During tax audits, loans to shareholders are often flagged by the tax authorities
One of the fundamental laws in the tax system is that a shareholder cannot take over funds for personal use from his own company without tax consequences.
In general, shareholders can withdraw funds from a company in one of three ways:
The salary and dividend methods are taxable for the shareholder. Therefore, it follows that the third method would be as well.
Loan to shareholders
When a shareholder withdraws funds from his company through either an advance or a loan, this shareholder must reimburse the sums to avoid paying taxes on this loan, such as he would if he had received dividends from the company. Therefore, when a company agrees to lend funds to a shareholder (other than a corporation resident in Canada), the amount of the loan must be included in the shareholder’s income for the taxation year during which the loan was granted.
This also applies if the loan is granted to a person related to the shareholder, i.e. a person dealing at non-arm’s length. The non-resident shareholder is subject to non-resident withholding taxes on such loans.
Upon the repayment of the loan, partially or in its entirety, the law allows a deduction from the shareholders’ income in the repayment year, except if the repayment is carried out as a series of loans and repayments.
Conditions of the application
- There is a debt or a loan;
- The debtor must either be a shareholder, a person dealing at non-arm’s length with the shareholder, a partner of a partnership who is a shareholder of the particular corporation, or a beneficiary of a trust who is a shareholder of the particular corporation; and
- The creditor must be one of the following entities: the particular corporation, a company related to the particular corporation, or a partnership of which the particular corporation or a related company to a particular corporation is a partner.
- Debts arising in the ordinary course of business (example: banks and loan companies).
- Loans to an employee who owns less than 10% of issued shares of a particular class of the corporation’s capital stock or of a related corporation.
- Loan to an employee for the acquisition of a dwelling.
- Loan to an employee for the acquisition of shares of the corporation (or other related corporation).
- Loan to an employee for the purchase of a motor vehicle.
- If the loan is repaid within one year following the end of the taxation year of the lender in which the loan was made (except if the repayment is part of a series of loan repayments).
For all these loans, repayment terms and conditions are arranged in good faith within a reasonable time.
Arrangements in good faith
- For the exceptions to apply (except for the exception of repayment within one year), terms must be arranged in good faith for the repayment of the loan within a reasonable time. Documents must be adequate (company resolutions), and the standard practice must be considered.
- It is not necessary that the loan bear interest or include a guarantee. However, a taxable benefit is calculated at a prescribed rate and is included in the income of the debtor.
On the other hand, if the total amount of the loan is included in the income, the alleged interest will be cancelled.
- For large sums, interest and security should always be required.
- The loan agreement must outline repayment terms.
Loans granted to shareholder vs. employee status
- Loans must be granted based on employment status and not on the number of shares owned by an individual;
- Similar benefits are granted to employees who are not shareholders; and
- Employees with similar functions working for similar employers can obtain loans of a similar nature.