If you are a guarantor of a business loan, you should be aware of your financial responsibility and recourse should the borrower default.

The owner/manager who gives a personal guarantee on a business loan is assuring that the contract will be fulfilled. In the event that the company defaults on the loan, he or she will personally discharge the debt as required. But as lenders frequently also require additional personal guarantees, the owner/manager may ask family members to give their guarantees as well.

What if the borrower defaults?

If the borrower defaults, the guarantor must assume the debt obligation. As well as having to repay the loan, the guarantor may also face an unfavourable tax treatment for this loss that could have been avoided with proper documentation and structuring. Guarantors typically do not consider the potential tax consequences of their personal guarantee until they face a situation where they must honour it.

For the guarantor, the key tax issues are:

• Can a deduction be claimed for the debt payment made under the guarantee?
• What is the timing of this deduction?
• Is the related interest expense deductible if the guarantor must borrow funds to make the payment?

Although the following discussion deals primarily with the tax implications where the guarantor is also a majority shareholder, these considerations may also be applicable to non-shareholder personal guarantee situations.

The guarantor's rights

If the guarantor is required to honour the guarantee, the guarantor has a legal right of action to sue the principal debtor for the amount paid to the lender and is also entitled to an assignment of security given to the lender by the principal debtor. The guarantor therefore becomes a creditor of the debtor in his or her own right. It is in respect of these rights against the debtor that for income tax purposes, the guarantor may realize a loss in certain circumstances.

Tax treatment of guarantor's loss

While the Income Tax Act does not contain specific provisions dealing with the tax consequences of providing and honouring guarantees, there may be some tax relief for the guarantor's loss.

The first consideration is that a capital loss does not arise by virtue of the guarantor making a payment. Instead, the guarantor must establish that the debt is a bad debt. This will require the guarantor to demonstrate that the original debtor is unable to reimburse the guarantor. As well, the deduction can only be claimed in the year that the debt is established to have become bad. In order for the loss to be claimed as a capital loss, the loan must have been made for an income-earning purpose.

To meet this test, it is generally sufficient for the owner/manager to demonstrate that the guarantee was made to earn dividend income on the shares that he or she owns in the company.

Unfortunately, when relatives guarantee loans, the arrangement to pay reasonable fees for this service (the only income-earning purpose they would have) is often overlooked. Where there is no consideration given, the capital loss and interest deductibility will not be allowed. In these cases,  CCRA considers the payment not to be of an income-earning nature, with no tax relief.

Tax treatment of loan interest

Generally, to deduct interest on borrowed funds, the taxpayer must establish that the interest is paid pursuant to a legal obligation to pay interest and that the funds have been used for the direct purpose of earning or producing income. This "income purpose" test also applies to interest payments made on a loan incurred to honour a guarantee. If the guarantor takes over the position of the original creditor and can claim the repayment of the debt from the debtor, the interest on the funds borrowed to honour the guarantee are deductible if a reasonable guarantee fee was received.

If no guarantee fee was received and the debtor is unable to pay reasonable interest to the guarantor, the interest is deductible only if CCRA's administrative guidelines are met. These guidelines allow the deduction for interest if the loan, that was guaranteed, was to a Canadian corporation in which the individual was a shareholder, was used to earn income from a business or property, and the corporation could not borrow the money without the shareholder's guarantee.

Talk to Logan Katz LLP Chartered Accountants

Before giving your personal guarantee or asking relatives or other shareholders to give their guarantees, talk to Logan Katz LLP to ensure you consider all of the implications of the transaction.

Logan Katz LLP can help you ensure:

• there is written agreement between the guarantor and the debtor that deals with the amount of the guarantee fee as well as the arrangements to be madein the event the debtor defaults and the guarantee is called; and
• the lender provides written confirmation that the funds will not be advanced without the personal guarantee.

Once the financing is in place, review the company's debt situation on a periodic basis. If the debt/equity ratio improves, approach the lender to see if it is possible to have the personal guarantee removed.

The above provides general information only. It should not be regarded or relied upon as accounting or taxation advice or opinions. Logan Katz LLP Chartered Accountants would be pleased to provide more information or specific advice on matters of interest to you.

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