The CRA has announced that they will be decreasing the Prescribed Rate for the third quarter of 2020 from 2% to 1%, effective July 1, 2020.
Consequently, Canadian taxpayers will have an opportunity to lock-in Prescribed Rate family loans at the lowest possible level and potentially achieve significant recurring tax savings on investment income by utilizing Prescribed Rate Loan Planning.
Specifically, eligible Canadians will be able to lock-in the 1% rate if they enter into their lending arrangements between July 1, 2020 and September 30, 2020 (possibly longer depending on the future direction of interest rates).
What is Income Splitting?
Income splitting is a tax strategy which aims to transfer income from a high-income family member to a lower-income family member (including a spouse or common-law partner, children or grandchildren). Having income taxed in a lower-income earner’s hands at their graduated rates reduces the family’s overall tax liability.
The tax laws include certain anti-avoidance rules (a.k.a., the “attribution rules”) which can make income splitting difficult in practice. However, there are exceptions, if funds are loaned, rather than gifted, from one family member to the other family member at the CRA’s Prescribed Rate in effect at the time a loan is made.
The Strategy (for Spousal and Family Loans)
Prescribed Rate Spousal Loans are simple in concept. Where there is a higher-earning spouse (including a common-law partner) in or near the top tax bracket, he/she can attribute capital to the lower-earning spouse through a loan that the lower-earning spouse must invest (documentation is required). This tax strategy could potentially yield tax savings amounting to thousands each year.
Consequently, the borrowing spouse is generally taxed (at a lower rate) on the investment income generated from the borrowed funds. By January 30th of the subsequent year, the borrower must pay back the 1% interest, an expense that is deductible for the borrowing spouse but taxable to the lending spouse. Investment earnings in excess of the Prescribed Rate will effectively be shifted and taxed in the hands of the lower-income spouse. The net effect is that the overall taxes for the family may be reduced significantly.
A wife (who is in the top tax bracket) lends her husband (who has very little income) $1,000,000 that is currently earning a 6% return. The money is loaned at 1%, or $10,000. The husband would report income of $60,000 on his return with a deduction for the interest of $10,000 leaving $50,000 of taxable income. On the flip side, the wife would report the $10,000 of interest income – versus the $60,000 reported in previous years.
Effectively, the benefit of this strategy is that it shifts $50,000 of income (or 5%) from the wife’s return to the husband’s return where it is now taxed at lower marginal rates. This tax savings can be achieved on an annual basis as long as the arrangement is properly maintained.
As can be seen by this example, entering into an income-splitting loan arrangement with your spouse can provide significant long-term tax benefits for your family, with the more money that is lent, the greater the benefit – subject to maxing out the family’s graduated rates.
It should also be noted that Prescribed Rate Loan Planning to a Discretionary Family Trust can be a very powerful planning tool to help fund family expenses – such as paying for private school, summer camp, extra-curricular activities, etc.
As the rate of a Prescribed Rate loan can be locked-in indefinitely, you may want to consider entering into an income splitting loan at the 1% rate after July 1, 2020 to take advantage of tax savings – before the Prescribed Rate eventually increases (again) in the future.
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