What are Shareholder Loans?
Shareholder loans are funds that a shareholder of a corporation lends to the corporation or borrows from the corporation. For the purposes of this articles, we will focus on the part of money being borrowed by the shareholder from their corporation. Shareholder loans can be a convenient way to obtain short-term financing from the business, and it may be easier to obtain and have more flexible terms than traditional loans from a financial institution.
Shareholder Loans Rules and Regulations
When a shareholder takes a loan from a corporation, there are certain rules and regulations that must be followed to ensure compliance with the Income Tax Act (ITA). The following are some important rules to keep in mind:
- The loan must be properly documented: The terms of the loan, including the amount, interest rate, and repayment terms, must be properly documented in writing.
- Interest must be charged: The loan must bear interest at a rate that is at least equal to the CRA’s prescribed rate at the time the loan is made. The prescribed rate is set by the CRA on a quarterly basis and is currently 4%, and going up to 5% as of April 1, 2023.
- The loan must be repaid: The loan must be repaid in accordance with the repayment terms documented at beginning. If the loan is not repaid, the loan amount will be added to shareholder’s income in the year the loan was made (i.e. retroactive adjustment). An exception to this rule is if the entire loan is repaid within one year from the end of the taxation year of the corporation.
- Interest must be paid: Interest must be paid on the shareholder loan in accordance with the terms laid out. This interest on shareholder loan must be paid within 30 days after the end of the year. In the absence of this, the amount of interest at CRA’s prescribed rate will be added to shareholder’s income.
- Forgiveness of shareholder loans: If a shareholder loan is forgiven or cancelled, the amount of the loan will be treated as a deemed dividend to the shareholder and will be subject to tax.
Shareholder Loans One Year Rule
To clarify the one year rule on shareholder loans, let’s take an example.
Mr. Musk is a shareholder of a small private corporation called T Inc.
T Inc. has a December 31st year-end. On January 1, 2021, T Inc. lends Mr. Musk $100,000. The company did not document formal terms of the agreement.
CRA’s prescribed interest rate for all four quarters of 2021 was 1%. As such, Mr. Musk would need to pay $1,000 of interest to T Inc. before January 31, 2022. To the extent this amount is not paid, or underpaid, the shortfall will get added to Mr. Musk’s 2022 personal income.
As for the principal, Mr. Musk would have until end of 2022 to pay back the principal in order to not have $100,000 to be considered as his personal income.
To draw this point home, let’s say here we are in February 2023 and Mr. Musk did not pay back the loan and did not pay the interest in 2021 or 2022. CRA will then likely assess the following:
- Add $100,000 to Mr. Musk’s 2021 income via a reassessment.
- Add $1,000 to Mr. Musk’s 2021 income via a reassessment.
- Add approx. $1,756 to Mr. Musk’s 2022 income. Why that much? Because CRA’s prescribed rate increased to 2% in Q3 and 3% in Q4.
How To Clear Shareholder Loans Balance Instead of Repayment
Let’s say the shareholder drew lump sums of money from the corporation during the year. At year-end, the shareholder determines that they do not intend to pay back the money. Here is how they can clear the balance:
- Process as Salary or Bonus – Note that the lump sum taken by the accountant will be treated as Net Pay for salary. The shareholder can work with their accountant to back-calculate the income taxes and CPP and remit the source deductions, plus company matching of CPP, to CRA by January 15th (for a non-accelerated remitter). This would then be captured on the T4 (due by end of February) and wash out the shareholder loan balance.
- Process as Dividend – In this case, the lump sum would be reported on a T5 slip and issued to the shareholder by end of February. The dividend will then be added to shareholder’s personal income.
Shareholder loans can be a convenient way for short-term financing between a corporation and its shareholders, but it is important to ensure that these loans comply with the rules and regulations set out by the CRA. Failure to comply with these rules can result in significant tax consequences for both the corporation and the shareholder. If you need help with your questions around shareholder loans or general tax planning for your business, reach out to our team here at Think Accounting!