Tax planning may not be top of mind while facing challenges from the COVID-19 pandemic. 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. This tax planning strategy is especially attractive in the current environment where the interest rate is low and a stock market rebound is anticipated.
To understand how this type of tax planning works, taxpayers should be aware of the “attribution rules” that can prevent the redistribution of income among family members where income-earning assets are transferred from high-income earners to lower-income family members.
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 is taxed at the higher marginal tax rates. The most important rules to keep in mind are as follows:
- If a taxpayer makes an interest-free loan to a spouse, any income or capital gains from the transferred assets will be attributed to the taxpayer.
- If a taxpayer makes an interest-free loan to a minor child, income from the funds will be attributed to the taxpayer. Any capital gains arising from the property will be taxed in the hands of the child.
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 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, as a net benefit will be realized because the income earned on the rate differential will be taxed at the lower marginal tax rate of the family member.
The Canada Revenue Agency sets the prescribed rate quarterly. The prescribed interest rate is expected to decrease to just 1% on July 1, 2020 due to recent interest rate reductions. If a loan arrangement is established after this time, the lower 1% prescribed interest rate will apply. Any return on investment on the invested funds made with the loan, whether that be capital gains, interest, dividends or other income, that is in excess of the 1% interest that has to be paid on the loan, will be taxed to the family member.
There are some important details to ensure that a prescribed rate loan is set up properly.
Reach out to your income tax advisory to see if this type of planning can benefit you and your family.
Scott Conner is a partner in BDO’s Huntsvile office, with over 20 years of experience providing corporate and personal tax planning strategies for family-owned businesses, entrepreneurs, and large corporations. He helps his clients with shareholder remuneration strategies, estate planning, as well as business structuring to minimize taxes.