Prescribed rate loans for family income splitting

Prescribed rate loans for family income splitting

Prescribed rate loans provide an opportunity to split income with a spouse, a common‑law partner, children or other family members. Although the prescribed rate is at the highest level since 2007, the timing might be right to make such a loan. We will discuss how to use the prescribed rate to your advantage by making a loan directly to family members ⁠–⁠ or using a family trust where minors are involved.

Income splitting is the transferring of income (or capital gain) from a high‑income family member to a lower‑income family member. There is no attribution of capital gains earned by minor children. 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. Prescribed rate loans can be used to help fund minor children’s expenses, such as paying for private school or extracurricular activities.

The “attribution rules” in the Income Tax Act (ITA) prevent certain 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. The ITA does provide an exception to this rule if funds are loaned, rather than gifted, at the prescribed rate in effect at the time the loan was originated and the interest is paid annually within 30 days (i.e., Jan. 30) after the end of the year. The loan must have bona fide repayment terms, and if the interest on the loan is not paid within 30 days after the end of any year, the loan will be offside and caught by the income attribution rules.

Prescribed rates are set by the Canada Revenue Agency (CRA). Even though the prescribed rate has crept up gradually from 1% ⁠–⁠ in effect from July 1, 2020 to June 30, 2022 ⁠–⁠ to 5% beginning April 1, 2023, it is expected to continue to increase in the fourth quarter (October through December) of 2023.

For loans put into place before Oct. 1, 2023, the 5% rate would be locked in for the duration of the loan without being affected by any future increases.

If a loan is made when the prescribed rate is 5%, the net effect will generally be to have any investment return generated above the 5% prescribed rate taxed in the hands of the lower income family member. Even if the prescribed rate increases to 6%, you will only need to use the prescribed rate in effect at the time the loan was extended.

Refinancing a loan when the prescribed interest rate decreases

What happens if you made a loan to your family member when the prescribed rate was 5% (or higher) and the rate drops? To be eligible to use the lower prescribed rate (for determining if there will be attribution of income from the investments), the family member should sell any investments made with funds from the original 5% loan and repay the loan to you. You can then enter into a completely new loan agreement using the new, lower prescribed rate.

What if this results in unwanted tax consequences such as triggering tax on capital gains or brokerage fees? Furthermore, given market volatility, what if the fair market value of the investments is insufficient to pay off the original loan? In these cases, while you may be tempted to either adjust the rate on the loan or refinance it at the lower rate, both measures may put you offside.

You must enter a new loan for the lower prescribed rate to apply. In fact, the CRA has stated simply repaying a higher prescribed rate loan with a lower rate loan could trigger the attribution rules.

Be sure to obtain tax and legal advice before implementing a prescribed rate loan, to determine the best way to structure and operate this type of arrangement, as well the implications for your unique circumstances.

Split the difference

For more information:

Segal GCSE Tax Team

taxquestions@segalgcse.com

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