There are some fairly onerous rules under the Income Tax Act that apply where a shareholder of a corporation receives a loan from the corporation.
The main rule provides that if you are a shareholder and receive a loan from the corporation, the full amount of the loan is included in your income (although it is deductible when repaid, as explained further below). Furthermore, the same general rule applies if a person “connected” with a shareholder of a corporation receives a loan from the corporation.
For these purposes, a person is connected with a shareholder if the person does not deal at arm’s length with, or is affiliated with, the shareholder. Generally, a person does not deal at arm’s length with a shareholder if the two persons are related for tax purposes, but also if they actually do not deal at arm's length (such as because they are acting in concert without separate interests). For example, if you are a shareholder of a private corporation and your child or spouse receives a loan from the corporation, the loan may be included in their income.
The “affiliated” concept is more complex, but it similarly captures certain relationships between closely-connected taxpayers. Fortunately, there are some exceptions where the shareholder loan inclusion rule does not apply. The main exceptions are discussed below.
Repayment by end of next taxation year: One exception applies if you repay the loan in full by the end of the corporate taxation year following the corporate taxation year in which the loan was made. For example, if the corporation has a calendar taxation year, a loan received in January 2018 can be repaid by the end of 2019 in order to avoid the income inclusion. Therefore, in this example, you have almost two full years to repay the loan.
The only catch is that the repayment must not be a series of repayments and loans – for example, the exception will likely not apply if you repay the loan and the corporation immediately gives you another loan.
Ordinary course of money-lending business: Another exception applies where the loan was made in the ordinary course of the corporation’s ordinary business of lending money where, at the time the loan was made, bona fide arrangements were made for repayment of the loan within a reasonable time. Although this exception would normally apply to loans from corporations such as banks and other financial institutions, it can apply to loans from other corporations, if they have an ordinary business of lending money.
Loans to shareholder / employee: If you are both a shareholder and an employee of the corporation, this exception can apply. It applies where any of the following is true:
(a) you are not a “specified employee” of the corporation, generally meaning that you deal at arm’s length with the corporation and you and persons that are non-arm’s length with you own less than 10% of the shares of any class of the corporation; or
(b) you receive the loan to acquire a home in which you will live; or
(c) you receive the loan to enable you to acquire treasury shares from the corporation or a related corporation; or
(d) you received the loan to acquire a motor vehicle to be used in your employment duties.
However, in each case, it must be reasonable to assume that you received the loan because of your employment rather than because of you shareholdings, and bona fide arrangements were made for repayment of the debt or loan within a reasonable time.
Shareholder is a Canadian corporation: If the shareholder receiving the loan is another corporation that is resident in Canada, the shareholder loan rules do not apply. The rationale for this exclusion is that dividends normally can be paid to a corporate shareholder free of tax, so there is generally no policy reason to tax loans made to corporate shareholders.
Repayment of loan
If the shareholder loan was included in your income because none of the above exceptions applied, you get a deduction in the year in which you repay it. The deduction is equal to the amount of the principal that you repay.
Until recently, it was not clear whether “back-to-back” loans were caught by the shareholder loan rules. Recent amendments clarify that they do apply. For example, if you arrange for your corporation to lend an amount to an intermediary third party, which then lends you money, you will likely be caught by these rules.
Effect of Tax on Split Income (“TOSI”) rules
Before 2018, the shareholder loan rules could be advantageous in certain cases where your adult child or other relative in a low tax bracket received a loan when they were in a low tax bracket, and then repaid the loan in a year in which they were in a higher tax bracket.
For example, if your 19-year child, not otherwise active in the corporation, received a loan in a taxation year when they were in a 20% tax bracket and repaid it in a later year when they were in a 50% tax bracket, they could have benefitted from the shareholder loan rules. That is, the deduction would have saved more tax than the tax payable upon the inclusion. However, beginning in 2018, a proposed amendment to the TOSI rules is expected to apply, so that the income inclusion will apply at the highest marginal rate of tax (generally around 50% or more depending on the province), thus negating the tax advantage that may have previously existed. These amendments have not yet been passed and could still be changed, but as currently proposed they will be retroactive to the beginning of 2018.
Interest benefit rules
If the shareholder loan rules do not apply, so that the principal amount of the loan is not included in your income, a deemed interest benefit rule may nonetheless apply.
Normally, this interest benefit rule will apply where the interest charged on the loan is less than the prescribed rate of interest under the Income Tax Act. In such case, you will have an income inclusion for each year in which the loan is outstanding, equal to the prescribed rate of interest during the year on the loan minus the interest you actually pay on the loan in the year or by January 30 of the following year.
On January 1, 2017, you received a $100,000 interest-free loan from your corporation. Due to one of the exceptions above, you were not subject to the regular shareholder loan rules, and thus the principal amount of the loan was not included in your income. The prescribed rate of interest throughout 2017 was 1%.
For the 2017 year, you must include in your income an interest benefit of 1% of $100,000, or $1,000.
If you actually paid any interest on the loan in 2017 or by January 30, 2018, the payment would reduce the benefit included in your income.