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It is common for financial institutions to require personal guarantees from shareholders or even family members of shareholders to secure corporate debt. There are also scenarios where related companies will guarantee the debt of other companies.
It should be apparent to those who guarantee the debt that they may have to honour the obligation if the debtor fails to meet its banking requirements. However; do they understand what happens from an income tax perspective when they have to make good on the loan? What happens if they have to borrow funds to repay the debt? Is the interest deductible? Do they get any "credit", that is, a deduction for the amount paid to honour the debt?
The obligation to fulfill the commitment of a guarantee commences upon the debtor defaulting on its responsibility to service the debt. Payments made by the guarantor may be characterized as a capital loss, business investment loss or could be deemed to be nil. The guarantor is considered to have acquired the debt at the time of honouring the guarantee equal to the amount paid under the guarantee. If the guarantee has been given for adequate consideration, that is, a guarantee fee is charged, it will generally be considered to have been given for the purpose of gaining or producing income. Therefore, it may be possible to treat the amount paid by the guarantor as a deductible capital loss or business investment loss.
Where a guarantee of corporate debts is made for inadequate consideration, that is, no guarantee fees paid, the Canada Revenue Agency has taken the position that the guarantee was not given for the purpose of gaining or producing income from a business or property and may deny the loss or restrict it to a capital loss.
Generally, losses that result from the disposition of debt are not deductible unless the debt was acquired for the purpose of gaining or producing income from a business or property or as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm's length. In situations where the shareholder has guaranteed the debt of the corporation, it may be possible for the shareholder to treat the amount paid as a business investment loss if certain criteria are met even if inadequate consideration was made to the shareholder (guarantor).
Guarantees honoured by non-shareholders of a corporation, that is, other family members, may result in situations where the loss incurred by the family member is not deductible due to inadequate consideration being received for granting the guarantee.
If the guarantor borrows money to honour the guarantee, interest payable on that borrowing may be deductible if the guarantor is able to show an income earning purpose associated with the borrowing.
Where providing guarantees is part of the guarantor's business, that is, a guarantee fee was charged, interest expense on borrowed money to honour the guarantee would generally meet the requirements of deductibility.
If no fees were charged for guaranteeing the corporate debt, the direct use of borrowed money to honour the guarantee would not be considered for an income earning purpose and the interest on the loan would not be deductible.
An exception to the direct use rule is where the guarantor (shareholder) can show that the guarantee was given for the purpose of increasing its income-earning capacity and borrowed money is needed to honour the guarantee. The borrowed money in this situation may be considered to be used for the purpose of earning income where it can be demonstrate that the indirect use test is met; such as a parent company guaranteeing the debts of its wholly owned subsidiary whereby it can earn income via dividends to be received from the subsidiary.
When you have a situation where a non-shareholder is the guarantor and a loan is needed to honour the guarantee, if inadequate consideration is received, the interest on the loan may be non deductible along with the loss incurred by the guarantor for guaranteeing the debt.
When agreeing to guarantee a loan, one must consider that they may have to honour the guarantee but should also be aware of the income tax limitations if a guarantee fee is not charged for the service of guaranteeing the corporate debt especially if the guarantor is not a direct shareholder of the company.
Related Topics:Financial Institutions; Shareholders
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