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Introduction – Shareholder loans and subsection 15(2) of the Income Tax Act
Shareholders can derive economic benefits from their corporation through a variety of channels, including salary, dividends, and shareholder loans. Shareholder loans are a common business practice that allows shareholders to extract funds from their company and they induce shareholders to invest in the company. The Income Tax Act contains complex provisions relating to the tax treatment and impact of shareholder loans. This is 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 – Shareholders’ debt and inclusion in income
Subsection 15(2) of the Income Tax Act (Canada) deals with “the direct loan of money by a corporation to its shareholder” and the inclusion of such loan in the shareholder’s income . In Lust v. Canadathe Federal Court of Appeal confirmed that the purpose of subsection 15(2) is “to include in the income of a shareholder amounts received from a corporation in the form of loans or other indebtedness”.
Subsection 15(2) of the Income Tax Act provides that where a person or partnership is: (a) a shareholder of the corporation; (b) related to a shareholder of a corporation; or (c) holds Company Shares through a partnership or a Company Trust, and as a result of such holding, the person or partnership has received a loan or is indebted to (i) the company; (ii) a related company; or (iii) a partnership of which that corporation or any related corporation is a member, then the loan or indebtedness will be included in the income of that person or partnership for the taxation year in which the loan arose. consented to, with exceptions in certain circumstances.
Subsection 15(2) does not apply where the borrower is a corporation resident in Canada, or where the borrower is a partnership that is a shareholder of a corporation resident in Canada.
Exceptions to income inclusion
Where a shareholder or taxpayer related to the shareholder can establish that the loan from the corporation falls within one of the exceptions in subsections 15(2.2) to 15(2.6), the loan will not be included in the shareholder’s income in accordance with subsection 15(2).
On the one hand, subsections 15(2.3) to 15(2.5) provide for income exceptions when the loan is made for a specific purpose. By contrast, subsections 15(2.2) and 15(2.6) provide for income exceptions where the loan is made in certain circumstances.
The most common exception to the rules is found 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 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 of the capital of a housing co-operative for the purposes to allow the individual to live in the dwelling while it belongs to the corporation; (b) acquire shares of the company or of another company related to that particular company; or (c) the acquisition of a motor vehicle to be used by the borrowing employee in the performance of his duties or employment; (d) the borrower or his or her spouse or common-law partner received the loan because of his employment rather than his shares in the company; and (e) at the time the loan was made authentic arrangements have also been made for repayment of the loan within a reasonable time. When a corporation lends money to a shareholder who is also an employee of the corporation, the tax treatment rules under the Income Tax Act require determining whether the loan is received by the taxpayer as shareholder or employee. In Mast against queenthe Tax Court of Canada referred to the Canada Revenue Agency’s (“CRA”) Interpretation Bulletin IT-119R4 which provides that the determination of the capacity of the borrower involves a finding of fact in the case per case.
Subsection 15(2.2) provides that subsection 15(2) does not apply if the debt is incurred between non-residents. For non-resident shareholders, paragraph 214(3)(a) deems amounts included in subsection 15(2) to be a dividend. Accordingly, corporations must remit withholding tax to non-residents in accordance with subsection 212(2).
Subsection 15(2.3) provides that subsection 15(2) does not apply if the loan is made to a borrower when the loan is made in the ordinary course of the lender’s business and at the time the loan was made authentic arrangements have also been made for repayment of the loan within a reasonable time.
Subsection 15(2.5) provides that subsection 15(2) does not apply where the loan made in respect of a trust (a) the lender is a private corporation, (b) the corporation is the settlor and the sole beneficiary of the trust, (c) the purpose of the trust is to facilitate the purchase or sale of shares of the company or another related company, and (d) at the time the loan was made
authentic arrangements have also been made for repayment of the loan within a reasonable time.
Subsection 15(2.6) provides that if a shareholder loan is prepaid within one year after the end of the taxation year of the lending corporation and so long as the amount of the repayment was not part of a series of loan transactions or repayments, subsection 15(2) does not apply and the loan is therefore not included in the borrowing shareholder’s income. In Canada Trustco Mortgage Co v. The Queenthe Supreme Court of Canada explains that “a series of operations involved a certain number of operations which are predetermined to produce a given result”.
Repayment of shareholder loans and deduction under paragraph 20(1)(j)
Paragraph 20(1)(j) of the Income Tax Act provides that where a shareholder repays all or part of a loan that was included in his income under subsection 15(2), the amount of the refund is deductible in computing income for the year in which the refund was made. According to the CRA, what constitutes a refund is a question of facts that is decided on a case-by-case basis.
In certain situations, temporary repayments of all or part of a shareholder loan may constitute evidence of a succession 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 took money from the corporation which he considered to be an advance of his earnings, but took it eliminated in the form of dividends and bonuses. The Tax Court of Canada explained that this was not a series of loans and repayments. However, the Tax Court of Canada in Sandia Mountain Holdings vs. R held that subsection 15(2) applied where a series of loans and repayments were, by the shareholder, the corporation and another related corporation, created to avoid tax liability under subsection 15( 2) of the Income Tax Act.
In addition, the decision of the Tax Court of Canada in VanNieuwkerk against the Queen confirmed that shareholders can transfer personal assets to their company to reduce their debt to the company. However, these transfers should be executed with caution, as they involve a complex area of law that requires detailed analysis and advice from an experienced Canadian tax lawyer.
Tax advice – Shareholder loans and their tax implications
In summary, shareholder loans are benefits for shareholders to invest in their company. However, it is important for shareholders and their corporation to understand the provisions of the Income Tax Act regarding shareholder loans and their tax treatment. It is also crucial for companies to implement effective business practices to prevent abuse of shareholder loans by shareholders. For example, shareholders and their company should ensure that authentic arrangements are made for repayment of the loan within a reasonable time. Such arrangements may 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 in drafting a shareholder loan agreement or for questions regarding the application and exceptions under subsection 15(2) of the Act income tax, please contact our office to speak to one of our experienced Certified Tax Specialists Canadian Tax Lawyers.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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