Prescribed-rate loan strategy can save on taxes
Low 1% loan rate a smart way to split income
So far, 2020 has been quite a downer – not just emotionally, but also economically. So it was only a matter of time before the Canada Revenue Agency (CRA) announced a drop in the prescribed rate.
For the past couple of years, the prescribed rate has held steady at 2% (it had previously been at 1% for many years before that). But with the Bank of Canada cutting rates, and the big banks following suit, the prescribed rate had to follow. How does the CRA come to this conclusion? The prescribed rate as set by the government is determined by using the simple average of the three-month Government of Canada Treasury bills for the first month of the preceding quarter, rounded to the next highest percentage point. Since the average yield on 90-day Treasury bills during April was only 0.27%, the prescribed rate was set for 1% as of July 1, 2020.
Since I want to try to focus on any available silver lining during this downturn in the economy, let’s look at a loan strategy for using the ultra-low prescribed rate to save on tax. The strategy is a simple one: It allows you to split income with low-tax-rate family members without tripping over the attribution rules (that is, where income generated by funds you give to someone else will still be attributed back to you and taxed at your high rate). So here’s how you can take advantage of the low prescribed rate and put more money back into your pocket.
You can lend after-tax money to a spouse, minor child, or a family trust for the benefit of your spouse and minor children at the prescribed rate that applies at the time of the loan. Those funds would then be invested, and any income arising from those investments can be taxed in the hands of the lower-tax family members.
Alternatively, you can transfer property-in-kind instead of cash, and take back a promissory note bearing the prescribed rate of interest. However, any transfer of assets could potentially trigger capital gains in your hands if the assets have an inherent, unrealized gain. So think twice before you transfer assets. (Happily, cash, by its nature, does not trigger any gains).
In order to qualify for this tax break, the interest on the loan for each year must be paid no later than Jan. 30 after the year end. Otherwise, the attribution rules will still apply, and the profits will be taxable in your hands. Furthermore, if you miss even one Jan. 30 interest payment deadline, the attribution rules will apply on the particular investment forevermore.
Here's a tip: If the borrowed funds are invested in something that will trigger a loss, you might want to purposely trigger the attribution rules by missing an interest payment. That way, for tax purposes, the loss will probably be treated as yours. So you can actually take advantage of the attribution rules, and tum them in your favour.
Note: Once you make the loan, the parties are locked in to the 1% rate. So if the prescribed rate were to increase after implementing this strategy, the original loan is still able to benefit from the lower 1% rate in effect at the time the loan was made.
Samantha Prasad, LL.B., is a Partner with Toronto law firm Minden Gross LLP, a Meritas Law Firm Worldwide affiliate, and specializes in corporate, estate, and international tax planning. She writes frequently on tax issues, and is the co-author of Tax and Family Business Succession Planning, 3rd Edition. She is also co-editor of various Wolters Kluwer Ltd. tax publications. This article first appeared in The TaxLetter, © 2020 by MPL Communications Ltd. Used with permission.
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The foregoing is for general information purposes only and is the opinion of the writer. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.