When you take out a loan from a bank or otherwise, the amount of the loan is obviously not included in your income.
However, if you are a shareholder of a corporation and receive a loan from the corporation, the “shareholder loan rule” under the Income Tax Act applies such that the principal amount of the loan will be included in your income, unless you fall within one of the exceptions discussed below.
Furthermore, if you are “connected” with a shareholder of the corporation, even if you are not a shareholder in the corporation, you can be subject to the shareholder-loan rule. You will be “connected” with a shareholder if you do not deal at arm’s length with them − for example, if you are “related” to the shareholder under the income tax rules.
First, the shareholder loan rule does not apply if you repay the loan in full by the end of the next taxation year of the corporation following the year in which the loan is made. This gives you almost two years to repay.
For example, say your corporation has a calendar taxation year (ending December 31). If you receive a loan from the corporation in January 2020 and repay it by the end of December 2021, the rule does not apply.
However, this exception does not apply if the repayment is part of a series of loans and repayments. For example, if you repay the loan in December 2021 and the corporation lends you more funds in January 2022, this exception likely will not apply.
Second, the shareholder loan rule does not apply if the corporation gives you the loan as part of its ordinary business of lending money, and there are “bona fide arrangements” for you to repay the loan within a reasonable time.
A third exception applies if you are both a shareholder and employee of the corporation. This exception applies if:
- You are not a “specified employee” of the corporation, generally meaning you own less than 10% of the shares of any class in the corporation. For these purposes, you are deemed to own shares owned by non-arm’s length persons. For example, if you are an employee of the corporation and own 9% of a class of shares and your spouse owns 2% of the same class, you will be a specified employee; or
- Regardless of whether you are a specified employee, you use the loan to purchase a home, new shares in the corporation, or a motor vehicle to be used in the course of your employment.
Additionally, for this exception to apply, it must be reasonable to conclude that you received the loan because of your employment with the corporation rather than your shareholdings in the corporation, and there must be bona fide arrangements for you to repay the loan within a reasonable time.
Repayment of loan
If a loan was included in your income under the above rules, you can deduct any amount you repay to the corporation for the year during which you make the repayment. This deduction is not allowed if the repayment is a series of repayments and loans. Again, for example, if you repay the loan and the corporation simply lends you money again shortly afterwards, the deduction likely will not be allowed.
Deemed interest benefit?
If you fall within one of the exceptions, such that the shareholder loan rule does not apply, you are not necessarily out of the woods. If the loan does not carry an interest rate that is equal to or greater than the “prescribed rate” under the Income Tax Act, you will normally have to include in your income a deemed interest benefit.
The deemed interest benefit for a taxation year equals the prescribed rate that applies during the year on the outstanding amount of the loan, minus the interest you actually pay on the loan within the year or by January 30 of the following year.
The prescribed rate is set each calendar quarter and therefore can change over the course of a year. The prescribed rate is currently 1%. The prescribed rate tends to be quite low, as is it based on Federal 90-day treasury bill interest rates, which are relatively low.
You receive a $100,000 loan from your corporation on January 1. You fall within one of the shareholder loan exceptions described above, so that rule does not apply. However, the loan is interest-free. You do not repay any of the loan in the year.
Suppose the prescribed rate of interest is 1% for the first two quarters of the year and 2% for the last two quarters of the year.
Rounding off to keep numbers simple, you will include in income:
$100,000 x 1% x ½ (since the 1% rate only applied to the first half of the year) = $500, plus
$100,000 x 2% x ½ (for the second half of the year) = $1,000.