Advisors should remind clients with prescribed-rate loans that interest must be paid on or before Jan. 30.
Failure to pay by that deadline will result in any investment income earned on the loan being attributed back to the lender for the year the interest was incurred — and all subsequent years. As a result, the strategy will no longer allow the lender and the borrower to split income, which is usually why the loan was set up in the first place.
However, if the annual interest is paid within 30 days of year-end, the loan can remain in effect at the prescribed rate that was current when the loan was originally made.
Maintaining the original rate is crucial if the prescribed-rate loan was established when interest rates were much lower than they are currently. As recently as the second quarter of 2022, the prescribed rate was 1%, the lowest rate at which the prescribed rate for family loans can be set. However, the prescribed rate has since risen with inflation. For the first quarter of 2024, the prescribed rate is 6%.
The borrower must transfer the interest payment to the lender and document the transaction, as the Canada Revenue Agency could ask for evidence that interest was paid.
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.
To avoid the application of attribution rules in the Income Tax Act, 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.