First, it’s important to understand how “attribution rules” can affect income splitting
Canada’s Income Tax Act has specific measures in place to limit income splitting opportunities. For example, if you were to gift or loan funds to your spouse or common-law partner without charging interest, any investment income and capital gains earned on an investment purchased with those funds would “attribute” back to you and be taxed in your hands. If the purpose of the gift or loan was to shift income to a lower income spouse, the attribution rules effectively eliminate any income splitting opportunities. Income attribution rules can also apply when loans bearing interest at less than the prescribed rate (including no interest loans) are made either directly to children or grandchildren, or indirectly through a trust.
However, attribution of income to the lender does not occur if interest is charged on the loan at a minimum of the prescribed interest rate on the date the loan is put in place. This is where a “prescribed rate loan” can become a simple and effective tax planning tool.
How do prescribed rate loans work?
A prescribed rate loan occurs when an individual loans money to their lower income spouse or common-law partner, adult child or an investment trust. Interest is charged at the prescribed rate in effect when the loan is made.
The borrower then takes these funds and invests the money to earn investment income and/or capital gains. Provided the loan is properly documented and interest on this loan is paid to the lender every year by January 30th of the following year, the attribution rules should not apply. However, if the interest is not paid within 30 days of the end of the calendar year, the loan will not meet the requirements for exemption from the attribution rules in the particular year and for all subsequent years. This would mean that all investment income and, in some cases capital gains/losses, would attribute to the lending individual for the year in question and all subsequent years, even if the interest payments in subsequent years are made within the required time period.
When prescribed rate loans work as planned, they effectively move any income earned in excess of the prescribed interest paid to a lower income family member, reducing the overall family tax bill. The lender would include the interest received at the prescribed rate in his or her income, while the borrower would include any investment income and/or capital gains/losses in his or her income and claim a deduction for the interest paid.
Here’s an example:
- Steven and Priya are married. Steven is in the top tax bracket while Priya works part-time and has taxable income of $25,000, meaning she is in a much lower tax bracket than Steven.
- Steven has $500,000 to invest, but instead of investing the money himself, Steven loans Priya $500,000 at the current prescribed interest rate and properly documents this loan. Priya invests the funds.
- Assuming the prescribed interest rate at the time of the loan is 3%, each year prior to January 30th Priya pays interest of $15,000 to Steven. In this example, Steven would be taxed on the annual interest income of $15,000, while Priya would be entitled to deduct the $15,000 of interest expense as the funds were used for investment purposes.
- Priya would be taxed on all income and the taxable portion (50%) of realized gains generated by the investment portfolio, minus the interest paid on the related loan, every year the prescribed rate loan strategy is in place.
- As Steven is in the highest tax bracket, the prescribed rate loan strategy should result in a lower overall tax obligation for the family assuming Priya’s after-tax return on the investment exceeds her after-tax interest cost on the loan.
How is the “prescribed rate” determined?
The prescribed rate is set each quarter based on the average 90-day Government of Canada T-bill rate for the first month of the last quarter. The prescribed rate for the first two quarters of 2022 was 1%, but increased to 2% for the 3rd quarter and for the 4th quarter of 2022 is 3%.
Should you be considering a prescribed rate loan strategy right now?
The current prescribed rate of 3% is the highest it has been for a number of years and could increase further in 2023. A higher prescribed rate reduces the effectiveness of the strategy as the higher income earner has more interest income to report and the borrower needs better investment returns. Therefore, you should consult with your tax advisor to determine whether this strategy would be advisable in the current environment and in your particular circumstances.
How should I set-up a prescribed rate loan?
When setting up a prescribed rate loan it is important to seek assistance from both your legal and tax advisor to make sure your loan is documented correctly. In particular:
- There must be a written loan document that includes the details of the loan and which is signed by both the lender and borrower.
- The agreement must clearly indicate that the funds have been loaned and that the borrower is legally required to repay the amount.
- The agreement must specify an interest rate (normally the prescribed rate that is in effect on the date the loan was made) and should indicate that interest is to be paid within 30 days of the end of the calendar year.
- Structuring the loan as a demand loan, which is repayable immediately at the request of the lender, provides the most flexibility.
When are prescribed rate loans most advantageous?
Any income splitting strategy, including a prescribed rate loan, is most beneficial when there is a significant difference between the marginal tax rates of family members and there are substantial funds available to lend and invest.
When considering a prescribed rate loan, many factors should be evaluated such as the expected investment performance as well as tax implications. We encourage you to speak with your IG Consultant and tax advisor for more information before making a decision.