Many affluent families make use of loans between high- and lower- income spouses to spit income and save taxes. A crucial element of these loans is the so-called “prescribed interest rate,” which is set by the federal government. That rate recently doubled to 2% from 1%, but experts say using these loans still could be an attractive strategy, depending on the circumstances.
Despite the recent rate hike, these loans may be particularly useful now, given the slow but inexorable rise in the prime rate expected over the next few years. With mortgage rates already starting to tick upward, some clients still can benefit from using these ultra-low-rate loans.
There are, however, a range of considerations to keep in mind. Use of the prescribed rate can “be a very effective income-splitting strategy,” advises Tim Cestnik, president and CEO of Toronto-based WaterStreet Group Inc. “But it has to make sense to be worthwhile.”
The prescribed interest rate is set at the beginning of each fiscal quarter, based on the average rate of the 90-day Government of Canada T-bill for the first month of the previous quarter. In addition to saving taxes through family loans, the prescribed rate also is used for low-interest employee and shareholder loans and is the basis for the interest charged on overdue taxes and the interest paid on excess tax remittances.
Your client couples can benefit from tax savings using the prescribed interest rate when the higher-income spouse makes a loan to: the lower-income spouse (including a common-law or same-sex spouse) who is taxed at a lower rate; other adult family members; or to a trust for which minor children are the beneficiaries.
The interest paid on the loan is a deductible expense for the borrower but is taxable in the hands of the lender. However, any investment earnings in excess of the prescribed rate are taxed in the hands of the borrower. Due to the very low interest rate on these loans, the result should be a reduction in the family’s total tax bill.
However, Cestnik cautions that a significant gap between the personal marginal tax rates of the lender and the borrower needs to be present, and that the amount of the loan must be sizable in order to realize any material benefits.
For example, a husband lends $10,000 to his wife at the prescribed interest rate of 2%. The wife invests the $10,000 and earns a return of 5% (i.e., $500). The wife pays the husband $200 ($10,000 x 2%) in interest, leaving her with net income of $300 on the loan. If the husband has a marginal tax rate of 45%, he will pay taxes of $90 ($200 x 45%) on the interest earned. If the wife’s marginal tax rate is 25%, she will pay taxes of $75 ($300 x 25%) on the income earned. Therefore, the family ends up with a tax saving of $15 ($90 minus $75) vs the scenario in which the higher-income husband had invested the $10,000.
A loan of this size, therefore, is not worthwhile. For a prescribed-rate loan to “make sense,” Cestnik suggests, it must be in the range of $100,000 or greater and the gap in marginal tax rates must be at least 20%.
Children can also participate in these income-splitting loan arrangements. Maria Severino, tax partner with Collins Barrow LLP in Toronto, notes that a prescribed-rate loan can be made to a trust for which minor children are the beneficiaries. Under this strategy, the trust invests the loan, which must be structured in such a way that the income flows out to the beneficiaries. That’s because all income in inter vivos trusts is taxed at the highest marginal tax rate. But under this strategy, the income is transferred to the minor children, and taxed in their hands.
In all cases in which these loans are used, Severino cautions, care must be taken to avoid triggering the attribution rules. These requirements have been litigated and the courts have required strict adherence to the rules, which require proper, written loan documentation stating the prescribed interest rate and repayment terms.
There must also be physical or verifiable evidence of the interest being transferred to the lender. The borrower must pay the interest due on the loan by Jan. 30 of each year.
If the prescribed-rate loan is made without documentation showing the use of the prescribed interest rate, the attribution rules under the Income Tax Act will apply, and any income earned on the loan would be taxed in the lender’s hands.
One of the other main benefits of using a prescribed interest rate loan is that the rate can be locked in indefinitely, creating a fixed cost for the loan even if interest rates rise in the future.
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