Shareholder Loans, Benefits, and Their Risks
Incorporation isn’t all upside when it comes to taxes
As with most areas of Canadian law, corporations and their shareholders function as separate persons for tax purposes. The Canadian tax code spends a significant amount of space attempting to achieve “integration”, the principle that the same activities should be taxed similarly regardless of whether or not they are undertaken through a corporation. For example, directors of companies who pay themselves all their business’ profits as a salary or dividends end up with tax bills very similar to if they had operated the business personally. Incorporation can also provide significant opportunities to defer tax or spread income over several years. However, particularly where taxpayers fall behind or don’t keep their records up to date, they can end up stuck paying tax on all of their income at both the corporate and the individual level. While deft use of incorporation can allow individuals to defer tax and protect their own assets, incorporating is not all upside.
Section 15 of the ITA deals with some transactions between corporations and their shareholder, and businesses need to keep it in mind when managing their finances. This section covers both shareholder loans and benefits, among other issues. Shareholder loans are the more benign of the two. Corporations maintain an account recording loans from and to their shareholders. If, at the end of the year, the shareholder owes the Corporation money, the shareholder must claim this amount as income. However, should the shareholder pay back the loan down the road, they can claim a deduction in the same amount under paragraph 20(1)(j). Where paid back prior to the end of the year, shareholders may also be required to include interest in their income if they receive a low interest or interest-free loan.
Properly utilized, by keeping a record of payments and an eye on interest, shareholder loans can be an effective tool to compensate shareholders, where the balance of the loan is declared as a dividend during the year to clear the balance.
However, shareholder benefits are almost always to be avoided. Where a corporation provides a “benefit” to a shareholder other than by using specifically authorized tools such as dividends, salary, and the repayment of loans, the shareholder needs to include the value of that benefit in their income. “Benefit” is intentionally broad, including, but not restricted to, shareholders taking money from the company, underpaying for the company’s services, or the company covering their personal expenses. However, the corporation is not allowed a corresponding deduction—resulting in “double taxation”.
The Excise Tax Act, legislation governing GST/HST in Canada, contains similar rules to limit self-dealing shareholders, and the company may be required to pay sales tax despite never collecting any from its shareholders.
A prime example of this issue is a closely held corporation paying the expenses of shareholders. If the company is audited, the CRA will likely not only deny the expenses that the company claimed, but also assess the same amount as a benefit to the shareholder. As a result, both the company and the shareholder pay tax on the cost of the expense.
Where the CRA audits small businesses to assess whether they have reported all of their sales, this second level of tax can make an enormous difference, particularly because they generally assess penalties as well. For example, a director reports his corporation paying him $95,000 in salary in a given year; the CRA audits the company and determines that it underreported its sales by $50,000. For an Ontario business and resident, the tax bill from this would be: 37.16% combined federal and provincial individual tax, along with 12.5% corporate tax (for 49.66%), plus a 50% penalty, resulting in a 74.5% tax rate. With HST and HST gross negligence penalties for an additional 16.25%, CRA would assess combined tax of over 90% of the sticker price of unreported sales! And it can then use these same transfers of assets from the business to its operators to justify shifting all of this tax to them personally.
These additional layers also increase the resources and time required to fight any assessments, as while some or all of them may be dealt with together, the taxpayer still needs to file multiple objections or appeals to court.
As such, incorporated business should be particularly vigilant in maintaining airtight books and records. Maintaining, for example, detailed sales journals with numbered entries can prevent unreported income audits before they begin in earnest; keeping notes of who you have business meals with and what you discuss can prevent both disallowed meal & entertainment expenses and personal assessment.
Taxpayers looking to minimize tax may notice the frequent, and often publicized, use of corporations by wealthy Canadians to save tax. Seeing this, they might consider buying a cottage or second property through a Corporation, thinking that it could limit their exposure to capital gains taxes when they sold the home. However, owning a personal-use or partially personal-use property under a corporation’s name can create both a shareholder benefit for the individual (rent-free use of a home) and deemed income to the Corporation, creating a tax bill for both of them without any meaningful benefit.
Even leaving aside risks of double taxation, in some circumstances, corporations simply lose their tax benefits. For example, companies that are for all intents and purposes employees, referred to as “personal services businesses”, can claim few expenses available to other businesses.
If you are considering incorporating your business and hope to do so in a tax-efficient way, or if the CRA is threatening you with shareholder benefit assessments, contact Kalfa Law to speak with a member of our corporate, commercial, and tax law team.
-James Alvarez, BA, JD
James Alvarez is a tax lawyer working for the tax law group of Kalfa Law.
© Kalfa Law 2019