a tax year that ends on July 31 and a shareholder borrows money from the company on August 1, 2022, the shareholder has until July 31, 2024, to pay back the loan. If the loan recipient doesn’t pay it back by that date, the total amount of the loan plus imputed interest will be counted as income for the tax year 2022 for that person. A shareholder may be eligible for a deduction under paragraph 20(1)(j) for the year in which repayment is ultimately made if they breach the “repayment within one year of corporate year-end” rule and the income is included in their income under subsection 15(2). If a market rate of interest is not levied by the corporation on the loan, even if repayment is made within one year of the corporation’s year-end, there may still be a presumed interest inclusion at the specified rate in the shareholder’s income.

When specific requirements are met, several exemptions from the income inclusion in subsection 15(2) of the Tax Act related to loans granted to shareholder-employees of a corporation are contained in subsection 15(2.4). As long as the employee is not a “specified employee,” paragraph 15(2.4)(a) permits corporations to lend money to employee shareholders for any reason. The Income Tax Act defines a specified employee as a non-length arm’s specified shareholder, which is defined as a shareholder who directly or indirectly owns 10% or more of the issued shares of any class in the capital stock of a corporation.

In accordance with the Tax Act paragraph 15(2.4)(b), a corporation may lend money to a shareholder-employee or that employee’s spouse in order to enable or assist that employee in purchasing a home.

The Income Tax Act’s paragraph 15(2.4)(c) permits corporations to lend money to employee shareholders, or shareholder-employees of companies to which the corporation is related, in order to enable or aid the employee shareholder in purchasing previously unissued, fully-paid shares of the company’s capital stock, or the capital stock of a company related to the company, as long as the shares are intended to be held by the specific employee shareholder for the company or a company related to the company.

Additionally, according to paragraph 15(2.4)(d), shareholder workers are eligible to acquire loans from the company in order to purchase a car that they may use to carry out the duties of their positions.

Requirements for the Exemptions

There are two conditions that must be met for each exemption listed in the Tax Act subsection 15(2.4). In order for a loan to an employee shareholder to be eligible for the exemptions listed in paragraph 15(2.4)(e), it must be made in connection with the recipient’s employment, or “qua employee,” and not in connection with any other person’s shareholdings, including the employee’s 15(2.4). According to CRA, a loan will be regarded as having been granted to an employee qua employee if it “may be deemed part of a fair employee pay package.” The Tax Court of Canada held in Mast v. The Queen, 2013 TCC 309 that a $1 million interest-free loan to the single shareholder was given due to the recipient’s ownership of the shares and not because he was working for the company. The judgment of the Tax Court in Mast was influenced by the size of the loan, the fact that it constituted a sizeable amount of the company’s retained earnings, the loan’s flexible and advantageous conditions, and the company’s own description of the loan as a shareholder loan.

In order for any of the exemptions in subsection 15(2.4) to be applicable, a loan must also satisfy the requirement set forth in paragraph 15(2.4)(f) of the Tax Act, which states that at the time the loan was made, bona fide arrangements had to have been made to permit repayment of the loan within a reasonable time.

The Tax Court of Canada interpreted paragraph 15(2.4)(f) to mean that at the time the loan was made to the recipient employee shareholder, there had to be evidence that would have allowed one to determine when the loan was going to be repaid, including the existence of specific terms and conditions of repayment. This interpretation was made in Barbeau v. The Queen,2006 TCC 126. Loans made to employee shareholders are usually subject to thorough examination during a CRA tax audit, and our knowledgeable Canadian tax law company can increase your chances of surviving such an audit by using adequate preparation, paperwork, and in particular a loan agreement.

Pro Tax Advice

1) Payback of Shareholder Loans must occur within two Fiscal Year Ends

As was mentioned above, breaking the shareholder loan rules of the Income Tax Act can have adverse tax repercussions, not the least of which is having the whole amount plus interest applied retrospectively to the shareholder’s income for the advance year. However, a surefire method of avoiding the application of subsection 15(2) of the Tax Act is to make arrangements for the repayment of shareholder loans within two corporate year ends. These payments may be made in the form of dividends or wages. Simply put, you cannot afford not to have comprehensive accounting procedures in place to track draws from and deposits into your organization if you are taking large sums of money from it.

2) Offer employees automobile and housing loans as a form of appreciation

According to the Income Tax Act, firms are allowed to make genuine loans to their employees for the purchase of a home or car. Such agreements, as long as they are properly recorded, maybe a great method to reward important personnel of the company as loans from the firm can often be secured on much more advantageous conditions than those offered by a traditional lending institution. To explore adaptable methods of rewarding important staff for your firm, talk to one of our renowned tax lawyers in Toronto.

3) Proposed Income Tax Act Changes Endanger Income-Splitting Techniques

Small companies have historically been able to delay taxes and divide revenue because of the exemption in subsection 15(2.6) of the Income Tax Act. A family-owned business may, for instance, lend money to adult children who are enrolled in college because they are likely to pay little or no taxes on their earnings. The whole amount of the loan would be included in the adult children’s income for the year in which it was made because the adult child would not pay it back within one corporate year-end. The adult children may ultimately decide to return the loan during a year in which they made more money in order to qualify for a deduction under paragraph 20(1)(j) of the Tax Act and shield income that would otherwise be subject to higher marginal rates.

The advantages of this widely-used tactic will be eliminated by the Department of Finance’s proposed amendments to subsection 120.4 of the Income Tax Act. According to section 15 of the Tax Act, amounts that are included in the income of a “specified individual,” which would include a child of the owner-manager of a corporation regardless of age, will be taxed at the highest marginal federal tax rate, completely eliminating any tax benefit from such a strategy. If your business has historically utilized revenue-splitting techniques, our knowledgeable tax lawyers can establish if such techniques might conflict with the upcoming revisions to the Canadian Tax Act.

Conclusion

There are several methods for shareholders, especially owner-managers, to withdraw money from a business, but in some cases, it may be more advantageous to refer to these withdrawals as shareholder loans. If shareholders are not diligent, they might be liable to an income inclusion under subsection 15(2) of the Tax Act for the whole amount of the loan plus interest. The requirements under the Income Tax Act pertaining to shareholder loans can be highly complicated. Adequate preparation is necessary in order to effectively handle subsection 15(2) of the Income Tax and its numerous exclusions. For your firm to be ready for a CRA tax audit, our knowledgeable Toronto tax lawyers can correctly document shareholder loans.

Disclaimer:

“Only general information is provided in this article. Only as of the publishing date is it current. It hasn’t been updated, therefore it could no longer be relevant. It cannot or ought not to be relied upon since it does not offer legal advice. Each tax circumstance is unique to its facts and will be different from the instances described in the articles. You should speak with a lawyer if you have particular legal inquiries.”