If you are looking for ways to lower your family’s income tax bill, you may want to consider using prescribed rate loans. Prescribed rate loans are loans made at a rate of interest that is set every quarter by the Canada Revenue Agency (“CRA”). Generally, the prescribed rates are lower than those rates offered by banks or other financial institutions. As such, they can be a great tax planning tool to income split and transferring income from high-income family members to lower-income family members to reduce total income taxes for the family unit.

Attribution Rules

Before we go further into how this type of tax planning can work in your situation, taxpayers should first be aware of the attribution rules under the Income Tax Act (“ITA”) that limit or prevent income splitting among family members in lower tax brackets. Attribution rules apply whenever a property is transferred or loaned at less than the prescribed rate by:

• one spouse to the other spouse;
• a parent to a child under the age of 18;
• a spouse to a trust for the other spouse’s benefit, or
• a parent to a trust for the benefit of a child under the age of 18.

Where such gifts or loans are made, any income or capital gains arising from the gifted or loaned property will be attributed back to the taxpayer who transferred the property and then taxed at the higher marginal tax rates of the taxpayer. However, in the case of a transfer to a minor child, the income will be attributed back to the taxpayer but any capital gains arising from the property will be taxed in the hand of the child. The following rules do not apply to gifts intended for adult family members who aren’t your spouse or common-law partner.

Prescribed rate loans

A simple approach 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, then any income they earn on the funds will be taxable to the recipient family member and not to the taxpayer.

When an appropriate strategy is used, these plans can be successful. When the investment rate of return generated is greater than or equal to the prescribed interest rate charged on the loan, they function effectively. Because the income earned on the rate difference will be taxed at a lower marginal tax rate for family members in such circumstances, a net benefit will be realized. It is also vital to note that, once a loan has been granted, the initial rate stated at the time of the loan remains in force for the duration of the loan, even if subsequent rates are increased or decreased.

Due to the latest interest rate increases, the prescribed interest rate will increase from 1% to 2% on July 1, 2022. As a result, if a loan agreement is entered into before July 1, 2022, the lower 1% prescribed interest rate will apply as long as the loan remains in good standing.

How can I use prescribed loans for income splitting and tax planning?

Prescribed rate loans can be beneficial for lowering your family’s income tax bill because it allows income splitting and avoids the income and capital gains attribution rules. One way to do this is by giving loans to a spouse or a trust for the benefit of a spouse at the prescribed interest rate. This allows the higher income spouse to split income with a lower-earning spouse (married or common law), resulting in tax savings based on the difference in marginal tax rates between spouses. This is an excellent way for anyone with investment funds earning more than 1% and whose spouse is in a lower tax bracket than them to save tax.

Another common way prescribed loans are used is for inter vivos family trust planning, where a family member who is the high-income earner, makes a loan to the trust. It is advantageous to provide a loan to a trust with minor children or grandchildren beneficiaries, who usually have a significantly lower marginal tax rate than the person loaning the funds. The trust income can be distributed to these minor beneficiaries and used for expenses like school tuition, education expenditures, and camp fees. Each minor beneficiary will be taxed at their lower marginal rate on the income used for their benefit.

Essentially, this type of trust and loan planning benefits anyone in a high tax bracket whose spouse is in a lower tax bracket or who has children or grandchildren at school and extracurricular expenses and who would like to decrease their overall family income tax burden.

Please note that the tax on split income (TOSI) rules will also have to be considered if a trust, partnership, or private corporation is part of the strategy. These rules are highly complex and may result in no advantage if they apply.

How do I set up a prescribed rate loan?

The critical thing to remember with prescribed rate loans is that they must be structured correctly to be considered a prescribed rate loan by the CRA. In addition, there are a few things you’ll need to do to set up a prescribed rate loan:

• Draw up a loan agreement that includes all the required information, such as the interest rate and repayment terms. The interest rate on the loan should be the prescribed rate in effect on the loan agreement date.. As mentioned above, the CRA sets this rate every quarter, so please ensure you are using the current rate. See current prescribed rates here.
• Make sure that you make all required interest payments on time. If you miss a payment, the loan will no longer be considered a prescribed rate loan by the CRA and will be subject to the attribution rules until the loan is repaid. Interest on the loan must be paid each year at the prescribed rate by January 30th of the following year, and interest payment should be recorded.

If you are looking for ways to reduce your family’s income tax bill, prescribed rate loans can be an effective tool. However, the prescribed rate rules can be complex and should be reviewed carefully before implementing any tax planning strategies. If you have any questions about prescribed rate loans and how you can take advantage in your specific situation, please contact us.

Disclaimer

The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting/tax professionals. NBG Chartered Professional Accountant Professional Corporation will not be held liable for any problems that arise from the usage of the information provided on this page.

If you’re running a business, there may come a time when you need to withdraw funds from your business. Many business owners put their salaries, dividends, or other compensation on hold during the early phases of their business in order to reinvest the gains in the company to help it expand. At some point though, the business owner would want to take some cash out for personal needs as the business becomes more established.

However, withdrawing funds from your business is not as simple as it sounds and can have tax consequences. Though there are tax efficient ways to take money out of your business, but it will differ for each business owner depending on their specific situation. Several factors may influence which method is better, including the tax rates where you reside, the tax rates where your business operates, and whether the corporation has certain tax attributes that can be utilized to minimize tax. In addition, while some methods of withdrawing cash from your corporation are taxable, some could be tax-free. Each option, however, has its own advantages and disadvantages which we will explore below.

Salaries and bonuses

Generally, the most common method owners will use to withdraw funds from their business is via a salary which is similar to an employee being remunerated. In addition, other family members that are working for the business can also be paid a salary as long as the amount is reasonable.

From a tax perspective, at the corporate level, the business is able to deduct the salary expense from its taxable income and lower the corporate tax rate. However, for a salary or bonus payments to be deductible for the corporation, the amount paid must be reasonable. Based on Canada Revenue Agency (“CRA”). a reasonable salary would be equivalent to the amount the business would pay a third party for the same work activities. Note that there is an exception for salary paid to owner-managers. The CRA would not question the amount of salary paid by a Canadian Controlled Private Corporation to its Canadian resident owner who actively participates in the operations of their company. Another thing to consider at the corporate level is the additional employer cost associated with payroll taxes such as CPP/QPP contributions and employment insurance (EI) premiums.

At the individual level, the taxpayer or business owner will be fully taxed on the salary amount at their personal marginal tax rates that are applicable based on the jurisdiction in which they live. In addition, payment of salary or bonus is considered earned income for the purpose of generating Registered Retirement Savings Plan (RRSP) contributions room for the individual.

Taxable dividend

Taxable dividends can also be used to withdraw funds from your business. Dividends are the profits a company keeps after paying off taxes from its net profits. They’re paid out to shareholders of the company, thus you, your spouse, and your children must own shares of your corporation directly or indirectly (i.e., through a trust or a holding company).

At the individual level, dividends are taxed more efficiently than a salary since the tax rate depends on the characteristics of the dividend (i.e., eligible or non-eligible). However, in contrast to salary, dividends can result in a larger reduction to Old Age Security benefits because of the dividend gross-up mechanism. At the corporate level, the payment of dividends will not be deductible to the corporation. In addition, payroll taxes such as CPP/QPP contributions and employment insurance (EI) premiums will not be an added cost to the corporation or the shareholder.

Under this option, consideration should also be given to both the tax on split income (TOSI) rules and corporate attribution rules before any distribution is made. Generally, taxable dividends from a private corporation to family members who don’t contribute to the business will be taxed at the top marginal rate under the TOSI rules. Similarly, corporate attribution rules under the Income Tax Act (“ITA”) can also apply when an individual tries to income split with family members  in lower tax brackets by transferring or lending property to a corporation. For corporate attribution to apply, the main purpose of the transfer or loan would be to reduce the income of the transferor or to benefit a designated person such as spouse or minor child, thus resulting in the income being attributed back to the transferor.

Capital dividend

Another tax-efficient way to withdraw funds from your business is to pay yourself a dividend through the corporation’s capital dividend account (CDA). The CDA is a notional account that tracks the non-taxable portion of the capital gains and the non-allowable portion of capital losses that is earned by a private corporation. In addition, other amounts such as capital dividends received or paid by the corporation and certain life insurance proceeds received in excess of the policy’s adjusted cost base are also included in the CDA calculation.

A positive balance in a corporation’s CDA is usually a result of net capital gains and can be distributed to Canadian resident shareholders as a tax-free dividend. However, because the CDA is calculated on a cumulative basis, a capital dividend must be paid as soon as capital gains incur to avoid the realization of capital losses. Capital losses incurred after paying a capital dividend will not retroactively affect the tax-free distribution previously received, even if the loss is carried back. Accordingly, it is advisable to pay out the balance of the CDA as soon as it becomes available.

Having said that, calculating the CDA can be complex. In addition to rules regarding what is allowed and what is not allowed in the CDA, timing considerations must also be taken into account when calculating the CDA balance. For these reasons, it is imperative that you speak to a tax professional in advance of paying a dividend from your corporation’s CDA.

Paid-up-capital

The paid-up capital (PUC) of your shares represents the consideration your corporation received in return for the shares it issued. In some cases, your corporation can return the PUC to you tax-free as return of capital . This may be a good strategy if you have a high PUC on your shares and the corporation no longer requires the funds.  In this case, you can take out a tax free distribution by reducing the PUC on your shares.

Obtaining shareholder loans

Another option to withdraw funds from your business is by obtaining a shareholder loan from your corporation. Shareholder loans can be a useful way to manage short-term personal cash needs. However, the ITA contains very specific rules limiting the ability of a shareholder to borrow funds from their corporation. The general rule is that if you borrow funds from your corporation and the loan is not repaid, the amount borrowed is included in your personal income in the year you borrowed the money, unless the loan meets certain exceptions.

The most common exception is if the loan is repaid within one year after the end of the taxation year of the corporation in which the loan was made. However, this exception will not apply if the repayment was part of series of loans and repayments.

Generally, if the business owner needs a short-term loan for less than a year, a shareholder loan could be an easy way to obtain the funds. If used properly, shareholder loans are a great tool for tax planning and cash management.  However, the shareholder rules under the ITA are complex, so speak to a tax professional to avoid negative tax consequences. For more details on shareholder loans, read our article titled “Shareholder loans and their tax implications.”

Repaying shareholder loans

Unlike the option above, if the shareholder has loaned funds to their company, there would be no tax consequences if they want the corporation to repay a portion or all of this loan.  Any amount the shareholder receives as settlement for the shareholder loan will be considered a tax-free distribution.

­­­The most important thing when withdrawing funds from your business is to take the time to properly plan how you are going to withdraw the funds to ensure you are paying the minimum amount of tax. The most tax efficient way to extract funds depends on your unique situation and various factors can influence the end result. The above-mentioned options are available as a general guideline but the best possible solution can be determined with the help of a tax professional as different options can have different tax consequences. If you need help to create a strategy that works best for you, please contact us.

Disclaimer

The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting/tax professionals. NBG Chartered Professional Accountant Professional Corporation will not be held liable for any problems that arise from the usage of the information provided on this page.