Now’s the time to remind clients with prescribed-rate loans that interest must be paid on or before Jan. 30.
If the 2024 interest isn’t paid by the deadline, investment income earned on the loan will be attributed to the lender for 2024 and all subsequent years. The result is a lost opportunity to split income, which is typically why a prescribed-rate loan is arranged.
When the annual interest is paid within 30 days of year-end, exemption from the attribution rules stands. Plus, the loan can remain in effect at the prescribed rate applicable when the loan was originally made.
The prescribed rate for the first quarter of 2025 is 4%, which is higher than the rate in some pre-2023 quarters.
“If you implemented the prescribed-rate loan strategy previously and were able to lock in a lower rate, it is important that the interest on the loan is paid (in cash) by the Jan. 30, 2025 deadline to preserve the benefits of the strategy,” according to an article from Grewal Guyatt LLP Chartered Professional Accountants, in Richmond Hill, Ont.
On the other hand, some taxpayers who already have prescribed-rate loans in place may have a higher rate of interest than the current 4%.
The prescribed rate began rising in the third quarter of 2022. Until then, the rate had been 1% for two years. In the first half of 2024, the prescribed rate rose as high as 6% before falling to 5% in the second half, and then 4% this year.
Taxpayers using a prescribed-rate loan strategy at a rate greater than 4% “may want to consider dismantling their current structure and take advantage of the lower prescribed rate starting Q1 2025,” Toronto-based RSM Canada LLP said in an article.
Typically, amending the interest rate on an existing loan is insufficient to lock in a new rate, RSM said.
“Instead, the debtor would need to liquidate their investments, incur the relevant tax implications due to the sale, repay the existing loan and introduce a new loan carrying the new prescribed rate,” the RSM article said. “Taxpayers considering this would need to model the triggered tax costs associated with liquidation against the possible tax benefits from re-establishing a new loan.”
The lower the prescribed rate, the greater the potential for income splitting using a prescribed-rate loan strategy.
Prescribed-rate loans can be used to split income with a lower-income spouse, common-law partner or other family member, who can use the loan to earn investment income. Prescribed-rate loans can also be used with family trusts to reduce the family’s tax liability.
To avoid the application of attribution rules in the Income Tax Act, the loan must be executed at an interest rate no less than the prescribed rate — the minimum interest rate as dictated by income tax regulations.