Perhaps you heard the story of Mark Smith, 59, who was arrested at a bank in Watsonville, Calif., three years ago. Mr. Smith allegedly demanded $2,000 and threatened to set off a bomb if he didn’t get the cash. The quick-thinking bank manager suggested that Mr. Smith consider borrowing the money instead. So, she went to retrieve a loan application and called the police while she was away from the counter. When the police arrived, Mr. Smith was busy filling out the loan application.
If you’re short on cash, I don’t recommend Mr. Smith’s approach. Borrowing from your bank is a better option (but skip the part where you threaten the bank employee), or consider borrowing from your employer. A loan from your employer could be considered a perk that forms just another part of a creative and tax-efficient compensation package. Let me explain.
You could save interest costs if a loan from your employer is made at a lower interest rate than you’d pay on other loans. You may have to include a taxable interest benefit in your income, but you’re still bound to enjoy savings. How much will your taxable benefit be? Simple. It’s calculated as our tax law’s prescribed interest rate minus the actual rate of interest you pay. By the way, if you’re paying interest to your employer, you’ve got to make those payments during the year or within 30 days following the end of the year (Jan. 30).
Take Bianca as an example. She wants to buy a new car. She needs to borrow $20,000 to make the purchase. If Bianca approaches her employer, who agrees to lend her the $20,000 at no interest, what is Bianca’s taxable benefit? It amounts to $200, which is simply 1 per cent (the current prescribed rate of 1 per cent minus the interest she pays on the loan – which is nil) of $20,000. This taxable interest benefit will appear on Bianca’s T4 slip. Her true cost of borrowing is just $92 (the tax on the $200 benefit assuming a 46-per-cent marginal tax rate). If Bianca had borrowed from another lender at, say, 5 per cent, she would have paid $1,000 in interest. Bianca would save $908 ($1,000 minus $92), or about 4.5 per cent (of the $20,000) in cash savings, just by borrowing from her employer.
If Bianca’s employer charges her, say, 2 per cent on the loan, she’d have no taxable benefit at all if the prescribed rate remains at 1 per cent. In this case, her taxable benefit would be nil, and the interest paid to her employer would cost her $400 (2 per cent of $20,000). Compared to the $1,000 she’d pay to another lender, she’d save $600, or 3 per cent in interest savings.
If the rate of interest charged by Bianca’s employer is equal to or greater than commercial rates available, she’d face no taxable benefit, even if that rate is lower than the prescribed rate under our tax law.
If your employer lends you money to buy or refinance a home, some special rules apply. And these rules will work to your advantage. In this case, the prescribed rate used to calculate your taxable interest benefit will be either the rate in effect at the start of the loan or the current prescribed rate, whichever is less. The loan is deemed to be a new loan every five years. As a result, the prescribed rate in effect at that time will be the maximum rate for the next five years.
There’s more good news if the purpose of your loan was to buy a home because of a job relocation (rather than to refinance your existing home). In this case, the tax collector will allow you to claim a deduction for the taxable interest benefit on the first $25,000 of the loan. This interest deduction is available only for the first five years of the loan and, to qualify, your relocation must have moved you at least 40 kilometres closer to your new work.
If you borrow from your employer to invest, to buy a car for use in your work, or for some other purpose that normally provides you with the ability to deduct interest, you’ll be entitled to claim a deduction for all or part of the taxable interest benefit. Hey, even where you haven’t paid your employer any interest, the amount of the resulting taxable interest benefit is considered by the tax collector to be interest paid, and may entitle you to a deduction.