Why borrowing money from your company is a risky proposition
There are three basic ways that an owner-manager can draw funds from their company:
- Payment of wages/salary,
- Payment of dividends, and
- Repayment of loans previously advanced to the company.
However, many owner-managers have found that a fourth way to draw funds from their company is to simply borrow money from the company. This seems like a great idea until the company is audited by the Canada Revenue Agency (“CRA”) and the owner-manager finds themselves facing a large tax assessment and incurring significant professional fees to dispute the CRA’s assessment.
When an owner-manager borrows money from their company, the income tax rules generally provide that:
- the amount borrowed will be included in the owner-manager’s income for tax purposes, unless the loan is repaid within a certain period of time,
- where the loan amount has been included in the owner-manager’s income, the owner-manager may be able to claim a deduction for subsequent repayments of the loan,
- the owner-manager may be required to include an interest benefit in respect of the loan in their income.
By themselves, these rules don’t sound too bad. However, problems arise when there is insufficient legal and other documentation of the loan and repayments of the loan.
One of the first things that CRA auditors do when auditing an owner-managed company is to examine the shareholder loan accounts and the owner-manager’s bank accounts. If they find that the owner-manager has been drawing money from the company, and there is insufficient documentation to substantive the draws as being true loans, then the CRA will consider the draws to be shareholder appropriations.
Shareholder appropriations are required to be included in the owner-manager’s income, and there is no deduction available if the amount appropriated is subsequently repaid to the company. When the CRA assesses the owner-manager for additional income tax in respect of a shareholder appropriation, they will often also assess a “gross negligence” penalty. The gross negligence penalty is equal to 50% of the additional income tax assessed.
Not surprisingly, the CRA has a strong bias towards considering owner-manager draws to be shareholder appropriations instead of loans. Thus, the safest thing for an owner-manager to do is to only take money from their company in the form of salary/wages or dividends. If an owner-manager must borrow money from their company, it is critical to properly and legally document the loan and the repayment and to ensure that the company’s accounting records are consistent with the documentation.
Similarly, it is equally important that owner-managers who loan money to their company properly and legally document the loan and the repayment, and ensure that the company’s accounting records are consistent with the documentation. Failure to do so could result in the CRA treating repayments of the loan that the owner-manager receives from their company as shareholder appropriations.
The importance of properly documenting and recording shareholder loan activity (whether to or from the company) was made clear by the December 21, 2020 judgement of the Federal Court of Appeal (“the FCA”) in Deyab v. Canada (2020 FCA 222) [1].
The FCA’s decision appears to have created a legal presumption that, even where it is established that the shareholder of a company has previously loaned money to the company, any funds advanced to the shareholder by the company are being advanced as a benefit conferred on the shareholder and not as a repayment of the previous loans. To establish that the advances by the company are repayments of the previous loans, they must be legally documented as repayments, recorded as such in the company’s accounting records, and a “proper shareholder’s loan account” must be maintained.
How we can help
Contact the DMCL tax team for help with documenting and recording shareholder loans and repayments.
[1] The taxpayer’s appeal to the Supreme Court of Canada was dismissed on Jun 10, 2021.