Rate on spousal loans to double October 1

However, given the outlook for interest rates to trend higher in the future, this opportunity is not expected to present itself again anytime soon, making it key to take advantage of it now. Family loans are relatively widely used as a tax splitting mechanism, especially among spouses, says Dave Chucko, partner at PricewaterhouseCoopers in Vancouver. But Henry Korenblum, tax specialist at Crowe Soberman LLP in Toronto says Canadians do not take advantage of this mechanism “as fully as possible.”

The prescribed interest rate is set at the beginning of each quarter and is based on the average rate of the 90-day Government of Canada T-bill for the first month of the previous quarter.

In addition to being used for calculating the taxable benefits on loans among family members, the prescribed rate can also be used for employee and shareholder loans. It is also the basis for the rate charged on overdue taxes and the interest paid on excess tax remittances.

Before October 1, the current 1% prescribed rate can be locked in indefinitely, once the appropriate loan agreements are in place. After this date, the anticipated 2% rate would kick in. By finalizing family loan arrangements now, clients would be able to realize tax benefits from income splitting if interest rates and investment returns exceed 1%.

In order to benefit from tax savings using the prescribed interest rate, the higher income spouse has the option of making a loan to the lower income spouse (including common law or same sex spouses) who is taxed at a lower rate. The rate can also be used for loans to other adult family members or to a trust in which minor children are the beneficiaries. Chucko suggests that loans to a trust can involve complex tax considerations and it is advisable to consult an expert prior to taking this route.

To make effective use of the prescribed rate, Chucko notes that key documentation must be completed. That includes proper loan documentation that states the prescribed interest rate. There must also be physical evidence that the money has been transferred to the borrower. In addition, the repayment term must be clearly stated (it may be indefinite), and the interest must actually be paid annually to the lender. “Interest must be paid by the borrower to the lender by January 30th of each year, not January 31,” cautions Korenblum.

In practice, the 1% prescribed interest rate is a deductible expense to the borrower once the loan is invested, but is taxable in the hands of the lender. However, any investment earnings in excess of the prescribed rate are effectively taxed in the hands of the lower income borrower. “The net effect is that the overall taxes for the family are reduced,” says Korenblum.

In an example provided by Korenblum, the wife who is in the top tax bracket provides a loan of $100,000 to her husband, who is in a lower tax bracket, at the prescribed 1% interest rate. The husband invests the $100,000 and earns a 6% return. The husband would report income of $6,000 ($100,000 x 6%) on his tax return and a deduction of $1,000 ($100,000 x 1%) as interest expense, for a net income gain of $5,000. The wife would report $1,000 in interest income paid to her by her husband — instead of $6,000 — had she herself invested the money for a 6% return. Effectively, this shifts $5,000 in income to the husband’s tax return, where it is taxed at a lower marginal tax rate, resulting in a tax saving.

Without the documentation noted above, if funds are loaned to a spouse or trust for minor children at the prescribed rate, the attribution rules will apply and any income earned on the loan would be attributed back to the taxpayer/lender and taxed in their hands.

Employees who have home purchase loans from their employers can also benefit by locking in the existing prescribed rate. Normally, if an employee receives a low interest or tax free loan, the employee is deemed to be receiving a taxable benefit from the employer. However, if the loan is used to purchase a home, the prescribed interest rate is used to calculate the imputed interest rate for the first five years of the loan. Effectively, the taxable benefit to the employee will be 1% if the loan is renewed or replaced by September 30 by the employee, advises Chucko. After five years the existing prescribed interest rate at that time will apply to the loan.