There are a few reasons Canadian companies can choose to grant a loan. However, corporations need to be aware that lending to non-residents can lead to a requirement for the Canadian company to pay tax. Clearly, this situation is far from ideal. In this article, we will look at the tax implications of Canadian corporate loans made to non-residents.
For a more fundamental look at corporate loans, visit our earlier article Canadian Corporate Shareholder Loans. Alternatively, visit another one of our resources: Shareholder Loans – How to Get Cash out of Your Corporation Tax-Free.
Section 17 of the Income Tax Act has a particular application. It involves corporate loans to non-residents that are outstanding for one year or longer. According to 17(1), the loan’s interest rate cannot be less than the CRA’s prescribed rate of interest, which is presently 1%. If the two rates are different, the corporation must include the difference as earnings. You can find the difference by subtracting the loan’s interest rate from the prescribed one.
The government originally established this section to prevent Canadian corporations from avoiding income tax through low-interest loans to non-residents.
Canadian corporate loans to non-residents – exceptions to income inclusion
Even if a low-interest loan is made, a corporation can still avoid income inclusion if they meet one of the following.
- If the corporation has paid Part XIII withholding tax, see below.
- If the non-resident debtor is a Controlled Foreign Affiliate (CFA) of the Canadian corporation. (By definition, a CFA is a foreign subsidiary corporation of the Canadian parent company).
- If the amounts owing are related to transactions arising in the ordinary course of business (i.e.: trade receivables and/or trade payables).
Part XIII tax
The government of Canada requires Non-residents to pay Part XIII withholding tax on certain incomes received from Canadian corporations. The most common type of withholding tax under part XIII is the dividend withholding tax of 25%.
Where a loan is owing by a non-resident company or individual to a Canadian corporation in which the non-resident has shares, part XIII tax of 25% will apply to the loan balance if the loan has been outstanding for more than one year. This is a result of the application of section 17 of the Income Tax Act. The reasoning behind this to prevent non-residents from stripping cash retained earnings from Canadian companies without paying any tax to Canada.
For example, assume that Mr. X is a non-resident of Canada and is a 40% shareholder in a Canadian private corporation. Mr. X decides to buy a Ferrari for $300,000. To do so, he takes a loan of $300,000 from his Canadian private corporation. If it were not for section 17 of the Income Tax Act, Mr. X would avoid paying any Canadian taxes on the $300,000 loan received. If the loan is outstanding for more than one year, section 17 requires a withholding tax of 25% ($75,000) on the $300,000 loan to be paid. The Canadian corporation is responsible for collecting this withholding tax.
If the non-resident’s country clarifies their tax obligation through a treaty, Part XIII withholding tax may be recovered. To learn about Non-Resident Corporations, visit Osler: New Canadian Amendments: Foreign Affiliate Dumping, Loans to Non-Resident Corporations, Thin Capitalization and Partnership Bumps and Sales.
Controlled Foreign Affiliate
Subsection 17(8) deals with Controlled Foreign Affiliates (CFA’s). If a Canadian Resident Corporation lends to one of its CFA’s, there is no income inclusion for low-interest loans and part XIII tax does not apply. The non-resident has to be a CFA throughout the corporation’s tax year during which they owe the loan. This paragraph applies where the company makes a loan or advance of money, and the CFA uses the funds to earn income from an active business. Alternatively, they could loan to another CFA of the corporation for them to earn active business income. Section 17’s definition of a CFA is more restrictive than the usual one. Specifically, the non-resident must be a CFA of a resident corporation lender or a corporation related to it. A shareholder loan can sometimes not be considered a loan by the CRA. To learn more, visit when is a Shareholder Loan not a Loan?
For example, assume that ABC Corporation (which is a Canadian private company) makes a loan of $1,000,000 to its subsidiary company in the United States. The loan has been outstanding for more than one year. The subsidiary corporation uses the loan proceeds to expand its business. In this case, part XIII tax will not apply because the subsidiary corporation is a controlled foreign affiliate and the monies are being used in an active business.
Finally, there is an exemption for amounts owing to Canadian resident corporations about particular transactions. An example is providing goods or services to an unrelated non-resident. However, terms of the agreement have to be similar to people dealing at arm’s length typically negotiate. For example, assume that your Canadian company hires a subcontractor in the US to perform a service over one month. The terms of payment are 120 days from the invoice date. Interest is not charged on the accounts payable balance. Because this is a trade receivable, the taxing shareholder loan rules will not apply.
If your organization is thinking of loaning to a non-resident, be sure that the loan is at a suitable rate. Otherwise, see if you meet one of the previous conditions to avoid income inclusion. To learn more about corporate loans to non-residents, visit Tax Traps & Tips: Loans to Non-Residents of Canada.
The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.