Help your client split income with a prescribed rate loan

The strategy

Income splitting transfers income from a high-income family member to a lower-income family member. Since our tax system has graduated tax brackets, the overall tax paid by the family may be reduced if the income is taxed in a lower-income earner’s hands.

The attribution rules in the Income Tax Act, however, prevent some types of income splitting by generally attributing income (and potentially capital gains) earned on money transferred or gifted to a family member back to the original transferor.

There is an exception to this rule if the funds are loaned, rather than gifted, provided the interest rate on the loan is set (as a minimum) at the prescribed rate in effect at the time the loan is made and the interest on the loan is paid annually by Jan. 30 of the following year.

If the loan is made at the prescribed rate of 1% before July 1, the net effect will generally have any investment return generated above 1% taxed in the hands of the lower-income family member.

Note that even though the prescribed rate varies by quarter, you need only use the prescribed rate in effect at the time the loan was originally extended. In other words, if you establish the loan before the July 1 increase, the 1% rate would be locked in for the duration of the loan without being affected by any future rate increases.

Example 1: Spousal income splitting

Here’s how we might lock in the 1% current rate for years to come, implementing a prescribed rate loan strategy to split income between spouses, using the example of Hi, who is in the highest tax bracket, and Lois, who is in the lowest bracket.

Hi loans Lois $500,000 at the current prescribed rate of 1% evidenced by a written promissory note. Lois invests the money in a portfolio of Canadian dividend-paying stocks with a current yield of 4%. Each year, she takes $5,000 of the $20,000 in dividends she receives to pay the 1% interest on the loan to Hi. She makes sure to do this by Jan. 30 each year starting the year after the loan was made, as required under the Income Tax Act.

The net tax savings to the couple would be in having the dividends taxed in Lois’s hands at the lowest rate instead of in Hi’s hands at the highest rate. This would be offset slightly by having the $5,000 of interest on the promissory note taxable to Hi at the highest rate for interest income. Lois would be able to claim a tax deduction at her low rate as the interest was paid to earn income, namely the dividends.

Example 2: Income splitting with kids

This strategy can be expanded to help fund children’s expenses, such as private school and extracurricular activities, by making a prescribed rate loan to a family trust. The trustee then invests the money and pays the net investment income, after the interest on the loan, to the kids either directly, or indirectly by paying their expenses. If the kids have zero or little other income, this investment income can be received perhaps entirely tax-free.

Continuing with the above example, let’s say Hi instead loans $1 million at 1% to a family trust, of which his two minor kids are beneficiaries. The trust’s funds are invested in a portfolio of Canadian dividend-paying securities, yielding 4% or $40,000. The trust can deduct the $10,000 of interest expense, netting $30,000 of dividend income. This income, if paid out to the beneficiaries or used for their benefit, is deductible to the trust and taxable to the children.

If the kids have no other income, each child could effectively receive up to $54,000 of eligible Canadian dividends either completely tax-free or, depending on the province, with minimal provincial tax, due to the basic personal amounts and the federal and provincial dividend tax credits.

Jamie Golombek, CPA, CA, CFP, CLU, TEP, is the Managing Director, Tax & Estate Planning with CIBC Private Wealth in Toronto.