Tax Efficient Ways to Obtain Funds from Your Small Business

Jose L. Riquelme, CPA, CGA

Small businesses are critical to the health of the Canadian economy.  According to a recent study by the Government of Canada, small businesses (1-99 employees as defined by the Government) represented 97.9% of all enterprises in Canada. According to the same study, these businesses employed 8.4 million individuals in 2019 or 68.8% of the private labour force. In addition, small business contributed 41.9% to the Gross Domestic Product generated by the private sector in 2016.  Now that we are in past-pandemic mode, understanding the needs of small businesses will pay off in better tax and financial planning solutions. 

In fact, it is critical to develop efficient and effective public policies and tax incentives to foster entrepreneurship to allow these companies to become or remain competitive in an ever-challenging business environment.

One of the many challenges business-owners face is the difficulty to obtain financing for growth and development. Even more difficult is for entrepreneurs to obtain financing for a home or a vehicle. Traditional banks favour the employee with a salary with a steady paycheque instead of a business owner that has little or no salary but withdraws dividends from his/her Company (even though these dividends may be significant).   These challenges may even require co-borrowing or co-signing from others, which is not part of an ideal wealth management plan.

One way that tax policy intends to partially correct this problem is using shareholder loans. According to the Income Tax Act (ITA) any benefit obtained by a shareholder from his/her corporation, must be included in the owner’s personal income (ITA15(1)). If the same benefit is granted to a person related to the owner (e.g.: spouse, siblings, etc.) the benefit is also taxable in the hands of the shareholder. These are the general rules; however, there are three very important exceptions described as follows:

1. Non-Resident Persons: ITA 15(2.2) excludes non-residents, so there is no income inclusion on these loans
2. Ordinary Lending: ITA 12(2.3) excludes companies that are in the business of lending money. For example, if a business owner has a private lending company and he/she borrows money from the business, this loan does not need to be included in income of the shareholder provided there is a bona fide arrangement to repay the loan (interest + principal)
3. Repayment Within One Year: ITA 15(2.6) allows shareholders to have a loan outstanding from one fiscal year to the next without income inclusion provided it is repaid within the subsequent fiscal year and that this transaction is not a series of loans (repaid before the year-end and then borrow again at the beginning of the next fiscal year.

If as a business owner you need an abnormal cash advance from your company, it would be more tax efficient to take it as a loan and spread the repayment over two years having the income inclusion declared as dividends (the outstanding balance may be subject to imputed interest). This would lower the average personal tax rate on the owner.

 Further exceptions to the general rule are granted to shareholders who are also employees of their corporation:

• Not Specified Employee: Shareholders/Employees who own less than 10% of the voting shares of a business may receive loans from the company without the adverse effects of the income inclusion
• Housing Loans: Shareholders/Employees may borrow funds to acquire a principal residence (not available for investment properties)
• Loans to Acquire Stock of the Company: A shareholder/employee that obtains a loan to acquire shares in a lending corporation are excluded from the general rule
• Vehicle Loans: Shareholders/Employees may borrow funds to acquire a motor vehicle to be used in performing his/her duties of employment

These provisions may result in large amounts of capital taken out from the corporation without adverse personal tax effects. To avoid this, these loans must be made to the shareholder in his/her capacity of an employee rather than just a shareholder. Hence, in order to avoid the income inclusion, the loans must be made available to all employees (there may be loan thresholds). In addition, all these loans must be repaid using reasonable terms and interest rates. The rate for these loans is prescribed quarterly by the CRA. For Q1 2022 the rate is 1% and this rate will apply for the full term of the loan regardless of possible subsequent increases. If the rate subsequently falls below the initial level, adjustments may be made.

As an example, we’ll use shareholder Amber. She’s 100% owner of Opco. Her successful company has accumulated enough funds to make housing or vehicles loans of up-to $20,000 for her two employees and herself. Amber needs an additional $20,000 for the closing costs of acquiring a principal residence where she will be closer to her place of business. Instead of paying herself a bonus or a special dividend of $20,000; she will take it as a loan. She makes arrangements to repay the loan over the next 10 years and she will use the prescribed interest rate of 1% (2022 Q1). Assuming Amber is in a 50% tax bracket, she would save $10,000 in tax in the year she receives the loan. She will only have an income inclusion of $200 after a full year of interest resulting in an extra tax liability of $100. The balance of the loan may be repaid by advancing funds back into the company or by declaring a special dividend of $2,000 on top of regular dividends if any (preferred choice).

CRA may want to reassess the loan to be considered a fully taxable benefit; but as long as the owner/employee can demonstrate that the loan is also available to employees and that bona fide arrangements have been made, there should not be any problems. This makes it difficult for business owners that don’t have employees but also face the extra scrutiny from banks for being “self-employed”. Perhaps it’s time to revise these rules in recognition of the risks that entrepreneurs take to grow their business. Business owners may have enough funds to advance a loan for their home or employment vehicle, but not enough to lend to employees. Not allowing business owners to borrow in their capacity of shareholders results in an adverse tax burden that makes home ownership even more distant to entrepreneurs.

Bottom line:  Anything that helps entrepreneurs level the playing field, it’s a benefit for the economy and society as a whole.   

Additional educational resources: Check out the Tax Planning for Corporate Owner-Managers certificate course: save $200 on tuition until March 31.