If you receive an interest-free loan from your employer, or a loan at an interest rate lower than the prescribed rate of interest under the Income Tax Regulations, you are required to include a deemed interest benefit in your employment income.
In particular, you must include (and pay tax on) deemed interest on the amount of the loan outstanding during the year computed using the prescribed rate of interest that applies during the year. The prescribed rate is set quarterly, so it may change during the year (it hasn’t moved from 1% in several years, but due to a recent Bank of Canada rate increase it might move to 2% in the last quarter of 2017).
Deducted from the deemed interest amount is any interest that you actually pay to your employer on the loan. However, the interest must be paid in the year or by January 30 of the following year.
As a result, if you pay at least the prescribed rate of interest on the loan for each year, you will have no net inclusion.
Home purchase loan
If the loan is used to purchase a home to be inhabited by you or a person related to you, a special rule effectively “caps” the deemed interest benefit to the prescribed rate at the time of the loan. In other words, if the prescribed rate increases, the deemed benefit for the year will not increase. However, if the prescribed rate decreases, you will get the advantage of that lower rate.
Example
You receive a $100,000 interest-free loan from your employer on January 1. At that time, the prescribed rate is 1%. It remains at 1% for the second quarter, but increases to 2% for the last two quarters of the year. You do not repay any of the principal during the year.
Your deemed benefit for the year will be capped at 1% of the amount of the loan, or $1,000.
If the loan remains outstanding for more than five years, the cap interest rate is re-set using the prescribed interest rate at the five-year anniversary mark. That cap will then apply for the next five years.
Home relocation loan
A “home relocation loan” is a loan used to buy a home that is at least 40 kilometres closer to a new work location than was your former home (to the new work location). For example, if your employer requires you to move from Toronto to Montreal and you use the loan to buy a new home in Montreal, the loan will be a home relocation loan.
Historically, there has been a rule that effectively exempts from tax the deemed interest benefit on the first $25,000 of the principal amount of the home relocation loan. However, this is the last year for this rule. The 2017 Budget eliminated this rule beginning in 2018.
However, the home purchase loan rules discussed above (the “cap”) will continue to apply.