Intercompany Loans: Mitigating Tax Risks under Canadian Law
By Dale Barrett
Navigating the business landscape is no easy task, particularly when it comes to intercompany loans between corporations with a common owner. If you are a business owner who owns multiple companies but each entity does not hold shares in the other, or if you are an accountant of such related corporations, this article is for you.
While they are a useful tool to move money around to where it is needed within a group of businesses, from a Canadian tax perspective, intercompany loans present unique challenges and potential pitfalls if not handled correctly.
A key aspect of this scenario lies in how the Canada Revenue Agency (CRA) views these loans. If not considered a bona fide or legitimate loan by the CRA, adverse tax consequences may ensue. Therefore, understanding how to establish a bona fide loan and what steps you can take to demonstrate this to the CRA is crucial.
What Is A Bona Fide Loan?
In simplest terms, a bona fide loan is one made in good faith and with an expectation of repayment. To determine if a loan is bona fide, the CRA will consider factors such as the existence of a loan agreement, security or collateral provided, a fixed repayment schedule, and whether interest is charged at a rate consistent with market norms.
If the loan does not pass the bona fide test, it have negative tax consequences such as being considered as income to the borrower and thus subject to tax under the Income Tax Act (ITA). This means that the loan, instead of being a non-taxable movement of funds between your companies, could become a taxable event.
Making Your Loan Bona Fide
To ensure your intercompany loans are perceived as bona fide by the CRA, there are several measures you can undertake:
- Formal Loan Agreement: The most critical step is creating a formal written loan agreement between the lending and borrowing companies. This agreement should clearly define the amount of the loan, the repayment schedule, interest rates, and any collateral provided.
- Appropriate Interest: Ensure that the interest charged on the loan is consistent with market rates, and at very least, at the prescribed CRA rate. A low or non-existent interest rate could lead the CRA to classify the loan as income.
- Fixed Repayment Schedule: A bona fide loan should have a fixed schedule of repayments, demonstrating that the borrowing company has a plan and capacity to repay the loan.
- Evidence of Repayments: Actual repayments, especially in accordance with the loan agreement, add legitimacy to the loan in the eyes of the CRA.
- Security or Collateral: Providing security or collateral for the loan suggests that the lending company expects repayment, contributing to the loan’s bona fide status.
- Documentation: Keep meticulous records. Evidence that the loan has been treated as such by both companies can be crucial in demonstrating its bona fide nature to the CRA.
Risks and Penalties
If a loan is not deemed bona fide by the CRA, the tax implications can be severe. Not only could the loan trigger a tax payable, but the CRA can also assess penalties under the Income Tax Act.
If you have existing intercompany loans or are considering them, it is strongly recommended to seek professional advice from tax advisors or legal counsel. They can help navigate the intricacies of the ITA and ensure your companies are adhering to Canadian tax laws.
By following the steps above, you can mitigate the risk of adverse tax consequences and ensure your intercompany loans stand up to CRA scrutiny. Remember, when it comes to intercompany loans, good faith and a solid paper trail are your strongest allies.