Mark Hunter pointed out to me that paragraph 20(1)(j) of the Income Tax Act (Canada) doesn’t work well as an income-averaging tool if used in circumstances where the person taking the loan can’t repay it any time soon or will do so in a year without much income.
For example, if Dad’s Opco advances funds to junior, which are included in junior’s income under 15(2), but Dad will have to take a dividend or salary from Opco to allow junior to repay the amount in a year when junior won’t have much income, then it is likely that not much has been accomplished from a tax perspective, and it is possible that Dad and junior will be worse off than if Dad had just given the money to junior. Junior won’t be able to make much use of the deduction, if he won’t have much income, but he might have had to pay some top-rate tax in the year of the 15(2) income inclusion. Dad, meanwhile, will likely pay some top-rate tax on his extra salary or dividend from Opco regardless of when he takes it.
Or what if junior does repay the loan from his own resources, but the repayment must wait for many years (perhaps because junior’s career is slow starting)? Is the present value of the future tax savings worth more than the present-day tax that must be paid on the loan? Of course, the answer might not matter if the only alternative is to have Dad, at a time when he’s in a higher tax bracket than junior, take extra salary or a dividend to make a gift to junior.
These questions can’t be answered in the abstract; the answers require attention to the specific circumstances and some number-crunching.
(The foregoing also assumes that paragraph 20(1)(j) will permit junior to take a deduction. One must also pay attention to the fact that the paragraph has its own anti-avoidance rule built into it.)
