If you are looking for ways to lower your family’s income tax bill, you may want to consider setting up a prescribed rate loan. 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.
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:
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.
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 4% to 5% on April 1, 2023. As a result, if a loan agreement is entered into before April 1, 2023, the lower 4% prescribed interest rate will apply as long as the loan remains in good standing.
A: 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 rate 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.
A; 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:
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 for an accountant in Hamilton about prescribed rate loans and how you can take advantage of your specific situation, please contact us.
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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.
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