Tax consequences of borrowing to and from your company
When faced with a sudden need for capital, some business owners end up borrowing money between themselves, other investors, and their own company coffers – without analyzing the true costs and benefits.
In this article, we explain some of the things you should know if you’re planning to use your company as a means of financing.
Borrowing from Your Company
You can receive a shareholder loan by borrowing money from your own company.
The Income Tax Act of Canada has serious tax implications for shareholder loans that apply to anyone who borrows money from a corporation – whether they’re a shareholder or a person closely related to the company.
These rules often cause unexpected consequences that can increase your personal and corporate tax bills.
Here are two rules that apply to any Canadian who borrows from a corporation:
- If you pay off the loan quickly, you can avoid paying tax on the loan. If the loan is not repaid after a certain period, CRA can deem it to be shareholder income and tax you on it.
- If you, as a shareholder, do not pay interest on the loan or pay it late, CRA will tax you for the “benefit” you received by not paying interest.
Lending to your Company
Preventing Share Dilution
Share dilution is one of the main reason business owners issue debt to themselves instead of new equity. Share dilution happens when the market value of a company stays the same but the number of common voting shares increases, often causing discord amongst the equity holders.
There are two main reasons why shareholders do not like dilutive financing:
- It often leads to a decline in the share price.
- New equity issuances can change an investor’s position from a majority stakeholder to a minority shareholder, decreasing their influence over decision-making.
Issuing debt instead of equity helps the business remain coherent, especially when the shareholders are heavily involved with management.
Most corporations improve their bottom line when they issue debt.
Cash flows from interest payments are tax-deductible (“above the line” on the income statement), which means corporations can pay less tax every year by favouring debt over equity.
Equity vs Debt for Investors
Equity positions always carry a degree of uncertainty. By lending money to your company instead of owning more shares, you trade an unknown future share value for a prearranged sequence of interest payments.
Debt financing gives you certainty by helping you estimate your tax liability before year-end. This is especially relevant for entrepreneur who are responsible for making tax deductions and payments.
Issuing debt is an easy way for corporations to raise funds while preserving equity structure. By taking advantage of interest payment deductions, corporations face a smaller tax bill at year-end.
If you’re not sure if you should issue debt or equity to your investors, or if want to know more about the management and tax consequences of each decision, contact Du Plooy Law to meet with one of our lawyers.
As of the date of publication, the contents of this article are believed to be accurate and reliable; however, tax laws are complex and subject to change on an annual basis. Before implementing any tax or succession plan, you should always consult professional legal and accounting advice.
This article is purely educational in nature and is not to be construed as legal advice. Du Plooy Law does not accept any liability for the tax consequences that may result from actions made based on this article.