Many individuals have accumulated financial assets through management companies. In most cases, they are invested in the stock market. If the shareholder or a family member were to require money, the holding company could lend them the funds needed.
If such a loan could be made, it would be possible to defer taxes resulting from a dividend payment. In a previous article we reported that the dividend tax rate has been increased over the past 24 months. The ability to defer taxes therefore acts as a financial lever, as less money would be required to achieve the objectives of the shareholder or his family members.
Some individuals will set an interest rate and loan guarantees in order to legitimize their transactions, and to make them comparable a non-arm's length arrangement.
The issue of shareholder loans was settled in 1977. It is therefore surprising that this topic is still unknown or misunderstood.
Benefits to the Shareholder
Subsection 15(2) of the Income Tax Act (ITA) provides that a person who is a shareholder of a company and who obtains a loan or becomes a debtor is required to include the loan or debt amount when calculating their income for the year in which the loan was made. This subsection of the ITA further provides that the loan amount(s) granted to a person related to the shareholder, including members of their family, will be further added to their income. This paragraph also provides other rules to thwart any clever individuals who might try to get around the rule by using several companies and legal entitiesfootnote 1.
There are certain exceptions to the law:
Companies that lend money as a normal activity are excluded from the above rule. Therefore, if a loan is made in the ordinary course of business of such company, the shareholder will not have to add to his income if repayment arrangements are made.
It is usually not possible for a holding company to qualify for this exemption, because the loan is not part of its normal activities, even if it holds government or corporate debt.
Certain loans to employees are also excluded if they allow the employee to:
- acquire a home for his personal use;
- acquire shares of his employer; or
- buy a vehicle that will be used in the course of their employment.
To qualify for this exemption, one must demonstrate that the loan was made as an employee of the company, and not the shareholder. Thus, it is not usually possible for a holding company to prove this, because no employees are normally required to manage its assets.
Finally, loans repaid within a period of one year following the end of the company’s tax year do not have to be added to the income of the shareholder.
Therefore, a company may lend money to a shareholder for a maximum period of 729 days.
You will have noted that the fact that a loan includes interest or a mortgage guarantee is not mentioned in the above exceptions. Simply the fact that a loan is made by a company leads to its inclusion in income, if the loan does not qualify for one of the above exceptions.
If the loan qualifies for one of the above exceptions, the shareholder must add an additional amount to their income, if no interest has been included or if the interest rate is lower than the prescribed rate (currently 1%). Indeed, subsection 80.4(2) of the ITA provides that the amount to be added is equal to the interest that would have been payable if the debt bore interest at the prescribed rate. The interest paid over the course of the year reduces the amount of the benefit.
When the shareholder repays the loan in whole or in part, paragraph 20(1)j) of the ITA provides that the amount repaid is deductible from income in the year of repayment, if that amount was previously added to their income.
The purpose of the tax legislation is to prevent a company from lending funds to its shareholders without the shareholders incurring income. It is rare that such a transaction can be completed without entailing the payment of income taxes. It is usually not recommended to proceed with such transactions, as an oversight is very expensive when the tax authorities discover it during an audit.
You can get more information on this topic from Interpretation Bulletin IT-119R4 NOTE - This link will open in a new tab..
Since the levels and bases of taxation can change, any reference in this publication to the impact of taxation should not be construed as offering tax advice; as with any transaction having potential tax implications, clients should consult with their own tax advisors.