An effective planning tool to reduce your overall family tax bill
Prescribed rate loans: An effective planning tool to reduce your overall family tax bill
Prescribed rate loans can be an excellent financial planning tool and are one of the few income splitting strategies that remain for many Canadian families. The concept of income splitting encompasses any strategy that shifts taxable income from an individual with a higher marginal tax rate to a family member who is subject to a lower marginal tax rate. While commonly used to split income between spouses, prescribed rate loans can also be used to efficiently split income with adult children or to fund family investment trusts. A prescribed rate loan can be a great way for a lower income family member to benefit from investment assets while also accessing their lower marginal tax rates.
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 was 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:
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 4th quarter of 2021 is 1% and has been set at this rate since the 3rd quarter of 2020 when it was reduced from 2%.
Now may be the time to implement a prescribed rate loan strategy prior to any possible increase in the rate.
If you are considering a prescribed rate loan, it may be advantageous, from a tax perspective, to consider implementing the strategy soon. If the prescribed rate increases, the opportunity to lock in the 1% prescribed interest rate for the life of the loan could be lost.
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:
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.
Written and published by IG Wealth Management as a general source of information only, based on the CRA information believed to be accurate as of the date of publishing. Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice. Seek advice on up-to-date withholding rules and rates and on your specific circumstances from an IG Consultant. Trademarks, including IG Wealth Management and IG Private Wealth Management, are owned by IGM Financial Inc. and licensed to its subsidiary corporations.