Subject to certain exceptions, where a shareholder (other than a corporation resident in Canada) of a corporation is indebted to the corporation (a “Shareholder Loan”), the shareholder is deemed by subsection 80.4(2) to receive an interest benefit to the extent that the notional interest on the Shareholder Loan, calculated at the prescribed rate, exceeds the interest actually owing and paid. However, for a Shareholder Loan that was included in computing the income of a person under Part I of the Income Tax Act (for example under subsection 15(2)), paragraph 80.4(3)(b) provides that no subsection 80.4(2) interest benefit is deemed to have been received.
Accordingly, a Shareholder Loan may be subject to either subsection 15(2) or subsection 80.4(2), but not both. If a Shareholder Loan is repaid within one year after the lender's year-end, subsection 15(2.6) provides that subsection 15(2) does not apply, with the result that there is no income inclusion in respect of the Shareholder Loan. Instead, the shareholder includes a deemed section 80.4 interest benefit for the time that the loan was outstanding.
If a Shareholder Loan is repaid after the subsection 15(2.6) time period, subsection 15(2) continues to apply but the shareholder is instead entitled under paragraph 20(1)(j) to a deduction equal to the amount repaid in the year of the repayment.
A repaid Shareholder Loan that was subject to subsection 15(2.6) is subject to section 80.4 because the principal amount of the loan was not included in computing the income of a person. A Shareholder Loan that is repaid after the subsection 15(2.6) time period gives rise to a paragraph 20(1)(j) deduction instead. This deduction economically offsets the prior income inclusion under subsection 15(2), but does not eliminate or override the original inclusion for tax purposes. Thus, no deemed interest should apply to such a Shareholder Loan by virtue of the exception in paragraph 80.4(3)(b).
This interpretation of the interplay between subsections 80.4(3), 15(2.6) and paragraph 20(1)(j) is supported by CRA commentary in IT-421R2 and External T.I. 2018-0738871E5 and Chapter 24.12.6 of the CRA Audit Manual dated November 2019 (the “2019 Manual”).
A previous version of the CRA Audit Manual dated May 2015 (the “2015 Manual”) suggested that repaid amounts that had been included in a shareholder's income via subsection 15(2) and later deducted via paragraph 20(1)(j) are to be added to the section 80.4 calculation such that an interest benefit would be paid on those amounts in years after repayment. The 2015 Manual provided an example to this effect, and stated that:
A subsection 15(2) amount reduces the sum subject to section 80.4 with effect from the first day of the taxation year to which it relates. A paragraph 20(1)(j) deduction, on the other hand, increases the sum [subject to section 80.4] with effect from the beginning of the year after the one in which it is deducted.
Although not clear, this approach suggested that amounts that had been subject to Part I tax and later repaid would also be subject to a section 80.4 interest benefit. The language has since been updated in the 2019 Manual to clarify that subsection 15(2) takes precedence over section 80.4:
If a repayment of a loan or indebtedness has been made in a year, no carry-back to the previous year will be permitted. Instead, assessments will be issued under subsection 15(2) and paragraph 20(1)(j) in respect of the years in which the loan or indebtedness was incurred and repaid.
The 2019 Manual further clarifies that the amount of a Shareholder Loan or indebtedness that is subject to section 80.4 is calculated by “taking the current shareholder loan balance, subtracting all amounts assessable under subsection 15(2) for that year and all previous years, and adding all previous years' paragraph 20(1)(j) deductions”.
The addition of paragraph 20(1)(j) deductions to the amount that is subject to section 80.4 appears odd at first, as paragraph 20(1)(j) can only apply to an amount that has previously been included in income under subsection 15(2), and subsection 15(2) and section 80.4 are mutually exclusive – only one can apply in respect of a particular loan at any time. However, the equation in the 2019 Manual ultimately leads to a correct result because it is based on the amount of the current Shareholder Loan balance, not the original Shareholder Loan amount, and therefore any amounts that have been repaid have already been removed from the equation. The requirement in the equation to add in previous years' paragraph 20(1)(j) deductions effectively makes the calculation A – B, where A is the amount of the original Shareholder Loans and B is the amount of any Shareholder Loan that was included in income under subsection 15(2).
The adjustments made to the 2015 Manual in the updated 2019 Manual highlight and clarify an important distinction in the applicability and role of subsection 15(2.6) and paragraph 20(1)(j) in the context of Shareholder Loans. While both provisions reduce a shareholder's income, the important distinction is the timing of the reduction – subsection 15(2.6) retroactively cancels the subsection 15(2) income inclusion in the year that the loan was made, whereas paragraph 20(1)(j) provides a deduction in the year that the loan is repaid. As Subsection 15(2.6) cancels the subsection 15(2) inclusion, section 80.4 may still apply to the Shareholder Loan for the period during which it is outstanding, whereas a paragraph 20(1)(j) does not cancel out the original income inclusion, meaning that section 80.4 will not apply.
Originally published in Taxation Law section on the Ontario Bar Association Sections & Community page
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