For many families, looking for ways to save on taxes is a common focus in tax planning. Did you know that, depending on your circumstances, if you have a spouse or common-law partner who earns less income than you (or vice versa), or children or other family members with little to no income, certain types of income splitting may be effective in lowering your family’s overall tax bill? Where implemented properly and when it makes sense for your family, there are specific income splitting strategies that may help you retain more after-tax income — and the potential benefits may be heightened in times when the prescribed interest rate is low.
Note: Any reference to a “spouse” in this article refers to both a common-law partner and a legally married spouse.
What is income splitting?
Income splitting is a tax-planning strategy that can shift income that would otherwise be taxed in your hands at a high marginal tax rate to your lower-income family member(s), taking advantage of their lower marginal tax rate(s).
In considering income splitting as a possible tax-savings opportunity and the various methods that exist, it’s important to be aware that not all forms are allowed; certain rules called the “attribution rules” may restrict your planning. The attribution rules (which exist within the Income Tax Act) are designed to prevent splitting income between family members in certain circumstances.
In situations where the attribution rules apply, any investment income and any capital gain or loss earned on that property by the lower-income family members may be attributed back to you; this means it would need to be reported in your income tax return rather than theirs, effectively removing the ability to achieve tax savings.
One exception to the attribution rules, however, is loaning money to family members at the Canada Revenue Agency (CRA) prescribed interest rate, and this is called a “prescribed rate loan.”
Note: The criteria to determine if attribution applies are complex and depend on a number of factors. With this in mind, it’s crucial to consult with your qualified tax advisor before considering any type of income splitting opportunity.
What is a prescribed rate loan?
A prescribed rate loan is a popular tax-planning strategy that can offer tax-savings opportunities if it’s correctly implemented and maintained. As a method of income splitting, it involves loaning funds at the CRA prescribed rate directly to your spouse, common-law partner or adult child, who then invests the loaned funds for the purpose of generating investment income. This strategy can also be implemented via a loan to a family trust for the benefit of low-income family members, including your spouse, minor and adult children, as well as grandchildren, nieces or nephews.
When the strategy is effectively carried out, the investment income earned in excess of the prescribed interest rate can be shifted to your low-income family members and taxed in their hands. For example — keeping in mind that the tax-free amounts vary by province and territory — a family member who has no other income may be able to earn up to $12,000 of interest income, $24,000 of capital gains or $50,000 of Canadian public company dividend income tax-free every year.
In times when the CRA prescribed rate is low, the effectiveness may increase, potentially boosting your family’s tax savings and leaving more funds available to meet your other financial planning goals.
The CRA prescribed interest rate
Each quarter, the CRA updates and publishes the prescribed interest rates. The rate is based on the average 90-day T-bill rates of the first month of the previous quarter. The rate can only be in whole percentage points, and the lowest it can be is 1 percent.
To implement a prescribed rate loan, the interest rate on your loan should be equal to or greater than the CRA prescribed rate in effect during the quarter in which you make the loan — that rate will be locked in for as long as the loan exists, even if the rate changes in the future.
Implementing a prescribed rate loan
Here’s an overview of two common prescribed rate loan strategies:
Spousal loan strategy
One method of income splitting that couples may consider is a spousal loan strategy. This approach may make sense where one spouse has a higher income. The higher-income spouse can loan personal funds to their lower-income spouse at the CRA prescribed interest rate, and the aim is to shift future investment income, in excess of the prescribed rate, to the lower-income spouse so it’s taxed at their lower marginal tax rate.
Let’s consider an example. Tammy and Albert are a married couple. Tammy is the higher-income spouse, and she has built a $350,000 non-registered investment portfolio in her name. She’s concerned that she’s paying high taxes on her portfolio’s investment income, and she’s keen to shift future investment income to Albert, since his income is lower. In consultation with her qualified tax and legal advisors, using what’s called a “demand loan” (which is backed by a promissory note and a loan agreement), Tammy lends personal funds to Albert at the CRA prescribed interest rate. Then, Albert invests the full amount of those funds in his name. The investment income — which may include interest, dividends and capital gains — in excess of the CRA prescribed interest rate will be taxable to Albert at his lower marginal tax rate.
Family trust strategy
In general, the principles of a family trust strategy are similar to those of a spousal loan strategy. The family trust is established for the benefit of lower-income family members; typically parents or grandparents set up a prescribed rate loan to a family trust for the benefit of their children, grandchildren, nieces or nephews. With this approach, you can loan funds to a properly structured trust at the CRA prescribed interest rate, and those loaned funds are then invested by the trust. Any investment income (less the annual interest payment) will be taxed in the hands of your family members who are named as beneficiaries of the trust. If the family member is a child or grandchild, for example, they may pay little or no tax.
With this approach, you retain access to the capital loaned, and it can be an effective strategy to fund expenses that directly benefit the child. For example, the investment income allocated to your children or grandchildren can be used to pay for private school tuition, camp fees or lessons. Normally these expenses are paid by the parent with after-tax dollars, so this is a more tax-effective way to fund these expenses.
Let’s consider another example. Omar and Isabelle have one child, Jonah, who’s four years old. They’d like Jonah to attend private school and are already thinking ahead to potential post-secondary education costs. They’re also interested in achieving overall tax savings as a family, if they can. In consultation with their qualified advisors, Omar and Isabelle loan $500,000 in capital to a properly structured family trust at the CRA prescribed interest rate, and Jonah is named as beneficiary of the trust. Those funds are invested in the trust, and all interest income, dividends and capital gains can be paid or made payable to Jonah as the beneficiary or used for his benefit and taxed at his marginal tax rate. Any income of the trust that’s in excess of the amount required to cover Jonah’s eligible annual expenses can be made payable to Jonah by issuing a promissory note; this enables it to be taxed in his hands.
With a family trust, it’s important to keep in mind that there is additional administration, record-keeping and costs involved, so be sure to consult with your qualified tax and legal advisors to ensure it’s set up correctly and continues to operate properly over time.
Key factors to keep in mind
In considering a prescribed rate loan or maintaining it over time, here are some important details to remember:
- This strategy should be implemented as part of a long-term financial plan. It’s possible that over the lifetime of the loan, you may not always achieve income splitting and the expected tax savings at certain points in time.
- If you dispose of appreciated securities to fund the loan, you will trigger capital gains, on which income tax will be payable.
- This strategy may not be as tax-effective for your family if you plan to invest in a very tax-efficient portfolio.
- The borrower must be able to pay the interest to you each year, as set out in the loan agreement, by the January 30 deadline to avoid the attribution rules.
- If the annual interest payment is not paid to you by January 30 of the following year, the attribution rules will apply. Even if the deadline is missed by one day, the attribution rules will be triggered. Once that happens, attribution will apply to that year and all subsequent years.
- Interest payments from the borrower should be done in a way that demonstrates they have used their own funds.
- If you already have an established prescribed rate loan and the CRA prescribed rate falls, you may be able to modify your loan to benefit from the lower prescribed interest rate. Keep in mind this needs to be executed carefully with the help of your qualified advisor; if not done correctly, there may be negative tax consequences.
- Over time, it’s important to consult with a qualified legal advisor to determine and confirm the requirements for keeping the demand loan legally enforceable in your jurisdiction.
Watch this video to find out more about prescribed rate loan planning.