Health care professionals who own shares in professional corporation (“PC”) can withdraw money from their PC in a variety of ways. These ways include expense reimbursements, salaries, dividends, management fees, a return of original investment made (known as return of capital) to name just a few. All of these are legitimate and permitted by the Income Tax Act (“ITA”). But a PC can also lend its shareholder money. These loans are called shareholder loans; the term given to advances taken from a PC. They aren’t formal loans as a loan from the bank is formalized with an application and legal documents. The Canadian Income Tax Act contains numerous provisions addressing the tax treatment of shareholder loans, many of which are designed to prevent their abuse by shareholders.
Loans to Shareholders Included in Income
According to provisions set out in subsection 15(2) of the ITA, withdrawals from corporations by non-corporate shareholders and taxpayers connected with such shareholders must be included in the recipient’s income if the withdrawal is characterized as a shareholder loan. The reason? Simply this; in the absence of subsection 15(2), individuals would take loans rather than income to avoid paying income tax. Subsection 15(2.6) of the ITA moderates the general rule by providing the following exception: If the loan is repaid within one year from the end of the taxation year of the corporation in which the loan was made, it will not be included in the income of the borrower during the time that the loan was outstanding.
An example: Dr. Mallory borrows $250,000 from her PC on August 1, 2019 for a landscaping project. Her PC (the lender) has a year-end of July 31, 2019. According to subsection 15(2.6) of the ITA, Dr. Mallory (the borrower) has until July 31, 2021 to repay the loan in one form or another. If she doesn’t to repay the loan by July 31, 2021, then the loan plus interest is added back to her 2019 income. (Note: Non-deductible interest will be charged by CRA on the resulting tax balance from April 30, 2020 – the 2019 payment due date.)
Relieving Provision – s.20(1)(j) of the ITA
If Dr. Mallory doesn’t repay the loan within one year of her PC’s year end such that the borrowed amount is included in her 2019 income under s. 15(2), s. 20(1)(j) permits Dr. Mallory a deduction in the year when the loan is eventually repaid.
Additional Tax Consequences to Both Parties
Even if repayment is made within one year following her PC’s year end, as required, an interest benefit is considered to have been received by Dr. Mallory; after all, she didn’t pay her PC any interest for the money borrowed. So, interest is added to Dr. Mallory’s income, by virtue of s. 80.4(2) at a rate established quarterly by the CRA (known as the prescribed rate). If Dr. Mallory had paid her PC interest, then this taxable benefit would have been avoided.
Repay Shareholder Loans Within Two Corporate Year-Ends
As discussed above, the consequences of running afoul of the shareholder loan provisions in the ITA, can result in harsh, retroactive consequences. However, repaying a shareholder loan within two corporate year ends is a foolproof way of avoiding the imposition of the ITA’s subsection 15(2). Funds borrowed are seldom repaid to the PC. Rather repayment typically occurs by the PC declaring a salary or dividend sufficient to eliminate the borrowed amount. The salary (or dividend) declared by PC is then reported as income to the borrower with personal income tax being paid as a result. Of course, as you borrow funds from your corporation, you are best advised to have up-to-date bookkeeping in place to keep track of draw and repayment dates to avoid the consequences of ITA sections such as subsection 15(2).
Obtain Professional Advice Beforehand
The rules contained within the ITA pertaining to shareholder loans are complex. If care is not exercised, the consequences of subsection 15(2) can be dire. To successfully navigate the ITA’s provisions, the expertise of a Chartered Professional Accountant should be sought. If you have not retained a Chartered Professional Accountant contact Jonathan Tucker, CPA, CA, LPA today to obtain the advice you need.