One of the benefits to incorporate your business is access to a shareholder loan (SHL). The Income Tax Act (ITA) and the Canada Revenue Agency (CRA) have rules and policies on how the SHL should be managed and taxed.
Review of shareholder loan in ITA:
Shareholder under the ITA is defined as a person, partnership, or trust that owns ownership in share capital in the corporation. Shareholders can take assets from his/her/its corporation as shareholder loan draws. Vice versa, shareholders can pay for assets or expenses on behalf of his/her/its corporation as a shareholder loan.
Just like most loans, there are principal and interest portions. The principal portion is, simply put, what the shareholder borrowed. The interest portion is calculated at the higher of (1) prescribed rate by the CRA and (2) the agreed rate.
The loan from the corporation must be repaid within a year after the taxation year. If the loan is not repaid within a year, the loan and interest are added to the shareholder’s taxable income. When the repayment happens, the ITA section 20 (1) (j) applies.
Repayment of the SHL:
The section 20 (1) (j) defines the shareholder loan repayment as follows:
Shareholder Loan Repayment
(j) such part of any loan or indebtedness repaid by the taxpayer in the year as was by virtue of subsection 15(2) included in computing the taxpayer’s income for a preceding taxation year (except to the extent that the amount of the loan or indebtedness was deductible from the taxpayer’s income for the purpose of computing the taxpayer’s taxable income for that preceding taxation year), if it is established by subsequent events or otherwise that the repayment was not made as part of a series of loans or other transactions and repayments;
The repayment of the interest must be paid in the calendar year or by Jan 30 in the following year. Therefore, shareholders have a maximum of [365 days + 30 days] 395 days to pay shareholder loan interests. Although the principal portion is paid wholly, the interest portion – that was accrued during the year – must be calculated and paid back to the company within the payment deadline. If the interest was not paid, the interest portion must be included as a low-interest benefit to the shareholder’s taxable income.
The principal portion must be paid within 1 year after the financial year. If the shareholder fails to do so, the shareholder should include the principal and interest portions to his/her/its taxable income.
The repayment of the shareholder loan can be formed in 4 ways:
- Repayment: paying the loan by cheque or cash to reverse the debit SHL balance
- Dividend payable: the dividend can reverse the debit balance, but this is only available if the retained earnings are positive and higher than the shareholder loan balance
- Bonus payable: the bonus can reduce the taxable income and tax payable. However, the bonus has its restriction to be paid within 180 days after the financial year.
- Forgiven loan: under ITA section 15 (1.2), the loan can be forgiven. “[T]he forgiven amount will be included as income in the shareholder’s hands in the year of forgiveness, as per s. 15(1.2) of the Income Tax Act.”
In case of the debit shareholder balance, this repayment (including dividends and interests) up to retained earnings balance should be dividended out for the most optimal tax consequence. However, there are exceptions to this. If the corporation exceeds it’s small business deduction limit, the bonus payable can be a better option.