Canada’s income tax system is progressive, meaning tax rates increase alongside taxpayer’s earnings. Households can minimize their overall taxes by dividing income rates between family members with lower marginal tax rates. This technique is known as income splitting.
Certain income splitting methods are prevented by attribution and anti-avoidance rules. For example, if a spouse or child earns investment income through a transfer, the taxation of the income may be handed back to the person transferring the income. However, there are workarounds for such attribution rules. One such method is the use of prescribed rate loans. The Canada Revenue Agency (CRA) has lowered the prescribed rate from 2% to 1% from July to September 2020, making it an advantageous time to use prescribed rates.
This article will cover the use of prescribed loan rates for avoiding attribution rules on income splitting.
What Are Prescribed Loan Rates?
The CRA annually announces the prescribed interest rates for each quarter. The rates apply both to the amounts that individuals and corporations owe to the CRA and the amounts owed by the CRA to individuals and corporations. The rates, therefore, establish the charges on unpaid taxes, as well as rates paid out for on tax rebates. Additionally, prescribed rates establish taxable benefits for employees and shareholders on low-interest and interest-free loans. Such rates also apply to loans between relatives carried out as a part of an income splitting method.
The Income Tax Regulations section 4301(c) defines the prescribed rate. It is calculated from the average rate of three-month Treasury Bills for the first month of the previous quarter, which is then rounded up to the next integer percentage. This means that the prescribed rate is unable to fall to less than 1%. Lower prescribed rates provide a good opportunity for Canadian taxpayers to use prescribed rate loans for income splitting, thus minimizing any owed taxes. As we are currently seeing prescribed rates lowered from 2% to 1%, anyone considering an income splitting strategy should take advantage of the opportunity.
How Do Prescribed Rate Loans Work?
Attribution rules mean that the high-income family member will be taxed on investment income from loans to low-income family members. It is possible to avoid this by setting interest rates on loans to the effective prescribed rate at the time of the loan. Loans that use prescribed rates are known as prescribed rate loans.
For the period of 1st of July to 30th September 2020, the prescribed rate is 1%. This means that any loans carried out during this time will benefit from a 1% prescribed rate for the duration of the loan, regardless of whether the prescribed rate changes in the following quarters.
When using prescribed loan rates, the most effective income splitting methods tax the lender at the highest marginal rates and the borrower at the lowest marginal rate. This yields a higher household tax saving because the difference between the tax rates for lenders and borrowers become greater.
For taxpayers issuing prescribed rate loans, there are some important considerations:
- Any interest accrued must be paid each year on 30th January
- It must, therefore, be within the means of the borrower to pay this interest on time each year
- If interest payments are not completed before the due date, then attribute rules come into action
- For the method to be effective, the income generated by the interest funds must be equal to or greater than the interest fees
- All formal requirements for issuing the loan must be adhered to, and the loan must be enforceable by law. This means a Canadian tax lawyer should draft the loan agreement and the note payable
- If the lender or borrower is not a resident of Canada, then there may be negative tax consequences
Example: Prescribed Rate Loans Between Spouses
David, who is taxed at the maximum amount, has decided to invest some of his liquid cash. He creates a loan of $100,000 to his wife Julie— who is taxed at the minimum amount—using the prescribed rate on the loan. They both sign the agreement on the loan and the note payable, which establish David as the lender and Julie as the borrower of a $100,000 loan at the annually payable prescribed rate of 1%. Julie invests the money from the loan, generating a 5% income equal to $5,000. Next year, she makes a loan interest payment to David at the prescribed rate of 1%, equalling $1,000. She completes the payment before the deadline on 30th January.
Under this example, David earns a $1,000 interest income, and Julie earns a $5,000 investment income, minus the $1,000 interest income repaid to David. This ultimately means that $4,000 of David’s taxable income has been shifted to Julie.
Key Takeaways On Making the Most of Current Low Prescribed Loan Rates
With a current prescribed low prescribed rate of 1%, now is a good opportunity to utilize prescribed rates for income splitting. However, making the most of income splitting methods merits meticulous planning to navigate your specific financial circumstances. Consult an expert Canadian tax lawyer to ensure that your income splitting method is tailored to maximize your tax savings.