There are various provisions in the Income Tax Act that prevent you from taking money or property of a corporation on a tax-free basis. Two of the main provisions are discussed below. One applies to shareholder benefits, and the other to certain shareholder loans.
If you are a shareholder of a corporation and receive a benefit from the corporation, the value of the benefit is included in your income. For example, if your corporation pays for your personal-use car, or a vacation property or renovations on your home, you will be required to recognize this benefit for income tax purposes.
This rule also provides that a person who receives a benefit from a corporation in contemplation of being a shareholder must also include the benefit in income. So the rule can catch prospective shareholders, and not only current shareholders.
There are some exceptions to the shareholder benefit rule. For example, a dividend is not a shareholder benefit, and is taxed more lightly to the recipient shareholder than regular income, due to the dividend tax credit. Also, if the corporation grants a right to all common shareholders to acquire additional shares, the grant of the rights is not normally a taxable benefit.
One of the main problems with the shareholder benefit rule is that the corporation cannot deduct the benefit in computing its income. This means that there is an element of double taxation.
If you are both a shareholder and an employee of the corporation, the payment of salary, wages and employment benefits is included as employment income and not shareholder benefits. The distinction is quite important, since the corporation can normally deduct these amounts, but not shareholder benefits.
There is a fairly onerous rule that provides that if a shareholder of a corporation, or a person “connected” with that shareholder, receives a loan from the corporation, the full amount of the loan is included in the person’s income. As with the shareholder benefit rules, the corporation cannot deduct the loan in computing its income. However, as discussed below, the shareholder or connected person can claim a deduction when the loan is repaid.
For these purposes, a person is considered “connected” with a shareholder if the person does not deal at arm’s length with the shareholder or is affiliated with the shareholder. The “arm’s length” and “affiliated” rules are quite complex, but they include the following persons (among others):
- Individuals related to the shareholder for tax purposes, which include lineal descendants and ascendants (e.g. parents, grandparents, children, and grandchildren), spouses and common-law partners, siblings and siblings-in-law, step-parents and step-children and parents-in-law. Interestingly, they do not include uncles, aunts, nieces, nephews, and cousins;
- Corporations that are controlled by the shareholder;
- Corporations that are controlled by a person related to the shareholder; and
- A trust of which the shareholder is a beneficiary.
Exceptions to the shareholder loan rule
Fortunately, there are several exceptions, as discussed below. Where an exception applies, the principal amount of the loan is not included in the shareholder’s income.
- The shareholder loan rule does not apply if the shareholder is a Canadian resident corporation.
- The rule does not apply to loans between non-residents.
- The rule does not apply to a debt that arose in the ordinary course of the corporation’s business or a loan made in the ordinary course of its ordinary business of lending money where, at the time the indebtedness arose or the loan was made, bona fide arrangements were made for repayment of the debt or loan within a reasonable time.
- The rule does not apply if the loan is repaid within one year after the end of the corporation’s taxation year in which the loan was made. For example, if the corporation has a December 31 year-end and lends you money in January 2017, you have until December 31, 2018 to repay to avoid inclusion of the loan in your income. However, the repayment must not be part of a series of loans (or other transactions) and repayments.
Lastly, there are exceptions that apply to shareholders that are also employees of the corporation. These are discussed under the next subheading.
Loans to shareholder / employee
If you are both a shareholder and an employee of the corporation, the shareholder loan rule does not apply in any of the following situations:
- You are not a “specified employee” of the corporation. Generally, in order to not be considered a specified employee, you must deal at arm’s length with the corporation and own less than 10% of the shares of any class of the corporation (and for these purposes, you are deemed to own shares owned by non-arm’s length persons like your spouse, children, and so on);
- The loan is used to purchase a home in which you will live;
- The loan is used to purchase shares from the corporation or a corporation related to it (the shares must be newly issued by the corporation, and not, for example, purchased from a previous shareholder); or
- The loan is used to purchase a motor vehicle to be used in your employment duties.
However, the above exceptions apply only if:
- It is reasonable to conclude that you received the loan because of your employment and not because of your shareholdings; and
- When the loan was made, bona fide arrangements were made for repayment of the loan or debt within a reasonable time.
Deduction upon repayment
If the loan was included in your income in one year, you can claim a deduction when you repay the loan. The deduction is allowed in the year of repayment (or years of repayment, if you repay the loan in instalments over several years).
However, a deduction is not allowed if it is established by subsequent events that the repayment was part of a series of loans or other transactions and repayments. For example, if you receive a loan in one year, repay it later, and then receive another loan of the same amount, you may be denied the deduction of the repayment.
The 2016 Federal Budget extended the shareholder loan rules to certain “back-to-back” loans. For example, the rules can apply where a corporation in which you are a shareholder lends money to a third party, which in turn lends money to you. The rules can also apply where the corporation provides security to the third party, and it is reason-able to conclude that the security was provided so that the third party would lend you money.
The rules can extend to multiple “intermediaries”, so that they can apply where the corporation lends money to a third party, which lends money to another party, and so on, where the chain ultimately results in you receiving a loan from a third party.
Where the back-to-back loan rule applies, you are generally treated as if you received the loan from the corporation, so that it will be included in your income unless one of the exceptions applies.
Deemed Interest Benefit Where Shareholder Loan Rule Does Not Apply
If the loan is not included in your income because one of the exceptions applies, you may be assessed an imputed interest benefit if the loan is interest-free or carries a rate of interest that is less than the prescribed rate of interest under the Income Tax Act. The prescribed rate is set quarterly, and is based on 90-day Federal Treasury bill rates, so that it a relatively low rate.
For the current quarter ending on March 31, 2017, the prescribed rate is 1%, and it has been that amount for several years.
The interest benefit is computed by applying the prescribed rate to the principal amount of the loan outstanding during the relevant year. The benefit is reduced by the interest you pay on the loan, as long as it is paid in the year or by January 30 of the following year. If you do not pay the interest or are late paying it, the benefit is not reduced.
You are a shareholder of a corporation and it lends you $100,000 interest-free on January 1 of this year. The principal amount of the loan is not included in your income under the shareholder loan rules because you fall within one of the exceptions discussed above.
The loan remains outstanding for the year. Assume that the prescribed rate of interest throughout the year remains at 1%.
You will include in income 1% of $100,000, or $1,000. The inclusion will be reduced if you actually pay interest in the year or by January 30 of the next.