Prescribed rate loans to reduce your family’s tax bill

It can be difficult to find time for tax planning when there are so many matters of immediate concern. However, a relatively simple strategy can be especially effective in tough economic times and can help reduce your family’s overall income tax bill.

Establishing a prescribed rate loan with family members can allow you to effectively shift income from high-income earners to low-income family members. This planning can result in a reduction in total income tax for the family unit and is particularly attractive in today’s environment where interest rates have hit historic lows and are now rising.

Allocation of income and capital gains

The attribution rules potentially apply when property is transferred or a loan is made at low or no interest to a family member. This means that income and capital gains can be attributed to the taxpayer who transferred the property and then taxed at the taxpayer’s higher marginal tax rates.

Some important rules to keep in mind are:

  • If a taxpayer makes an interest-free or low-interest loan or gifts property to a spouse or common-law partner, any income or capital gain from the transferred assets will be attributed to the taxpayer.
  • If a taxpayer makes an interest-free or low-interest loan, or gives property to a minor child (i.e. a son, daughter, niece or nephew, or other minor child with arm’s length), income from the funds will be attributed to the taxpayer.
  • If a taxpayer makes an interest-free or low-interest loan to an adult child or other adult relative, the income from the funds may be attributed to the taxpayer if the purpose of the loan was to reduce taxes.

Prescribed rate loans

A simple way to avoid these attribution rules is to use a prescribed rate loan. If a taxpayer makes an investment loan to a spouse, adult family member, minor child or family trust and charges interest on the loan at the prescribed interest rate, any income he earnings on the funds will be taxable to the beneficiary family member. and not to the taxpayer. These schemes work effectively when the rate of return on the investments is higher than the prescribed interest rate on the loan.

The Canada Revenue Agency sets the prescribed rate quarterly. The interest rate on the loan does not have to be adjusted each time the prescribed interest rate changes. Rather, the prescribed rate applicable to the loan is the prescribed rate in effect at the time the loan is contracted.

Currently, the prescribed interest rate is 1%, but it will change to 2% on July 1, 2022. Therefore, if a loan agreement is entered into before July 1, 2022, the lower prescribed interest rate of 1% will apply as long as the loan remains in good standing.

There are a few important details to ensure that a prescribed rate loan is set up correctly:

  • It is important that the interest on the loan is paid no later than 30 days after the end of the calendar year.
  • It is also important that the loan is documented. It is recommended to include repayment terms or document the loan as a demand loan.

Now is the time to make sure you have maximized the benefits of income splitting loans.

Contact Scott Conner at the Huntsville office to recommend an income splitting plan that’s right for you! Scott and his team can help ensure the important details of the plan are in place.

Scott Conner, CA CPA
Tax Partner at BDO Canada LLP

Scott Conner is an experienced tax practitioner and practical problem solver at BDO. As a partner specializing in Canadian income tax, Scott has particular specialties in private business, estate planning, trusts and complex transactions. Scott works closely with clients to understand their specific needs and adjust strategies accordingly. Scott and his team take a proactive and hands-on approach. They closely monitor existing and proposed legislation to determine how it will affect individual financial goals and provide ongoing advice.

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