Before all this commotion about income splitting and the many ways that corporations, trusts and partnerships could allocate income to lower tax-bracket individuals, there has been in place for quite some time a very simple tool. This tool is known as the prescribed-rate loan. Generally, the income attribution rules under subsection 74.5(2) of the Income Tax Act (ITA) restrict any attempts to shift income from a high earning individual to a lower earning individual by “attributing” the income back to the higher earning individual. Basically, if you transferred assets (shares, investments or other items) to your spouse or children the income earned on those assets would be attributed back to you and treated as if you had earned the income. This can be very punitive.
Thus, step in the prescribed-rate loan. This tool follows an exception to the attribution rules under the ITA, whereby if you make a loan to your spouse or child and interest is charged at a rate equal or greater to the CRA’s prescribed interest rate the attribution rules will not apply. For example, using a very basic scenario, say you set in place a prescribed-rate loan of $50,000 at the current prescribed rate of 1% to your lower income spouse and they invest the monies and earn significant dividends off the investment. As a result, your spouse would have the dividends taxed on their return at a lower rate as opposed to your own return at a higher rate, the only cost is the $500 (1%) which would have to be paid from your spouse to you and declared as income on your own return. This represents significant tax savings to individuals whereby monies can be shifted from a higher earning individual to a lower earning individual while staying onside with CRA and the ITA. Quite simply, with savings of up to 46% in income tax this is the best thing since sliced bread if implemented correctly.
If you are considering a prescribed-rate loan do remember that the loan agreement must be a formal agreement and documented. The interest on the loan must be paid in full by January 30th of the following year (if this is missed it taints the loan and is no longer valid), and on any loans to minors any income earned legally belong to the child. CRA’s administrative policy with regards to these loans is that you cannot repay and then issue a new loan – this is very important to remember, conversely it is important to note that a loan could be setup that does not have to be paid back until a time much further down the road.
Another tool is the use of the prescribed-rate loan to a trust. Why should you use a trust? If you are wishing to have income received by a minor child to pay for school bills, extra-curricular event and possibly tuition, keep in mind that minors cannot enter into an enforceable contract. Thus, if you were to do a prescribed-rate loan directly with your child for the purpose of having income go to them at a very low or nil tax rate it could be challenged as the loan agreement would not be enforceable. However, by setting up a trust with you children (and spouse should you wish) as beneficiaries and making the loan agreement with the trust you can now effectively split income and have the loan agreement honoured. This is a great tool for tax efficiency and allows parents some tax relief when it comes to kids who have very busy schedules.
That beings said, if you are looking at implementing a prescribed-rate loan to either a spouse or a family trust you may need to act quickly as currently the bargain CRA prescribed rate of 1% is set to double effective as of April 1, 2018. The prescribed rate as set by the CRA is tied directly to the yield on the Government of Canada 90-day Treasury Bills and effectively rounded up to the nearest percentage point. Given that the average has been 1.185 for January, the prescribed rate shall be hiked to 2% at the start of the next quarter.
Please remember to always consult a tax professional before entering into a prescribed-rate loan to ensure that you are on side, as each scenario is different depending on your circumstance.