One principle of our tax system is that a shareholder cannot take out money from their corporation without tax consequences.
Three common ways a shareholder withdraws money from a corporation are:
The first two methods are taxable in the hands of the shareholder in the year received. It stands to reason that the third method is also taxable on the same basis, with some qualifications as outlined below.
If a “specified person” (other than another corporation resident in Canada) borrows money from a “specified corporation”, the amount received is taxed as ordinary income to them in that year, much like a salary, although the corporation is not allowed to deduct the payment.
Who are Specified Persons?
A specified person is a shareholder of a corporation, a person who does not deal at arm’s length with the shareholder (generally a related person), a member of a partnership that is a shareholder of the corporation or a beneficiary of a trust that is a shareholder of the corporation.
What are Specified Corporations?
A specified corporation is a corporation of which a person is a direct shareholder, a corporation related to such a corporation, a partnership of which the corporation or a corporation related to the corporation is a member.
Exceptions to the General Rule
There are, however, some exceptions to this general rule. The withdrawn money is not included in income if:
- The debt is incurred in the ordinary course of business of the corporation (banks, loan companies).
- The loan was made to an employee who owns less than 10% of the issued shares of a particular class of the capital stock of the corporation or other corporations related to the corporation.
- The loan was made to an employee for the purpose of purchasing a home.
- The loan was made to an employee for the purpose of acquiring the shares of the employer-corporation (or a corporation related to it).
- The loan was made to an employee for the purpose of acquiring a motor vehicle.
- The loan was repaid within one year of the end of the tax year of the lender or creditor in which the loan was made (unless the repayment is part of a series of loans and repayments).
For all such loans however, there must be good faith arrangements made for repayment within a reasonable period of time.
What is a Good Faith Arrangement?
- For the exceptions to apply (except for the one-year repayment exception), there must be a good faith arrangement to repay the loan within a reasonable period of time, the documentation must be adequate (i.e., a corporate resolution) and the current practice must be considered.
- The loan need not bear interest or be secured, however if interest is not charged and paid a taxable benefit is calculated at a prescribed rate and included in the debtor’s income, unless the entire loan is included in income, in which case deemed interest at the prescribed rate is waived. If the loan is interest bearing any unpaid interest would be considered a new loan and subject to the income inclusion rules using the same criteria outlined above.
- For large amounts, interest and security should always be provided.
- The loan agreement must provide for repayment terms.
The loan must be made in their capacity as an employee and not as a shareholder, meaning the loan must be made because of employment and not because of the number of shares held. Similar benefits must be provided to non-shareholder employees and employees in similar positions with similar employers can obtain loans of the same nature.
If the loan has been included in income and is subsequently repaid, the amount repaid can be deducted from income in the year of the repayment. If the specified person is a non-resident, the loan is treated as a dividend paid to the non-resident and withholding tax of 25% (reduced by certain treaties such as the Canada U.S. Tax Treaty to a lower rate) is required to be made by the corporation on behalf of the shareholder. If the specified person subsequently repays the loan, they can apply for a refund of the withholding tax.
There are some planning possibilities when dealing with shareholder loans. For example, if a loan is made in year when the recipient has very little other income, tax on the included income would be paid at a low marginal rate. If the loan is repaid in a year with greater earnings, the deduction can be applied against income taxed at higher rates, thus leading to permanent tax savings.
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Have questions about shareholder loans? Please feel free to contact one of our Tax team members.