The All-Time Low Prescribed Interest Rate About To Increase
Most Canadians understand the concept of income splitting which is designed to shift taxable income from individuals in high tax brackets to family members in low tax brackets. For instance, John is a high income earner with a marginal tax rate of 46% and has an investment portfolio of $500,000. Assuming that the portfolio generates annual investment income of 5%, the income tax paid by John on the investment income would be $11,500 (46% of $25,000). If John could somehow transfer the portfolio to his non-working spouse, Mary, or minor children and have the investment income earned in their names, the income tax payable on the investment income could be significantly reduced or eliminated. However, there are a set of anti-avoidance provisions in the Income Tax Act known as the income attribution rules which provide that, even if the portfolio is gifted by John to one or more family members, the investment income will continue to be attributed back to John and taxed in his name.
However, it is possible to avoid the attribution rules by having the high income earning family member loan the investment funds to a spouse, common-law partner, children or grandchildren at the prevailing interest rate prescribed by CRA. This rate has been at an all-time low of just 1 per cent since April 1, 2009 and is expected to rise to 2% as of October 1, 2013. Individuals need to act before then to lock in the low interest rates and to obtain maximum benefit from this tax planning strategy available to families.
Using the above example, here is how the income splitting strategy works. John loans Mary $500,000 at the current prescribed rate of 1% secured by a written promissory note. Mary invests the funds and earns annual investment income** of 5% or $25,000. Each year, Mary pays $5,000 back to John which represents the 1% interest on the loan. John pays income tax on the loan interest and Mary pays income tax on the remaining $20,000 of investment income at her marginal tax rate which will be much lower than John’s since she doesn’t have other sources of income.
A couple of points to keep in mind:
- The loan must be made by means of a written agreement which sets out the repayment terms and stipulates an interest rate that is at least equal to the current prescribed rate.
- The loan interest must be paid by January 30th the following calendar year. If this deadline is missed, there is no way to correct the error and attribution will result for all subsequent years.
- The loan doesn’t have to be for a fixed term. Therefore, it is possible to lock in the low interest rate indefinitely. Since interest rates are widely anticipated to increase, the potential annual income tax benefits from this strategy may also increase significantly in the future.
- Any subsequent loan advances must bear interest at the prescribed rate in effect at the time the advance is made.
- This strategy can also be used to split income with minor children. A prescribed rate loan would be made to a family trust. The trust would invest the funds and pay the investment income, after the loan interest, directly to the children or indirectly by paying their expenses such as tuition, lessons, sporting activities, etc.
Keep in mind that the current all-time low prescribed rate of 1% is expected to double to 2% on October 1. As such, in order to lock in the 1% rate, family loan arrangements need to be completed by September 30th, 2013.
William Hinz is an Associate at BrazeauSeller.LLP. He practices in the areas of Tax & Estate Planning and Corporate & Commercial Law. William can be reached at 613-237-4000 ext. 249 or firstname.lastname@example.org. For more information about William, please visit www.brazeauseller.com.
** It should be noted that income generated from investments in private corporations (as opposed to GICs, mutual funds, ETF’s, publicly traded shares, etc.) may be subject to a different set of rules under s. 120.4 of the Income Tax Act.
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