The Tax Pitfalls of Shareholder Loans, and How to Avoid Them
Dean Blachford, Tax Litigation Lawyer
Valentine Gurfinkel, Student-at-Law
Shareholder loans—loans given by a corporation to its shareholders—are a common business practice. It is often a perk shareholders receive for investing in the company. It is also a common way for business owners to extract money from their corporation.
However, under the Income Tax Act (ITA) a simple shareholder loan can lead to a significant tax dispute, thanks to section 15(2).
In this article, we discuss the taxation of shareholder loans under section 15(2) and what to do if the CRA attempts to impose a section 15(2) assessment on you.
What is section 15(2)?
Section 15(2) is an income-inclusion provision: it causes an amount that usually isn’t considered income to be included in a person’s income for tax purposes. The provision states that if a taxpayer has received a loan from a corporation of which she is a shareholder, then that “amount of the loan or indebtedness is included in computing the [taxpayer’s] income for the year.” Hence if CRA concludes that section 15(2) applies, the taxpayer will have to pay tax on the loan she received from the corporation, something she wouldn’t have to do if she took out the loan from a third-party lender, such as a bank.
Additional tax consequences for the shareholder and corporation
The application of section 15(2) may also trigger the application of section 80.4(2), further increasing the taxpayer’s tax burden. Section 80.4(2) deems a taxable benefit to flow to the taxpayer from the difference between the shareholder loan’s interest rate and the market interest rate, which is often higher. In other words, a taxpayer receiving a section 15(2) shareholder loan will often have to pay tax both on the loan itself and on the loan’s beneficial interest rate.
Moreover, unless the corporation is in the business of making loans, the corporation cannot deduct the shareholder loan from its income as an expense, even if the loan is never repaid. Conversely, any interest the corporation earns on the loan will be taxed.
Section 15(2) also captures individuals connected to the shareholder
Section 15(2) captures not just the shareholder herself, but also those “connected” to the shareholder, including spouses, family members, and business associates, as well as related trusts and partnerships. As such, section 15(2) can apply even when the taxpayer receiving the loan is not a shareholder of the lending corporation. In effect, shareholder loans are subject to double, or even triple, taxation. First, the corporation pays tax on the money it lends; then this money is taxed again in the shareholder’s hands as a section 15(2) shareholder loan; and finally, there is additional tax on the interest the corporation receives on the loan.
How to avoid being captured by section 15(2)
Despite the stringency of section 15(2), there are ways to avoid it. Most notably, a shareholder loan will be exempt from taxation when it is repaid within a year or when it is actually an employee loan.
Section 15(2.6): Repayment within a year of the end of the corporation’s taxation year.
Under section 15(2.6), a shareholder loan will not be captured by section 15(2) if it is repaid within one year of the lending corporation’s taxation year end in which the loan was made. In practice this means that the shareholder can have up to two years to make use of the shareholder loan tax-free before repaying it. For example, if the lending corporation’s taxation year runs from October 1st, 2016 to September 30th, 2017, a shareholder who receives a loan on October 1st, 2016 would not need to repay the loan until September 30th, 2018.
Under section 15(2.6), a shareholder loan does not need to be repaid in cash. A shareholder can repay the loan by transferring property to the corporation at fair market value. Both personal property (assets, stocks, etc.) and real property (land, real estate, etc.) can be transferred. This alternative repayment option is often forgotten by shareholders, and by CRA agents assessing a shareholder loan.
Section 15(2.4): Employee loan
The other carve-out to section 15(2) is a section 15(2.4) employee loan. Section 15(2.6) states that a loan will not be subject to tax under section 15(2.4) if it is a genuine loan given to the taxpayer because of her employment with the lending corporation. Since many shareholders are also employees of the lending corporation (particularly because a corporation’s directors are considered its “employees” under the ITA), section 15(2.6) can be a viable defence against CRA’s claim that the taxpayer received a taxable shareholder loan. Indeed, the CRA will often apply section 15(2) without first considering whether the loan was actually an exempt employee loan.
Section 15(2) is one of the most frequently utilized provisions under the ITA by the CRA. It is also one of the most misapplied sections. HazloLaw – Business Lawyers have extensive experience successfully resolving shareholder loan assessments by the CRA.
If you have recently received a shareholder loan, or have been reassessed for one, contact Dean Blachford to discuss your options.
This article is for informational purposes only and does not constitute legal advice. If you wish to discuss your issue with a lawyer, contact Dean Blachford today. 613-747-2459 ext.310, [email protected]