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. 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, by 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/or capital gains earned on an investment purchased with those funds would “attribute” back to you and 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 at a minimum of the prescribed 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 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 every year within 30 days of the end of the calendar year (i.e. by January 30th of the following year), the attribution rules should not apply. However, if the interest is not paid by January 30th, 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 prescribed time period.
When prescribed rate loans work as planned, they effectively move any income earned in excess of the prescribed rate interest paid to a lower income family member, reducing the overall family tax bill. The lender would include interest 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 has no taxable income.
- 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 rate at the time of the loan is 2%, each year prior to January 30th Priya pays interest of $10,000 to Steven. In this example, Steven would be taxed on the annual interest income of $10,000, while Priya would be entitled to deduct the $10,000 of interest expense as the funds were used for investment purposes.
- Priya would also be taxed on all income and realized gains generated by the investment portfolio. As Priya has no other sources of income, she would need to earn over $10,000 of interest income, $20,000 in capital gains or $50,000 in eligible dividends, net of the interest deduction, before incurring any Federal tax liability (whether there is a provincial tax liability depends on Priya’s province of residency).
- As Steven is in the highest tax bracket, the prescribed rate loan strategy results in a lower overall tax obligation for the family.
- If the prescribed rate decreases to 1%, and Steven and Priya implement a
prescribed rate loan subsequent to that decrease, interest of only $5,000 (instead of $10,000) would have to be charged and paid, and thus, $5,000 more could be taxed in Priya’s hands at her lower marginal tax rates.
How is the “prescribed rate” determined?
On April 1, 2018, the prescribed rate increased to 2% (for taxable benefits and prescribed rate loans). Prior to that increase the prescribed rate had been at a historically low level of 1%. Since this time, the rate has remained at 2% and the second quarter rate for 2020 has already been set at 2%.
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. Based on the current economic environment and the recent interest rate decreases that have followed, there is a real possibility that the third quarter rate for 2020 rate could decrease back to 1%. We are monitoring this situation as it progresses. The rates are available at the Bank of Canada’s website here.
If the prescribed rate decreases, a prescribed rate loan may become an even more valuable income splitting tool.
If you are considering a prescribed rate loan, it may be advantageous, from a tax perspective, to consider implementing the loan after July 1, 2020. If the prescribed rate does decrease, this will enable you to lock in the new 1% prescribed rate for the life of the loan and charge the 1% interest rate even if the rate increases in the future.
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 Financial Advisor for more information before making a
Published as a general source of information only. Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice. Seek advice on your specific circumstances from an IG Wealth Management Consultant. Trademarks, including IG Private Wealth Management, are owned by IGM Financial Inc. and licensed to its subsidiary corporations