The Income Tax Act has a fairly onerous rule that provides that a shareholder of a corporation that receives a loan from the corporation must include the full amount of the loan in income for tax purposes. This rule also applies to a loan received from the corporation by a person “connected” with a shareholder, which generally includes a person who is non-arm’s length with (related to) the shareholder.
Fortunately, there are various exceptions to the rule.
Exceptions to the rule
The rule also does not apply to a shareholder loan that is repaid within one year after the end of the corporation’s taxation year in which the loan was made. However, the repayment cannot be part of a series of loans and repayments from and to the corporation. This exception allows you to repay the loan almost two years later, depending on when the loan is made.
The corporation has a calendar taxation year. On January 2, 2019, it makes a loan to a shareholder. As long as the shareholder repays the loan by December 31, 2020 (almost 24 months in total), the loan will not be included in the shareholder’s income.
The rule does not apply to a loan received from a corporation which makes the loan in ordinary course of its business of lending money where bona fide arrangements are made for repayment of the loan within a reasonable time. This exception may apply to loans from banks or trust companies, although loans from any corporation that has a money-lending business can qualify.
Another significant exception applies if you are both a shareholder and an employee of the corporation, but not a “specified employee”. You are a specified employee if you and non-arm’s length persons (related persons) own at least 10% of the shares of any class of the corporation. If you are not a specified employee, the shareholder loan will not be included in your income if it is reasonable to conclude that you received the loan because of your employment and not because of your shareholdings, and bona fide arrangements were made for repayment of the loan within a reasonable time.
In addition, even if you are a specified employee, another exception exists. In this case, you must use the loan to acquire a home for your family, shares in the employer corporation, or a motor vehicle to be used in the course of your employment. Still, it must be reasonable to conclude that you received the loan because of your employment and not because of your shareholdings, and bona fide arrangements were made for repayment within a reasonable time. If you meet these conditions, the loan will not be included in your income.
Repayment of loan
If none of the exceptions apply and the full amount of the loan is included in your income, you get an offsetting deduction in a future year in which you repay the loan. If you repay only a part of the loan, you get a partial deduction.
Imputed interest benefit where shareholder loan rule does not apply
If one of the exceptions does apply and the full amount of the loan is not included in your income, you may still be subject to an imputed interest income inclusion. This will be the case if the loan is made at zero interest or an interest rate that is lower than the “prescribed rate” of interest under the Income Tax Act (currently 2% per year). In such case, you must include in your income the difference between the prescribed interest for each year less the interest you paid for the year, either in the year or by January 30 of the following year.
A shareholder of a corporation receives a $100,000 loan from the corporation on January 1, 2019, at 1% interest. The shareholder pays the 1% interest in the year. The prescribed rate of interest throughout the year is 2%.
In such case, the shareholder will be required to report, and pay tax on, a taxable benefit of (2% −1%) x $100,000, or $1,000.
If you pay the interest for a year after January 30 of the following year, the benefit is not reduced. In other words, if you pay late, you are out of luck.