Taxation of shareholder loans – Analysis by a Canadian tax lawyer – Taxation
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The shareholders of a company can legitimately extract funds from their company in a number of ways, including through a salary, dividends, management fees, return of capital and, if they qualify as an independent entrepreneur, a business income. Shareholders can also withdraw funds from their company through shareholder loans. Canada’s 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 shareholder distribution and what makes the most sense for your business.
Income inclusion and exceptions
Under subsection 15 (2) of the Income Tax Act, withdrawals from corporations by unincorporated shareholders and taxpayers related to such shareholders are fully included in the income of the beneficiary if the withdrawal qualifies shareholder loan. The reason is that if the amount was not included in income, shareholders would take out tax-free loans from 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 common exception to this general rule, namely that if the loan is repaid within one year after the end of the corporation’s taxation year in which the loan was made, it will not be included in the borrower’s income. For example, if a corporation has a tax year end on July 31 and a shareholder borrows from that corporation on August 1, 2017, the shareholder has until July 31, 2019 to repay the loan. If the loan recipient does not repay the loan by that date, the total loan amount plus interest will be included in the individual’s income for the 2017 tax year. the year following the end of the corporation’s fiscal period ”and the income is included in its income through 15 (2), a deduction is available under paragraph 20 (1) (j) for the year in whose reimbursement is finally made. Even if the repayment is made one year after the end of the corporation’s year, there may still be a deemed inclusion of interest at the prescribed rate (currently 1%) in the shareholder’s income if a rate of market interest is not charged by the company on the loan.
Subsection 15 (2.4) contains several exemptions from the inclusion of income in subsection 15 (2) of the Tax Act that relate to loans made to employee shareholders of a corporation when certain conditions are met. Section 15 (2.4) (a) allows corporations to lend funds to employee shareholders for any purpose as long as the employee is not a “specified employee”. A specified employee is defined in the Income Tax Act as a specified non-arm’s length shareholder who, in turn, is a shareholder who owns, directly or indirectly, 10% or more of the issued shares of any class of the share capital of a corporation.
Section 15 (2.4) (b) of the Tax Act allows a corporation to loan funds to an employee shareholder or his or her spouse for the purpose of enabling or assisting the employee in the purchase of housing.
Section 15 (2.4) (c) of the Income Tax Act empowers corporations to make loans to employee shareholders or employee shareholders of corporations to which the corporation is related for the purpose of enabling or ” help employee shareholders to buy unissued and fully paid-up shares of the share capital of the company or of a company related to the company, provided that the shares are held by the specific shareholder for his benefit.
In addition, paragraph 15 (2.4) (d) allows employee shareholders to receive loans from the corporation for the purpose of acquiring a motor vehicle for the performance of their office or employment.
All of the exemptions 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 by reason of the beneficiary’s employment, or “as an employee”, and not by virtue of the participation of the beneficiary. ” a person, including that of the employee, in order to be eligible for the exemptions provided for in subsection 15 (2.4). In the opinion of the CRA, a loan will be considered to be made as an employee if the loan “can be considered as part of the employee’s reasonable remuneration”. In Mast v. The Queen, 2013 TCC 309, the Tax Court of Canada concluded that an interest-free loan of $ 1 million to the sole shareholder was attributable to the beneficiary’s shares and not to his employment in the company. In Mast, the large amount of the loan, the fact that the loan represented a significant portion of the company’s retained earnings, the flexible and favorable terms of the loan, and the company’s qualification 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 subsection 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, the proper fide arrangements must have existed to allow repayment of the loan within a reasonable time.
In Barbeau v. The Queen, 2006 TCC 126, the Tax Court of Canada interpreted paragraph 15 (2.4) (f) to mean that at the time the loan was made to the beneficiary employee shareholder, there must be evidence that would make it possible to determine when the loan was to be repaid, including the existence of special repayment conditions. Loans to employee shareholders are always subject to careful examination during a CRA tax audit and our experience Canadian tax firm can maximize your chances of passing such an audit with proper planning and documentation and in particular a loan agreement.
1) Repay shareholder loans within the two year-ends of the business
As noted above, the consequences of violating the shareholder lending provisions of the Income Tax Act, the main one of which is retroactively adding the total amount with interest to shareholders’ income for the year ahead, can be devastating. However, making arrangements for the repayment of shareholder loans within both business year-ends is a surefire way to avoid the application of subsection 15 (2) of the Tax Act. These repayments can be made in the form of salary or dividends. Quite simply, if you are withdrawing large amounts from your company, you cannot afford not to have proper accounting policies in place to track withdrawals and deposits in your company.
2) Reward employees with car and home loans
The Income Tax Act specifically allows corporations to take out bona fide loans with employees for the purpose of purchasing a home or vehicle. As long as such agreements are properly documented, they can be a great incentive for key company employees, as company loans can be obtained on much more favorable terms than a typical lending institution. . Speak with one of our leading Toronto tax lawyers to discuss flexible mechanisms to reward key employees in your business.
Income splitting strategies compromised by proposed changes
The exception in subsection 15 (2.6) of the Income Tax Act has traditionally provided opportunities for tax deferral and income splitting for small corporations. For example, a family company could make loans to adult children at university, when these children are likely to be subject to little or no tax. The adult child would not repay the loan until the end of the business year and the total loan amount would therefore be included in their income for the year in which the loan was made. The adult child could possibly choose to repay the loan in a year in which he or she earned a higher income and thus obtain a deduction under paragraph 20 (1) (j) of the Act of tax, shielding income that would otherwise be subject to higher marginal rates. .
The changes proposed by the Department of Finance to section 120.4 of the Income Tax Act would serve to eliminate the benefits of this widespread strategy. The amounts included in the income of a “specified individual”, which would include the child of the owner-manager of a company, regardless of his age, by reason of section 15 of the Tax Act, will be taxed at the highest federal marginal tax rate, entirely eliminating any tax advantage of such a strategy. If your company has traditionally benefited from income splitting strategies, our experienced tax lawyers can determine if such strategies run counter to upcoming changes to the Canadian Tax Act.
While there are a myriad of ways for shareholders, particularly owner-managers, to withdraw compensation from a corporation, in certain circumstances it may be beneficial to qualify withdrawals of shareholders from a company as loans. to shareholders. The rules in the Income Tax Act relating to shareholder loans can be very complex and if shareholders are not careful they may be subject to income inclusion for the full amount of the loan plus interest on the loan. under subsection 15 (2) of the Tax Act. In order to successfully navigate income tax subsection 15 (2) and its many exceptions, good planning is essential. Our expert Toronto tax lawyers can properly document shareholder loans so that your corporation is ready for a CRA tax audit.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.