General rule
If you are a shareholder of a corporation or “connected” with a shareholder of a corporation, and you receive a loan from the corporation, you may be required to include the entire principal amount of the loan in your income under the “shareholder loan” provisions of the Act. In most cases, you will be connected with a shareholder if you do not deal at arm’s length with the shareholder. In turn, you will not deal at arm’s length with a shareholder if you are “related” to the shareholder (as defined in the Act).
Obviously, the rule can be quite harsh. The basic intent of the rule is to prevent shareholders of private corporations from extracting funds tax-free from their corporations in the form of loans, which might not be repaid for a long time, if at all.
Exceptions
Fortunately, there are exceptions where the share-holder loan rule does not apply.
- The rule does not apply if you repay the loan in full within one year after the end of the corporation’s taxation year in which you received the loan, as long as the repayment is not a series of loans and repayments. For example, if the corporation has a taxation year ending every March 31 and you received a loan in April 2014, you could repay it by March 31, 2016 and the rule would not apply. In this example, you can see that the repayment period can actually be close to 2 years.
- Another exception applies if the corporation provides you with the loan in the course of its money-lending business, and bona fide arrange-ments are made for the repayment of the loan within a reasonable time. For example, if you are a shareholder of and work for a bank or trust company or credit union, you can normally qualify for this exception.
- The other main exception applies to shareholders who are also employees of the corporation. The exception varies, depending on whether you are a “specified employee” of the corporation. If you are not, this exception can apply if you receive the loan in your capacity as employee (rather than shareholder) and bona fide arrangements are made for the repayment of the loan within a reasonable time. If you are a specified employee, further criteria must be met – the loan must be used for one of the following purposes:
- To purchase new shares from the corporation;
- To purchase a home or other dwelling in which you will reside; or
- To purchase a car to be used for employment purposes.
For these purposes, a “specified employee” includes an employee who owns at least 10% of the share of any class in the corporation, or who does not deal at arm’s length with the corporation. Furthermore, for the purposes of the 10% threshold rule, you are deemed to own shares owned by any person not dealing at arm’s length with you – for example, your spouse, your children, another corporation that owns the shares, among others.
In terms of the “in capacity as employee” test, the Canada Revenue Agency (CRA) takes the general view that the test will be met if all other employees at your level receive the same opportunity to receive a loan from the corporation. In all cases, it will depend on the facts.
Deduction for repayment
If the rule applies and you are required to include the loan in your income, you get a deduction in the year in which you repay the loan. You get a partial deduction if you repay part of the loan.
Deemed interest rule (if shareholder loan rule does not apply)
If the shareholder loan rule does not apply because you fall within one of the exceptions, you may still be taxed on a benefit from “deemed interest”, if the loan is made at a rate that is less than an arm’s length commercial rate (one that would apply if the corporation was in the money lending business). Basically, where this rule applies, you will be required to include the prescribed rate of interest on the loan while it is outstanding.
However, the inclusion will be reduced to the extent you pay interest for the year or by January 30 of the following year. Therefore, if you pay the prescribed rate of interest that applied throughout the year, there will be no net inclusion. For these purposes, the prescribed rate is set every calendar quarter, and it is 1% for the current quarter and has been that rate for several quarters.