July 1 was Canada Day. In an ordinary year, the date alone would have been reason enough to celebrate. But in 2020, July 1 also marked the official drop in the Canada Revenue Agency’s prescribed rate to 1%, which opens up a potentially lucrative opportunity for some clients to execute an income splitting strategy.
What is the prescribed rate?
The prescribed rates are set by the CRA quarterly and are tied directly to the yield on Government of Canada three-month Treasury Bills, albeit with a lag. The calculation is based on a formula in the Income Tax Regulations, which takes the simple average of three-month Treasury Bills for the first month of the preceding quarter, rounded up to the next highest whole percentage point. As a result, the prescribed rate can never be zero and 1% is the lowest possible prescribed rate.
To calculate the rate for third quarter (July through September) of 2020, we look at the first month of the second quarter (April 2020) and take the average of April’s T-Bill yields, which were 0.24% (April 7), 0.30% (April 14), 0.27% (April 21) and 0.27% (April 28). That average is 0.27%, but when rounded up to the nearest whole percentage point, we get 1% for the new prescribed rate for the third quarter of 2020. This marks the first time that the prescribed rate has dropped since it increased to the present rate of 2% back in April 2018.
The drop in the prescribed rate may provide some clients with a significant opportunity to split income with a spouse or common-law partner, (grand)children or other family members. Income splitting is the transferring of income from a high-income family member (who pays tax at a high rate) to a lower-income family member (who pays tax at a lower rate). Since our tax system has graduated tax brackets, by having the income taxed in the lower-income earner’s hands, the overall tax paid by the family may be reduced.
The “attribution rules” in the Income Tax Act prevent some types of income splitting by generally attributing income or gains earned on money transferred or gifted to a family member back to the original transferor. There is an exception to these rules if funds are loaned, rather than gifted, provided the rate on the loan is set (as a minimum) at the prescribed rate in effect at the time the loan was originated and the interest on the loan is paid annually by January 30 of the following year.
So, if the loan is made at the prescribed rate of 1%, the net effect will generally be to have any investment return generated above 1% taxed in the hands of the lower-income family member. Note that even though the prescribed rate varies by quarter and may ultimately rise, one need only use the prescribed rate in effect at the time the loan was originally extended. In other words, if the loan is extended between now and the end of September 2020 (and possibly longer, if the prescribed rate remains unchanged), the lower 1% rate would be locked in for the duration of the loan without being affected by any future rate increases.
Refinancing a 2% loan at 1%?
Finally, what if your client entered into a prescribed rate loan with a family member when the rate was 2% (or higher) and the family member invested the proceeds? To take advantage of the upcoming lower prescribed rate, you should encourage the family member to consider selling the investments (which could trigger capital gains tax, depending on the market value of the investments compared to their tax cost), and repaying the loan. They can then enter into a completely new loan agreement using the new 1% prescribed rate. The CRA has stated that simply repaying a higher prescribed rate loan with a lower rate loan could trigger the attribution rules on the investment income.