Income splitting – Utilizing the Recent Drop to the CRA’s Prescribed Rate to Reduce a Taxpayer’s Income – Canadian Tax Lawyer Tax Planning Tips
Taxpayers can Decrease Tax Liability by Utilizing Prescribed Rate Loans for Income Splitting
Canada has a progressive income tax system, which means that a taxpayer’s tax rate will increase as they earn more income. Thus, it is advantageous for a household to spread the income amount to family members who are taxed at lower marginal rates to reduce the overall family tax burden. This method to minimize taxes paid is called income splitting. However, taxpayers must avoid being caught by the “attribution rules” and other anti-avoidance rules which prevent certain income splitting strategies. For instance, if there is a transfer to a spouse or a minor child to earn investment income, the taxation of the investment income earned by the spouse or the minor may be attributed back to (taxed in the hands of) the person who has made the transfer. In this example, there may be valid ways to work around the attribution rules, and one method is by utilizing prescribed rate loans, discussed in this article. This topic is especially relevant today since the Canada Revenue Agency (CRA) recently announced that the prescribed rate for the third quarter of 2020, which runs from July to September, has dropped from two percent to one percent.
What is the Prescribed Rate?
Every year, on a quarterly basis, the CRA announces new prescribed interest rates that apply to amounts owed to the CRA by individuals and corporations and to amounts owed to individuals and corporations by the CRA. In other words, the prescribed rate will determine the rate charged on overdue taxes to the CRA and the rate paid to the taxpayer for excess taxes remitted. The prescribed rate will also determine the rate used to calculate the taxable benefits for employees and shareholders from interest-free and low-interest loans. This rate also applies to loans made between family members for the purpose of income splitting.
The prescribed rate is defined by section 4301(c) of the Income Tax Regulations. It is calculated by averaging the rates for three-month Treasury Bills for the first month of the preceding quarter. Then, the number is rounded up to the next highest whole percentage. This formula effectively prevents the prescribed rate from falling below one percent.
In the third quarter of 2020, the prescribed rate dropped from two percent to one percent. This drop presents an excellent opportunity for Canadian taxpayers to utilize prescribed rate loans for effective income splitting strategies, which could minimize taxes owed.
What is a Prescribed Rate Loan?
As described earlier, the attribution rules state that when a high-income family member makes an investment loan to the low-income member or a family trust, investment income from the loan will be taxed by the high-income lender. However, this rule may not apply if the interest rate on the loan is set to the prescribed rate in effect at the time the loan was made. This type of loan is known as a prescribed rate loan.
If a loan is put into place between July 1, 2020, and September 30, 2020, the 1% rate would be in place for the duration of the loan without being affected by any future rate changes. In other words, the prescribed rate at the time that the loan was extended initially will be the only rate that will affect a loan.
Income splitting strategies that utilize prescribed rate loans are most effective when the lending spouse has their assets and income taxed at the highest marginal tax rate, and the other spouse or child is taxed at the lowest marginal rate. The amount of tax savings within the household will be higher as the disparity between their tax rates become greater. There are a few key points to consider when a taxpayer wants to create a prescribed rate loan:
- The interest on prescribed rate loans must be paid annually by January 30 of the following year in which the interest accrued;
- The borrower must be able to pay the interest to the lender each year before the deadline;
- If the interest payments are not paid until the due date, then the attribution rules will apply;
- The strategy will only be effective if the invested funds can generate an income equal to or greater than the interest expense on the loan;
- Formal requirements for establishing a loan must be met, and the loan should remain legally enforceable (in other words a Canadian tax lawyer should draft a loan agreement and promissory note); and
- There may be adverse tax implications if either the lender or borrower is not a Canadian resident.
An Example of a Prescribed Rate Loan to a Spouse
John is taxed at the highest tax bracket and wants to make some investments with his excess cash. He thus makes a prescribed rate loan in the amount of $100,000 to his spouse, Jane, who is taxed at the lowest tax bracket. John and Jane sign a loan agreement and promissory note, which states that John is the lender, and Jane is the borrower of $100,000 at the prescribed rate of 1%, which is payable annually. Jane makes an investment with the loan and generates a 5% in income, or $5,000. In the following year, Jane makes a loan interest payment to John at 1% or $1,000 before January 30.
In this example, John will receive a $1,000 interest income, and Jane will have a $5,000 investment income with a deduction of the $1,000 interest income which she paid to John. Thus, at the end of the year, John can shift $4,000 of taxable income to Jane.
Pro Tax Tip – Structure Prescribed Rate Loans Now
Income splitting strategies require careful planning because each financial circumstance is different. Because of the low prescribed rate, now is the best time to enter into this type of income splitting arrangement. If you wish to plan income splitting strategies you need an experienced Toronto tax lawyer to ensure that your financial circumstance has been adequately considered, we can help. Please do not hesitate to reach out to our qualified Toronto tax lawyers for tax help.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."