High net worth individuals and families in Canada have until June 30, 2022 to take advantage of a prescribed rate loan for tax planning purposes at the current historically low interest rate of 1%. Prescribed rate loans, a tax planning tool used to lower a family’s total tax bill, are one of the few income-splitting tools permitted in the Income Tax Act (Canada) (the “Act”). These loans, while typically used for income splitting between spouses, can also be used for income splitting between family members, including adult children, minor children, or even to a family trust.
What is a prescribed rate loan and how does it work?
Prescribed rate loans split income between a higher-income earning spouse or family member to a lower-income earning spouse, family member, or family trust. Using a prescribed rate loan, the higher-income individual will make a loan to a lower-income individual or family investment trust at the prescribed rate in effect as of the date of the loan. The current prescribed rate set by the CRA has been at an all-time low of 1%, but is set to rise to 2% on July 1, 2022.
The borrower can then use the loan to earn investment income and/or capital gains. If the loan is documented appropriately and the interest is paid on the loan within the requisite deadline (by January 30 of the following year), it will be exempt from the attribution rules.
Income splitting under the attribution rules
Generally speaking, the Act contains a number of rules, commonly referred to as the “attribution rules”, that are designed to prevent high-income earning family members from lowering their income while increasing the income of a low-income earning family member, with the intent of lowering the overall tax burden of the family unit as a whole. However, prescribed rate loans are one exception to the attribution rules in the Act. As such, prescribed rate loans can be very effective at lowering a family’s overall tax bill by transferring the income earned on the amount of the loan that exceeds the prescribed rate (1%) to the lower-income earning family member. The lower-income family member will be taxed on the investment income at a lower marginal tax rate, thereby lowering the overall tax burden to the family unit.
As the prescribed rate is expected to rise to 2%, Canadian families and high net worth individuals who are considering utilizing this tax planning tool have until June 30, 2022 to lock in the prescribed rate of 1%. Prescribed rate loans made before July 1, 2022 will continue to have a 1% interest rate as long as the loan continues in good standing, notwithstanding future rate hikes.
It is important to note that loans that do not satisfy the prescribed rate requirements (e.g., where the loan interest is set lower than the prescribed rate, and/or the loan interest is not paid by the deadline) will still be subject to the attribution rules in the Act.
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