Introduction – Shareholder Loans & Subsection 15(2) of the Income Tax Act
Shareholders may derive economic advantages from their corporation through various avenues including a salary, dividends and shareholder loans. Shareholder loans are a common business practice that allow shareholders to extract funds from their corporation and they incentivize shareholders for investing in the corporation. The Income Tax Act contains complex provisions relating to the tax treatment and implications of shareholder loans and they are a complex area of law that requires detailed analysis and advice from an experienced Canadian tax lawyer.
Subsection 15(2) of the Income Tax Act – Shareholder Debt & Income Inclusion
Subsection 15(2) of Canada's Income Tax Act pertains to "the direct loan of money by a corporation to its shareholder" and the inclusion of such loan in the income of the shareholder. In Lust v. Canada, the Federal Court of Appeal confirmed that the purpose of subsection 15(2) is to "include in a shareholder's income amounts received from a corporation in the guise of loans or other indebtedness".
Subsection 15(2) in the Income Tax Act provides that where a person or a partnership is: (a) a shareholder of the corporation; (b) connected with a shareholder of a corporation; or (c) owns shares of the corporation through a partnership or a trust of the corporation, and due to such shareholding, the person or partnership received a loan or became indebted to (i) the corporation; (ii) a related corporation; or (iii) a partnership of which that corporation or any related corporation is a member, then the loan or debt will be included in the income of that person or partnership for the taxation year in which the loan was made, with exceptions to certain circumstances.
Subsection 15(2) does not apply where the borrower is a corporation resident in Canada, nor does it apply where the borrower is a partnership that is a shareholder of a corporation resident in Canada.
Exceptions to Income Inclusion
Where a shareholder or a taxpayer connected to the shareholder can establish that the loan extracted from the corporation falls under one of the exceptions in subsections 15(2.2) through 15(2.6), the loan will not be included in the shareholder's income pursuant to subsection 15(2).
On the one hand, subsection 15(2.3) through subsection 15(2.5) provide the income exceptions where the loan is provided for a specific purpose. On the other hand, subsections 15(2.2) and 15(2.6) provide the income exceptions where the loan is provided under certain circumstances.
The most common exception to the rules is in subsection 15(2.4) of the Income Tax Act. Subsection 15(2.4) provides that subsection 15(2) does not apply where the borrower is a shareholder and an employee of the corporation or is the spouse or common-law partner of an employee of the corporation. Pursuant to subsection 15(2.4), subsection 15(2) does not apply where the loan was made for the purpose of: (a) acquiring a dwelling or a share in the capital of a cooperative housing corporation for the purpose of the individual inhabiting the dwelling while it is owned by the corporation; (b) acquiring shares from the corporation or from another corporation related to that particular corporation; or (c) acquiring a motor vehicle to be used by the borrower employee during the performance of his or her duties of office or employment; where (d) the borrower or the borrower's spouse or common-law partner received the loan because of his or her employment rather than shareholdings in the corporation; and (e) at the time the loan was made bona fide arrangements were also made for the repayment of the loan within a reasonable time. Where a corporation lends money to a shareholder who is also an employee of the corporation, the tax treatment rules under the Income Tax Act requires determining whether the loan is received by the taxpayer in his or her capacity as a shareholder or employee. In Mast v The Queen, the Tax Court of Canada referenced the Canada Revenue Agency's ("CRA") Interpretation Bulletin IT-119R4 which provides that determining capacity of the borrower involves a finding of fact on a case-by-case basis.
Subsection 15(2.2) provides that subsection 15(2) does not apply to if the indebtedness is between non-resident persons. For non-resident shareholders, paragraph 214(3)(a) deems amounts included in subsection 15(2) to be a dividend. As a result, corporations must remit non-residents withholding tax pursuant to subsection 212(2).
Subsection 15(2.3) provides that subsection 15(2) does not apply if the loan is made to a borrower where the loan is made in the ordinary course of business of the lender and at the time the loan was made bona fide arrangements were also made for the repayment of the loan within a reasonable time.
Subsection 15(2.5) states that subsection 15(2) not does apply where the loan made in respect of a trust where (a) the lender is a private corporation, (b) the corporation is the settlor and sole beneficiary of the trust, (c) the purpose of the trust is to facilitate the purchase or sale of the shares of the corporation or another related corporation, and (d) at the time the loan was made bona fide arrangements were also made for the repayment of the loan within a reasonable time.
Subsection 15(2.6) provides that if a shareholder loan is prepaid within 1 year after the end of the taxation year of the lender corporation and as long as the repayment amount was not a part of a series of transactions or loan repayments, subsection 15(2) does not apply and thus the loan is not included in the income of the borrower shareholder. In Canada Trustco Mortgage Co v The Queen, the Supreme Court of Canada explains that "a series of transactions involved a number of transactions that are preordained in order to produce a given result".
Repayment of Shareholder Loans & Paragraph 20(1)(j) Deduction
Paragraph 20(1)(j) of the Income Tax Act provides that when a shareholder repays part or all of a loan that was included in his or her income pursuant to subsection 15(2), the repayment amount is deductible in calculating the shareholder's income for the year in which the repayment was made. According to the CRA, what constitutes a repayment is question of facts that is decided on a case-by-case basis.
In certain situations, temporary repayments of all or part of a shareholder's loan may be evidence of a series of loans and repayments. For example, in Attis v Minister of National Revenue, the Tax Court of Canada ruled that subsection 15(2) did not apply where a shareholder extracted money from the corporation that he considered to be advances against his earnings but cleared them as dividends and bonuses. The Tax Court of Canada explained that this did not a constitute a series of loans and repayments. However, the Tax Court of Canada in Sandia Mountain Holdings v R held that subsection 15(2) applied where a series of loans and repayments were, by the shareholder, corporation and another related corporation, created to avoid the tax liability under subsection 15(2) of the Income Tax Act.
Further, the Tax Court of Canada decision in VanNieuwkerk v The Queen confirmed that shareholders can transfer personal assets to their corporation to reduce their indebtedness to the corporation. However, these transfers should be executed with caution as they pertain to a complex area of law that requires detailed analysis and advice from an experienced Canadian tax lawyer.
Tax Tips – Shareholder Loans & their Tax Implications
In summary, shareholder loans are perks to shareholders for investing in their corporation. However, it is significant for shareholders and their corporation to understand the provisions in the Income Tax Act relating to shareholder loans and their tax treatments. It is also crucial for corporations to implement effective business practices to prevent the abuse of shareholder loans by shareholders. For example, shareholders and their corporation should ensure that bona fide arrangements are made for the repayment of the loan within a reasonable time. Such arrangements can be made in the form of a written agreement or a corporate resolution setting out the terms and conditions of the loan.
If you have questions regarding shareholder loans, for assistance with drafting a shareholder loan agreement or for inquiries regarding the application and exceptions under subsection 15(2) of the Income Tax Act, please contact our office to speak with one of our experienced Certified Specialist in Taxation Canadian tax lawyers.