Business owners may have the ability to self-finance short-term loans or purchases through the wealth accumulated within their companies. This is where short-term shareholder loans can come to your rescue and provide interim relief. In this article, we will discuss how individual shareholders of a Canadian Corporation may arrange corporate loans without having to include them in income.
Section 15(2) of the Income Tax Act discusses how individual shareholders and employees may access cash through loans from a corporation that they own. These loans are generally included in the income of the borrower in the year in which the loan was received, unless certain exceptions are met. If the full amount of the loan is repaid within one year after the end of the corporations tax year, then section 15(2) does not apply.
Corporations maintain records of these loans advanced to their shareholders. If the loan remains outstanding at the end of the tax year following the year the loan was made, the shareholder must claim this amount as income. However, if the shareholder pays back the loan prior to one year after the end of the tax year of the loan, the amount will not be included in his income. Additionally, under section 80.4(2), he may be required to include interest on his income if he had received a lower interest than the prescribed rate by the Canada Revenue Agency (CRA) or an interest-free loan. At the time of writing, the current prescribed interest rate used is 1%.
By keeping a record of payments and an eye on interest, shareholder loans can be an effective tool to compensate shareholders, where the balance of the loan is declared as a dividend during the year.
For example, a corporation ends the fiscal year on December 31. If a shareholder receives a loan for $100,000 on June 1, 2020 from the corporation, then the loan must be repaid by December 31, 2021 otherwise the loan will be included in the shareholder’s income for the 2020 taxation year. If, however, the shareholder repays the loan by December 31, 2021, then the amount of the loan will not be included in the shareholder’s income. If the interest rate charged on the loan is lower than the prescribed rate, then interest will be added to the income of the shareholder.
Series of loans or other transactions and repayments
It is important to note that the repayment of the loan must not be part of a series of loans or other transactions and repayments for the loan not to be included in income for the year. For example, when a repayment is of a provisional nature or where the loan is repaid shortly before the end of the year, and the same amount, or significantly the same amount is borrowed shortly after the end of the year. This arrangement will not qualify for the exception and will be included in the income of the borrower.
Another important point to note is if the loan or debt to a shareholder is forgiven, or settled by payment of less than the amount of the commitment outstanding, or by no payment, the amount forgiven will be included as income in the shareholder's hands in the year of forgiveness.
When a borrower has repaid all or part of a loan that was included in income in a preceding year, the amount of the repayment is deductible in calculating income for the year in which the repayment is made. This ensures that amounts included into income are subject to an offsetting deduction on repayment. However, deduction is not allowed if the repayment is made as a part of a series of loans or other transactions and repayments.
While the CRA has indicated that a written agreement is not necessary to establish that a loan exists, it is always advisable to have a written agreement supporting the existence of a loan. The financial statements can also act as a proof for the existence of loan.
The new tax on split Income rules (“TOSI”) introduced in 2018 can apply to the income inclusion for a shareholder loan. As mentioned, this income inclusion might apply if the loan is not repaid within one year after the end of the taxation year of the corporate lender in which the loan was made. Care must be taken to consider the TOSI rules application and consequences.
It is important for small business owners to recognize that, although they may borrow funds from the corporation, they must repay these amounts by the end of the following corporate fiscal year either through salaries, dividends or direct repayment. If not, the amount of the loan will be included in your income for the year in which the loan was taken, which can result in significant taxes payable as well as interest and penalties.
We recommend that clients consult with their tax advisor prior to planning and implementing such lending arrangements. At CWB Wealth Management, we provide integrated wealth solutions for our private wealth clients. Our client teams have strong relationships with accountants and lawyers that can help assess these strategies for you. Please fill out the form below if you would like one of our team members to reach out to you.
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