Shareholders who need cash can borrow money from their companies, but they need to do it properly or face tax complications. Here’s how to avoid some common pitfalls.
Funds can be extracted from a corporation in several ways. Shareholders may draw a salary or bonus, collect taxable and tax-free dividends, or withdraw funds in the form of a shareholder loan.
When funds are withdrawn as a shareholder loan, this transaction results in a shareholder loan balance listed on the company’s year-end financial statement. While this type of transaction is not uncommon, shareholders need to be aware of the potential tax consequences that may result when the funds withdrawn leave the shareholder owing the corporation. Under these circumstances, in the absence of drawing salary or dividends, the shareholder now owes money to the corporation.
Why would a business owner do this? Simply put, to avoid paying tax personally on the funds withdrawn. Of course, the CRA is aware of this type of transaction and has complex rules surrounding the tax implications of shareholder loans – often requiring advice and analysis on the part of an experienced Canadian tax accountant or lawyer.
Subsection 15(2) of Canada’s Income Tax Act refers to “the direct loan of money by a corporation to its shareholder” and the inclusion of such loans in the income of the shareholder. Highlighting the spirit of law, subsection 15(2) states that the purpose is to “include in a shareholder’s income amounts received from a corporation in the guise of loans or other indebtedness.”
Two years to repay?
This subsection further states that where a person or a partnership is a shareholder of the corporation or connected with a shareholder of a corporation, and the person or partnership received a loan or became indebted to the corporation or a related corporation, then the loan or debt will be included in the income of that person or partnership for the taxation year in which the loan was made, with exceptions to certain circumstances.
One exception is cited in subsection (2.6). It states that if a shareholder loan is prepaid within 1 year after the end of the taxation year of the lender corporation (as long as the repayment amount was not part of a series of transactions or loan payments), subsection 15(2) does not apply, and therefore the loan is not included in the income of the borrower/shareholder.
So, what does that mean?
Do you have two years to repay the loan? Not quite. This is because the loan needs to be repaid “by the end of the following taxation year of the lender” after the loan was made.
For example, if the year-end is, say, June 30 and you borrow on June 30, 2021, you have until June 30, 2022 to repay the loan. If you borrow on July 1, 2021, you have until June 30, 2023, to repay. Essentially you can have anywhere from one to two years, depending on the date that the borrowing is made, relative to the year-end of the corporation.
Offsetting double taxation
Therefore, if a shareholder loan balance has been outstanding for more than two consecutive fiscal years of the corporation, including the year in which the funds are originally withdrawn, the outstanding loan will be included on the shareholder’s personal T1 tax return and taxed as ordinary income in the year that the funds were withdrawn. In this case, the shareholder would not only be liable for the personal income tax on the amount withdrawn, but also interest if the tax was not paid for the year of withdrawal.
On the other hand, the corporation cannot deduct the amount to reduce corporate taxes, creating double taxation. To offset any double taxation, the shareholder may eventually deduct repayment of the borrowed funds on his or her personal tax return. However, this may be far from a perfect solution.
For example, the shareholder may have been subject to a 53% income tax rate (based on the top marginal rate in Ontario) at the time the funds were borrowed, but only a 24% or 30% income tax rate at the time the funds were repaid. As a result, tax payment is at the 53% rate, whereas the tax recovery is only at the 24% or 30% rate, leaving 23% to 29% unrecovered tax.
Imputed interest benefit
Under subsection 80.4(2) of the Income Tax Act, unless the rate of interest paid on the loan was at least equal to or greater than the Canada Revenue Agency prescribed interest rate (1% in 2021), another benefit would be deemed to have been received by the shareholder. The shareholder would then be subject to an imputed interest rate benefit. The taxable benefit is reduced by any actual interest paid. If someone pays interest but at less than the prescribed rate, it reduces the taxable benefit. If there is a benefit for the year, it should be reported on a T4 slip, so there is also a reporting requirement for the corporation.
The payment of interest must be made no later than 30 days after the corporation’s year end; otherwise, the shareholder could be subject to an imputed interest benefit.
The shareholder loan rules also apply to any person who is related to the shareholder and who borrows funds from the corporation. This would include a spouse or child of the shareholder, even if they do not own any shares in the corporation.
Therefore, if you borrow funds from your corporation, beware. Although shareholder loans are still a viable way to address short-term cash flow needs, the funds need to be repaid, generally speaking, within one year after the end of the taxation year of the lender corporation. The funds must also be borrowed at an interest rate equal to or greater than the prescribed rate to avoid an imputed taxable benefit issue. It may also be an option to pay a dividend or salary to clear the balance of the loan, but care must be taken as to how and when this is carried out.
Nancy Grouni, a Certified Financial Planner with Objective Financial Partners Inc., specializes in financial, tax and estate planning for business owners and professionals. She is based in Markham, Ont.