Prescribed rate loans can be used to shift income from a spouse or parent in a high income tax bracket to a spouse or child in a lower income tax bracket; if carried out properly, the attribution rules in the Income Tax Act (Canada) (the “Tax Act”) will not apply.
The prescribed rate of interest is determined by reference to the yield on the Government of Canada 90-day Treasury Bills. Consequently, on October 1st 2013, the prescribed rate of interest will increase from 1% to 2%. Accordingly, Canadians have only a short time left to implement loans at and otherwise take advantage of the current 1% prescribed rate.
An example of inter-spousal income splitting is as follows: assume that a wife is in the top tax bracket and her husband is in the lowest tax bracket. Viewing the couple as a single unit and from the perspective of minimizing the income tax of that unit, it is more tax efficient for income to be taxed in the hands of the husband because of his lower marginal tax rate. If the wife gives cash to her husband to invest, any income earned from the investments will be attributed back to the wife and taxed in her hands, at her higher rate. Consequently, there is no tax savings achieved by the wife and husband.
If instead the wife lends money to her husband pursuant to a loan agreement and charges interest on that loan at the prescribed rate in effect at the time the loan is made, any net income earned from the investments, after payment of interest on the loan, by the husband will not be attributed back to the wife. As a result, the net income from the investments will be taxed in the hands of the husband, thereby achieving overall collective tax savings for the wife and husband. The wife will have to include in her income the 1% interest charged on the loan to her husband. Depending on what the investments are, the interest paid by the husband should be deductible to him. The lower the prescribed rate, the more effective this strategy becomes. The tax savings of such an arrangement can be significant over an extended period of time. It is important that interest actually be paid by the husband to the wife each year within 30 days after the end of the calendar year (not to be confused with within 30 days of the anniversary of when the loan was made). Furthermore, the loan should be properly documented.
It is important to note that the rate that needs to be charged on these prescribed rate, income splitting loans is determined at the time the loan is made. As such, it is possible to “lock in” the loan agreement at the current 1% prescribed rate for a long period of time, notwithstanding the pending increase in the prescribed rate.
Similar income-splitting arrangements may be made with a minor child. Income splitting with a minor child is most commonly carried out using a trust in which the minor child in question is a beneficiary. Instead of making a loan at the prescribed rate directly to the minor child, the loan is made to a trust. The trustees of the trust then use the loaned funds to invest and earn income, which net income may then be paid or made payable to or on behalf of the minor beneficiary and taxed in the child’s hands. A trust is used in these circumstances to avoid the various issues associated with making a loan directly to a minor child and their purchase and ownership of investments.
Another use of the prescribed rate in the Tax Act relates to a home purchase loan made by an employer to an employee. Home purchase loans can be part of an employee compensation package. In the ordinary course, interest free or low interest loans made by an employer to an employee will result in the employee being deemed to have received a taxable benefit equal to the prescribed rate of interest then in effect from time to time on the outstanding amount of the loan, less any interest paid by the employee in respect of the loan no later than 30 days after the end of the calendar year. An exception to this is if the funds are used by the employee to purchase a home, in which case interest at the prescribed rate in effect at the time the loan is made is deemed to be a benefit to the employee, less any interest paid by the employee in respect of the loan no later than 30 days after the end of the calendar year (though often no interest is actually paid by the employee on such loans). It follows that if the loan is made prior to October 1, 2013, notwithstanding any subsequent changes in the prescribed rate of interest, the taxable benefit that the employee will be deemed to receive (assuming no payments on account of interest are made by the employee) is 1% on the outstanding amount of the loan. Accordingly, prior to October 1, 2013, the interest rate of 1% on a home purchase loan may be locked in for up to 5 years, after which a new loan is deemed to have been made at the prescribed rate then in effect. Certain conditions must be met in order for this strategy to work.
If you are considering implementing a tax plan involving these or other strategies that incorporate the prescribed rate of interest, you should implement the plan on or prior to September 30, 2013 as the current 1% prescribed rate will rise to 2% on October 1, 2013.
If you have any questions or are interested in discussing whether such arrangements may be beneficial to you, please contact a Miller Thomson LLP Tax Professional.