Interesting Tax Saving Strategy…
Note: the information in this blog is NOT legal advice and is provided for educational purposes only. If you require advice / assistant, contact DMC LLP. Laws are subject to change with little notice.
Now… On the subject of avoiding (not evading) taxes, I thought I would share an idea that recently came up which allows you to build up cash in your professional corporation while paying minimum taxes. This strategy involves borrowing and repaying $$$ every year while paying yourself dividends. Now, keep in mind that it only works well if interest rates are low, you don’t need to show a lot of personal income taxes (because you’re not trying to qualify for anything, and the government has messed around with the tax laws).
So with that said, here’s the idea:
In Year 1, your dentistry professional corporation earns income, pays 15% tax (current rate) on active business income and then dividends out 50k. Let’s use 50k as an example, OK? It’s easy math. Then, you have your spouse (who is also a shareholder) receive 50k. Now you’ve got 100k worth of dividends that you need to pay tax on. How much tax? Well, not that much, since they’re non-eligible dividends and you may be using certain other tax-saving strategies. But let’s assume (for simplicity’s sake) that your overall tax bill is 2500 and so is your spouse’s. So that’s 5k in taxes that you’re paying personally to live on 100k.
Now for the next move: you borrow another 50k as a line of credit at a very good rate (assume it’s like 3% because you’re borrowing it from the equity in your home from your mortgage lender). So if you take out 50k, by the end of the year, you’ll have racked up 1500 in interest. Not that much to have access to 50k!
OK, so now you have access to 150k for the year. Here’s the kicker: have your spouse keep their 50k untouched. Use only your 50k plus the borrowed 50k. That’s year 1. In year 2, your spouse repays the loan with their 50k from year 1. And in year 2, you begin the process all over again (your professional corporation pays 15% tax on active business income and distributes dividends of 50k to each of you and your spouse while you borrow an additional 50k from the equity in your home). The best part is this: you’ll save a bundle in taxes, you can use the funds that are piling up in your corporation to invest in other income-producing assets, you’re only taking out 50k at a time (so you’re not paying that much in tax), plus you’re income-splitting with your spouse. If you have children or parents that you can also income split with in this way, even better. Importantly, the 50k you’re taking out from your home isn’t considered income so you’re not paying tax on it. And with interest rates at historic lows, borrowing and repaying 50k at a time and paying something like 1500 a year is a no brainer for having access to that kind of money.
Now, why can’t you just avoid paying the interest by borrowing from your own corporation (and not paying any interest)? Well, for starters, s. 15(2) of the Income Tax Act says that, where a person is a shareholder (i.e. you or your spouse) of a corporation and that person receives a loan from that corporation, then the amount of the loan “is included in computing the income for the year of the person”. Ouch!
But wait… there is an exception: Section 15(2.6) of the Income Tax Act says that section 15(2) doesn’t apply if the loan is repaid within a certain period of time AND if that repayment isn’t part of a series of loans or other transactions and repayments:
15 (2.6) Subsection 15(2) does not apply to a loan or an indebtedness repaid within one year after the end of the taxation year of the lender or creditor in which the loan was made or the indebtedness arose, where it is established, by subsequent events or otherwise, that the repayment was not part of a series of loans or other transactions and repayments [emphasis added].
So section 15(2.6) says that, if the corporate loan is repaid within 1 year after the end of the taxation year (of the lender/creditor in which the loan arose), then it would not need to be included in the spouse’s income (and hence no taxes would need to be paid). So, the shareholder would not need to include the amount of the loan in his or her income and pay taxes on it so long as the loan was repaid within 1 year from the end of the corporation’s taxation year.
To better understand this situation, take the following example. A corporation’s year end is August 31. A shareholder takes out a loan on December 31st, 2017. The clock would only start ticking on September 1st, 2018. The shareholder would only need to repay it by August 31st, 2019 to avoid including it in his or her tax return.
I bolded the last part of s. 15(2.6) for a reason. The Canada Revenue Agency Interpretation Bulletin (IT-119R4) on shareholder loans helps explain what is meant by the phrase “series of loans or other transactions and repayments”:
¶ 28. It is a question of fact whether or not a repayment of a loan is part of a series of loans or other transactions and repayments. In most cases, when there are only a few loans or other transactions and a few repayments made during a taxation year of a lender, there is no such series. However, when only one loan or other transaction and one repayment occur in each taxation year of a lender, a series of loans or other transactions and repayments may still be in evidence. This could occur, for example, when a repayment is of a temporary nature, such as a loan that is repaid shortly before the end of the year and the same amount, or substantially the same amount is borrowed shortly after the end of the year. Such a repayment of a temporary nature is not considered to decrease the loan balance in applying subsection 15(2) and paragraph 20(1)(j) to a series of loans or other transactions and repayments.
¶ 29. Persons affected by subsection 15(2) may have loan accounts, drawings accounts, or other similarly named accounts that contain several charges for loans, payments made to third parties on behalf of the shareholder, advances against future salaries, rents or anticipated dividends or other charges, and one or more repayments. If a shareholder has an account with a number of these features (a running loan account), all of the relevant factors will be considered to determine whether a series of loans or other transactions and repayments exists. Bona fide repayments of shareholder loans that result from, for example, the payment of dividends, salaries, or bonuses, are not part of a series of loans or other transactions and repayments.
So if a shareholder were to take out a corporate loan and repay that amount before the year end (e.g. August 31st), and then shortly thereafter take out “substantially the same amount” as was repaid before the corporation’s year end, then the Canada Revenue Agency may deem such transactions to be “a series of loans or other transactions and repayments” – for which the shareholder would need to include the amount as income under s. 15(2).
Oh yeah… and let’s not forget about the interest-free part of the loan. Section 80.4(2) of the Income Tax Act says that, where a person is a shareholder of a corporation and gets a loan, then that person will be deemed to have received a taxable benefit (i.e. must pay tax on) equal to the difference of the interest they paid in the year and the interest they should have paid in the year (i.e.a prescribed rate).
Bottom line: it’s probably better to pay a small amount in interest (e.g. 3%) to a third party creditor instead of trying to borrow money from your corporation and pay no interest. If you screw things up, you might be on the hook for paying income tax on BOTH the principal and the interest on the loan!