How the prescribed interest rate interacts with employee loans

We hear about prescribed rate loans most often in the context of spousal tax planning. However, it’s probable that non-arm’s length loans are more commonly used between employers and employees.

This is a good time to bone up on where the opportunities and exposure lie, as it’s possible the prescribed rate will rise soon. For those holding or contemplating an employee loan, an increase in the prescribed rate could affect the personal cash flow required to service the interest and, potentially, the tax benefit.

Scope of employee loans

Salary or wage compensation for labour is the most common exchange between an employer and employee. Beyond that, there are also familiar benefits like health and dental coverage, and life and disability insurance.

It is also not uncommon for employers to loan money to employees, often on quite favourable terms. This covers cash, including an advance or overpayment of salary, and also captures unpaid cost of goods or services. The arrangement could even have the employer paying interest on behalf of the employee to a third-party finance provider.

Whichever form it takes, if your client doesn’t repay the loan, the value will be a fully taxable employee benefit. However, if you are set up to pay it back, the taxable benefit will be reduced under the employee loan rules.

Caveat for shareholder-employees

If you are both an employee of the business and a shareholder (or connected to a shareholder), the rules are different. It is a question of fact as to whether the loan is received by virtue of the employment relationship or the ownership interest.

If it’s the latter, the shareholder rules kick in, which are quite complicated. In brief, not only might there be a taxable benefit for any interest differential from the prescribed rate (calculated similarly to the employee loans), but the entire loan amount could be taxable.

Tax benefit calculation

The value of the taxable benefit for an employee loan is:

the prevailing prescribed interest rate applied to the outstanding loan amount, plus any interest paid by the employer on the employee’s behalf, LESS
actual interest paid by the employee during (or within 30 days after) the calendar year, plus any repayment of employer-paid amounts.

In a simple direct loan where the interest rate is lower than the prescribed rate, the difference is the taxable benefit. For example, if the prescribed rate is 1% all year, the taxable benefit on a $1,000 no-interest loan is $10. In reality, the calculation is more complicated as the prescribed rate is set quarterly, with the taxable benefit based on the day-to-day outstanding loan balance.

As is often the case, if the loan rate floats with the prescribed rate, then there will be no taxable benefit—assuming all interest is paid on time by the employee. This still means that the employee has to come up with cash to pay the interest, as well as the cash to eventually retire the loan principal.

Home-purchase loan

One special application of employee loans is for the purchase of a residence or to retire an existing mortgage. The residence can be for the employee or a related person (generally immediate family).

Such a loan may stand on its own or be a part of broader borrowing. For tracking, it is preferable to isolate the home-related debt.

What makes these loans special is a five-year lockdown of the prescribed interest rate from the day the loan was advanced. That will continue to be 1% at least to the end of 2017. If the loan is not retired in that time frame, then it can be renewed with another five-year lockdown, which will be based on the prescribed rate five years to the day from when the loan was established.