It happens often. You’re strapped for cash, so you hit up your brother/sister/mom/dad for a loan. It’s perfectly legal and perfectly normal.
But what if the loan doesn’t come directly from that relative? What if that relative owns and controls a private corporation and the loan is between you and that corporation?
In a recent Tax Court of Canada case on July 8, 2019, the CRA had reassessed a taxpayer to add loans received from a corporation controlled by her brother and his wife to her income.
Why did they do this?
The Income Tax Act has special rules that apply to loans advanced from a Canadian corporation to a shareholder or “connected person” (this includes related individuals). In effect, these rules can lead to an income inclusion in the hands of the borrower if the loans are not repaid by the end of the corporation’s year following the year in which the loan was advanced.
In this case, the court handed out punitive punishments.
The court felt that the taxpayer was negligent in avoiding obtaining appropriate tax advice with respect to the series of loans advanced between 2009 and 2012. The court allowed the CRA to reassess each of the taxpayer’s years in respect of the loans and add the amounts to her income. This was beyond the ordinary three-year reassessment period.
Effectively the loans were converted to taxable income for the taxpayer.
So how do you avoid this?
First, talk to your accountant and get advice whenever forwarding “loans” to related individuals. A plan can be documented to avoid the pitfalls if planning is sought out before the loans are made.
Loans and transactions with related parties have historically been touchy subjects with the CRA and income tax in general. Generally, any transactions with related parties should occur at fair market value, or in other words, they should mimic a regular commercial transaction.
Failure to comply with related party rules when dealing with private corporations can land you in hot water.
Further to this, the Liberal government has implemented the Tax On Split Income rules (TOSI) to prevent what they believe are unfair income-splitting advantages that owners of private corporations have had for years.
This has increased the complexity of tax reporting across the board for small business accountants and their clients.
We aren’t yet sure how the CRA will audit and enforce these rules but we can speculate that they will likely take a hard stance on the application of the rules, especially in situations where they feel the taxpayer has received an unfair advantage, or where the transactions do not reflect a true business transaction.