The “Dark Path”: Subsection 15(1) of the Income Tax Act
There are many provisions in Canada's Income Tax Act (ITA) that are cause for concern for the unwary taxpayer. However, few have the broadness of application or the potential for damage of subsection 15(1).
The Canada Revenue Agency (CRA) has a number of provisions in the ITA to prevent shareholders from extracting wealth from a corporation without attracting income tax. Subsection 15(1) is, in many respects, a catch-all. It provides generally that, where a corporation has conferred a benefit on a shareholder, the value of that benefit will be included as income to that shareholder. The amount, or value, of the benefit is taxed as regular income to the shareholder in the year the benefit is conferred. The provision also applies to a person contemplating becoming a shareholder.
Staying in the light
Generally, when shareholders (particularly of private corporations) extract wealth from their corporations, they do so in the form of employment remuneration (salary, wages and bonuses), investment income (dividends or interest), or an assortment of methodologies sanctioned by the ITA (private pension plan contributions and private health service plans (PHSPs), to name a few). These approaches are, by and large, well-established and generate few concerns if executed properly.
In many cases, shareholders will draw on funds owed to them from their corporations out of their shareholder's loan accounts. A shareholder's loan account is somewhat akin to a kitchen sink in that it is a repository for all contributions made by a shareholder to a corporation, less draws taken by the shareholder.
Contributions to the account may be in the form of unpaid dividends or bonuses, cash contributions, or operating expenses paid for the corporation. Draws may be of cash, personal expenses paid by the corporation, or the value of corporate assets used by the shareholder. Generally, one will have strayed and started down the "dark path" when the values of these draws are not properly charged to the shareholder's loan account.
Knowns and unknowns
There are three important definitions relevant to the concept of a shareholder benefit.
First, the term "shareholder" is defined as a person (individual or corporation) who is entitled to receive payment of a dividend from the corporation. The quantum of the shareholdings is not, in itself, an issue.
Second, there is no definition of "benefit" in the ITA. Accordingly, the term has received broad interpretation, covering all manner of transactions between shareholders and their corporations. Taxable benefits can include:
- Personal use of corporate assets (e.g. real estate, aircraft, horses)
- Corporate payment of personal expenses
- Gifts to shareholders' relatives
- Inadequate consideration for sale of corporate assets
- Travel reward points
- Excessive payments under PHSPs
Finally, the "value" of the benefit must be established. This is by far the most subjective and contested of the three concepts. The CRA's position, that the value of the benefit is equal to its fair market value, raises issues concerning the determination of that fair market value. In some cases, the CRA's valuation approach to the personal use of corporate assets can lead to the value of the benefit greatly exceeding what the property could have earned in the form of rent from the asset in question.
The end of the road
The application of subsection 15(1) to a transaction can create some unpleasant tax consequences. Not only is the amount of the benefit taxed to the individual at the applicable marginal tax rates, there may be no deduction to the corporation for the amount, even if the benefit is repaid by the shareholder.
For example, in a situation where a personal shareholder expense is paid for and deducted by the corporation, not only will the deduction be disallowed to the corporation, but the value of the benefit will be taxed to the shareholder as well. For an investment corporation in the province of Alberta, say, this could create an initial combined tax liability at 83.67% the value of the benefit. Once penalties and interest are added, an assessment under subsection 15(1) can easily generate a tax liability equal to the value of the benefit.
GST liabilities can also result in situations where subsection 15(1) applies.
There may be ways to avoid an assessment under subsection 15(1). No "benefit" will arise from a bona fide business transaction between the shareholder and the corporation. As well, if one can demonstrate that the benefit arose as a function of employment, as opposed to shareholding, the income tax consequences can be mitigated and in some situations extinguished.
Further, there are certain exceptions in the ITA to the subsection 15(1) income inclusion, though they tend to exist only as a function of some other section of the ITA catching and taxing the transaction. Further, on appeal, certain arguments (like being a victim of unintended bookkeeping errors) have been occasionally, but certainly not consistently, successful in mitigating the damage.
Shareholders of private corporations should be aware of situations to which subsection 15(1) may apply. Be sure to ask your Collins Barrow adviser how to stay off the "dark path."
Brian Mitchell, CA, is a Tax Partner in the Banff office of Collins Barrow.
Information is current to February 7, 2012. The information contained in this release is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.