If you receive a loan from your employer, you may be subject to tax on an “imputed interest” inclusion in your income.
Basically, the amount included in your income for a year will be the amount by which the prescribed rate of interest on the loan during the year exceeds the amount of interest, if any, that you paid on the loan in the year or by January 30 of the following year. For the current quarter of 2022 (April 1 to June 30), the prescribed rate is 1%.
On January 1 of a particular year, you received an interest-free loan of $100,000 from your employer. We will assume the prescribed rate of interest for the first half of the year is 1% and 2% for the second half.
Your income inclusion will equal 1% of $100,000 x ½ (since only half of the year) plus 2% of $100,000 x ½.
So you would include $500 plus $1,000, or $1,500, in your income for tax purposes. As noted above, if you ended up paying some or all of the interest, the inclusion would be reduced accordingly.
There is an exception to the rule, which basically says that if you pay a reasonable arm’s length rate of interest on the loan, there is no income inclusion for you.
So that’s the downside of the rule.
There is a potential upside, if you use the loan for the purpose of earning investment income or business income. In such case, you get an offsetting deduction equal to the interest – so in the above example, you would get an offsetting deduction of $1,500. You can also claim a deduction if you use the loan to purchase a motor vehicle used in your employment duties, but in such case the amount of the deduction will be pro rated based on your employment use of the vehicle relative to your personal use (since the personal portion is not deductible).
Home purchase loan
If you use the loan to purchase a home in which you live (so this doesn’t include a property you rent out to someone else), the prescribed interest rate is capped at the rate at the time of the loan. The cap lasts for 5 years. If the loan remains outstanding after 5 years, then a new cap kicks in based on the prescribed rate of interest at that time.
So if the prescribed interest rate increases over time, you will only be taxed on the lower prescribed rate that was in effect at the time of the loan. Right now – April through June 2022 – is likely the last quarter that the rate will be at 1% (as it has been since July 2020), as interest rates are rising.
Forgiveness of loan
If your employer subsequently forgives the repayment of the principal amount of the loan, then the remaining unpaid principal amount is fully included in your income. Although that result might seem a bit harsh, the rationale is that your employer gave you some money, which you didn’t have to repay, so that it’s similar to them giving you extra remuneration for your work.