Canadians looking to refinance their existing prescribed rate loan at a lower rate may now be able to do so with part of the proceeds from the original loan without triggering attribution rules in the Income Tax Act (ITA).

The Canada Revenue Agency (CRA) commented on such tax planning at the national conference of the Canadian Tax Foundation last Wednesday.

During the CRA roundtable portion of the conference, a question was asked regarding an individual who had taken out a prescribed rate loan at 2% and who wanted to use the proceeds from that loan to take out a second prescribed rate loan at 1%. Would the borrower trigger the attribution rules by only selling a portion of the investment purchased with the 2% loan?

In response, the CRA confirmed that the borrower would not need to sell all of an investment purchased with funds from the 2% loan to avoid triggering the attribution rules.

“It’s great news,” said Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth Management in Toronto. “You don’t have to take that conservative approach that we were always suggesting to clients of selling all of the investments [including any gains], paying off the loan, and then buying the investments back. You only need to sell off enough to pay the actual loan.”

Selling only as much of the investment as needed to repay the original loan means triggering less capital gains tax, said Golombek, who is a member of the Canadian Tax Foundation and submitted the question regarding prescribed rate loans.

Normally, the attribution rules in the ITA prevent many kinds of income splitting by attributing the income and gains on money transferred to a family member back into the hands of the transferring family member. Income splitting involves spouses or other family members transferring income from a high-income family member to one with a lower income, thereby lowering a family’s overall tax bill.

However, there is an exception to the attribution rules in the ITA if the transferred funds are loaned from one family member to another at the prescribed rate of interest (or higher), which is set by the government of Canada on a quarterly basis. Once a loan is made at a particular rate, that rate can be used indefinitely for that particular loan.

Interest paid on the loan is taxable in the hands of the transferring family member, so a loan set at a lower prescribed rate is generally more tax-effective.

Since the third quarter of this year, the prescribed rate has been set at 1%, meaning families with existing prescribed rate loans at higher rates could benefit from refinancing them. However, the lender could trigger the attribution rules by simply lowering the rate on the loan, or by issuing a new loan at the 1% rate to repay the 2% loan.

“You had to basically sell off all the investments [purchased with funds from the loan], pay off the loan, and do a new loan,” Golombek says.

Now, if the value of investments purchased with funds from the loan exceed the value of the original loan, the borrower only needs to sell enough to be able to repay the loan — not the full amount.

At the conference, the CRA was given a scenario of an individual using funds from a prescribed rate loan of $100,000 at 2% to purchase securities. The securities double in value. The individual sells half the securities and uses the proceeds to repay the loan. The individual then borrows $100,000 at the prescribed rate of 1% and uses the proceeds to purchase new securities for $100,000.

The CRA confirmed that the attribution rules would not apply to either the securities still owned and purchased with the original loan or to the investments purchased with the new loan.

Golombek says clients have expressed “enormous interest” in refinancing existing prescribed rate loans since the rate dropped in July. With the Treasury Bill rate for October being set at below 1% this week — a rate used to set the prescribed rate — the prescribed rate for first quarter of 2021 is set to continue to be 1%, he says. (That rate hasn’t been officially announced.)

Whether it makes sense to sell investments in order to refinance a prescribed rate loan will depend on a taxpayer’s individual circumstances, balancing the benefit gained from refinancing a loan at a lower rate and the potential downside of effectively “pre-paying” capital gains tax on investments the taxpayer might otherwise have held for the longer term, Golombek said.

“Generally speaking, yes, [a refinancing] is worthwhile doing, unless there’s a substantial capital gains tax,” he said.