It can be hard to find time for tax planning when there are so many issues of immediate concern. However, a relatively simple strategy can be particularly effective during tough economic times and can help lower your overall income tax bill for your family.
Setting up a prescribed rate loan with family members can allow you to effectively transfer income from high-income earners to lower-income family members. This planning can result in reduced total income taxes for the family unit and is especially attractive in the current environment where interest rates have been at an historic low and are now rising.
Income and capital gains attribution
The attribution rules potentially apply whenever a property is transferred or a loan is made at little or no interest to a family member. This means that income and capital gains can be attributed back to the taxpayer who transferred the property and then taxed at the higher marginal tax rates of the taxpayer.
Some important rules to keep in mind are as follows:
- If a taxpayer makes an interest-free or low-interest loan, or gifts property, to a spouse or common-law partner, any income or capital gains from the transferred assets will be attributed to the taxpayer.
- If a taxpayer makes an interest-free or low-interest loan, or gifts property, to a minor child (i.e. a son, daughter, niece or nephew, or other minor child not at arm’s length), income from the funds will be attributed to the taxpayer.
- If a taxpayer makes an interest-free or low-interest loan to an adult child or other adult relative, income from the funds may be attributed to the taxpayer if the purpose of the loan was to reduce taxes.
Prescribed rate loans
A simple method to avoid these attribution rules is to use a prescribed rate loan. If a taxpayer makes an investment loan to a spouse, adult family member, minor child, or family trust, and charges interest on the loan at the prescribed interest rate, then any income they earn on the funds will be taxable to the recipient family member and not to the taxpayer. These plans work effectively when the investment rate of return earned is higher than the prescribed rate of interest charged on the loan.
The Canada Revenue Agency sets the prescribed rate quarterly. The interest rate on the loan does not have to be adjusted each time the prescribed interest rate changes. Instead, the applicable prescribed rate for the loan is the prescribed rate in effect at the time the loan is entered into.
Currently, the prescribed interest rate is at one per cent, but is increasing to two per cent on July 1, 2022. Therefore, if a loan arrangement is established before July 1, 2022, the lower one per cent prescribed interest rate will apply as long as the loan stays in good standing.
There are some important details to ensure that a prescribed rate loan is set up properly:
- It is important that the interest on the loan must be paid no later than 30 days after the end of the calendar year.
- It is also important that the loan be documented. It’s recommended that repayment terms be included, or the loan be documented as a demand loan.
This is the time to ensure you have maximized the benefits of income-splitting loans.
Contact Scott Conner at the Huntsville office to recommend an income-splitting plan that works for you! Scott and his team can help make sure the important details of the plan are put into place.
Scott Conner is an experienced tax practitioner and practical problem solver at BDO. As a partner specializing in Canadian income tax, Scott has particular specialties in private companies, planning for estates, trusts, and complex transactions. Scott works closely with his clients to understand their specific needs and adjust strategies accordingly. Scott and his team take a proactive, hands-on approach. They closely follow existing and proposed legislation to determine how it will affect individual financial goals, and provide ongoing guidance.