Advisors should remind clients using prescribed rate loan strategies that interest on the loan must be paid on or before Jan. 30.
A late payment will result in any investment income earned on the loaned amount being attributed back to the lender for the year the interest was incurred and all subsequent years, thwarting the income splitting opportunity created by use of the strategy.
On the other hand, as long as annual interest on the loan is paid within 30 days of year-end, the loan remains in effect — as does the interest rate on the loan. This is important because many active prescribed-rate loans were created when interest rates were much lower than they are now.
“A lot of high-net-worth clients considered and engaged the strategy because of the attractiveness of [low prescribed rates],” said Wilmot George, vice-president of tax, retirement and estate planning with CI Global Asset Management in Toronto.
“Having your strategy compromised today because of a failure to pay interest by Jan. 30 and perhaps having to collapse your original arrangement and establish a new arrangement based on a much higher prescribed rate would, I think, frustrate a lot of families,” he added.
To ensure the Canada Revenue Agency (CRA) will regard the interest as paid, money should actually be transferred from the borrower to the lender, and documentation retained.
“The CRA, in case of an audit, will want to see proof that interest was paid, so it’s important that there be some sort of paper trail,” George said.
A prescribed-rate loan strategy involves someone in a high tax bracket loaning money for investment purposes to a spouse, common-law partner or adult child in a lower tax bracket so the investment income is taxed at that lower rate, thus achieving income splitting and tax savings.
The loan must be executed with a minimum interest rate as dictated by income tax regulations, known as the prescribed rate. The lower the prescribed rate on the loan, the greater the potential for income splitting using a prescribed rate loan strategy.
The prescribed rate was 1% from July 1, 2020 to June 30, 2022, but has risen by one percentage point every quarter since. The rate is 4% for the first quarter of 2023.
Based on Government of Canada three-month Treasury bill yields issued so far this month, the prescribed rate is likely to rise to 5% as of April 1.
The prescribed rate, which the CRA sets quarterly, is based on the average yield of Government of Canada three-month Treasury bills auctioned in the first month of the preceding quarter, rounded up to the next whole percentage.
The auction yields for three-month T-bills were 4.36% on Jan. 3 and 4.45% on Jan. 17. Another T-bill auction yield will be determined on Jan. 31. Should the average of those three yields fall between 4% and 5%, the prescribed rate will be rounded up, and increase to 5% for the second quarter of 2023.