Reduce Your Family Taxes with a Prescribed Rate Loan

Are you in a higher tax bracket than your spouse? Do you earn investment income from a non-registered account? If so, a prescribed rate loan can provide you with a method of income splitting that will reduce your taxes.

Income splitting is a strategy used to transfer income from a high income earner to a spouse in a lower tax bracket. The lower income spouse pays tax on this income at a lower rate than the high income spouse would have paid, and the family’s overall taxes are reduced.

Income tax rates vary by province of residence. In most provinces, shifting income from the higher income spouse to a lower income spouse can reduce taxes by about 20%.

However, the Income Tax Act has rules affecting the benefits of simply transferring an investment portfolio from a high income spouse to a lower income spouse. These rules will attribute the income back to the higher income spouse, who would still have to report and pay tax on the investment income. Thus, no advantage would be gained as the income would be reported as if there had been no transfer. These rules are commonly referred to as the income tax attribution rules.

A properly implemented prescribed rate loan strategy will avoid the income tax attribution rules. A prescribed rate loan involves transferring income-earning assets, such as cash, savings or an investment portfolio, from a high income spouse to a lower income spouse. To avoid the attribution rules, two features must be added to the transfer:

1. the transferor must take back an interest-bearing loan from the lower income spouse; and
2. the interest owing on the loan for the year must be paid by the lower income spouse each and every year that the loan is outstanding.

There is no need to repay the principal of the loan but the interest payment must be made by January 30 of the following year. If these features are included and followed, the investment income will not attribute back to the higher income spouse; it will be taxed at the lower income spouse’s tax rates. The interest paid on the loan will be reported by the higher income spouse, but the lower income spouse will claim a deduction for this same amount.

To maximize income splitting, the interest rate charged on the loan should be as low as possible to minimize the interest income that the higher income spouse must report on the loan. To comply with the income tax rules, the interest rate charged on the loan must be equal to or greater than the Canada Revenue Agency’s (CRA) prescribed rate, which has been at the historically low rate of 1% since the second quarter of 2009.

The prescribed rate is adjusted each quarter and will undoubtedly rise at some time in the future. However, the prescribed rate loan is like a mortgage with a locked-in interest rate and does not have to change with future prescribed rate increases. The rate in effect at the time the loan originates determines the interest rate that must be charged on the loan until it is fully repaid. With the currently low prescribed rate of 1%, there is an advantage to having the loan set up before a future rate increase is announced.

As an example, assume that a higher income spouse has an investment portfolio of $150,000 on which they earn an average return of 5% ($7,500) and pay tax at a rate of 45%, while their spouse is at a 25% bracket. If they were able to transfer this annual income to the lower income spouse using a prescribed rate loan, the lower income spouse would have to pay interest of $1,500 (1% of $150,000) but would then pay tax at their lower rate.

The result is annual total family tax savings of $1,200. While this amount might not seem impressive to some, when the prescribed rate loan strategy is continued over a number of years, the cumulative tax savings can be significant. 

The requirement to pay interest on the loan reduces the benefit of the income splitting. However, implementing the loan while the prescribed rate is at the current level of 1% will set the amount of interest at a fixed amount. When rates rise in the future, as they are expected to do, the tax savings should be larger if rates of return on the investments also rise.

Some additional factors are relevant:

• A transfer of an investment portfolio from the higher income spouse to the lower income spouse can cause some tax issues if there are accrued gains or losses on the investments in the portfolio. The transfer should occur at fair market value, which will require the high income spouse to file an election with their tax return for the year of the transfer in order to avoid the spousal rollover rules. If there are accrued gains, the capital gains will be taxable to the transferor. Any capital losses will be denied under the superficial loss rules if the lower income spouse retains the investment with the loss beyond the first 30 days after the transfer. It may be advisable not to transfer investments with significant gains, and care must be taken when there are investments with losses.
• The interest owing for the year must be paid by January 30 of the following year. If this deadline is missed in any year, the attribution rules will apply again for that year and all years that follow, even if the interest is properly paid in future years. 
• The interest owing must be calculated for the period of the calendar year over which the loan was outstanding, rather than calculated and paid on an anniversary date of the loan. For example, consider a prescribed rate loan set up on July 15 on principal of $100,000 using the prescribed rate of 1%, and a promissory note stating that interest will be paid and calculated annually. The interest that must be paid for the calendar year 2013 will be based on the period from July 15 to December 31 (169 days x 1% of $100,000 = $463), and the $463 must be paid on or before January 30, 2014. If the parties waited until the anniversary date of July 15, 2014, and made the annual interest payment of $1,000 at that time, the interest for 2013 would not have been paid within the required time limit and the attribution rules would apply for 2013 and all future years. Ideally, the promissory note should be worded so that interest is calculated to December 31 of each year and paid within the following 30 days so that it is consistent with the income tax requirements.
• Funds must be available at year-end to allow the lower income spouse to make the required interest payment. If that spouse does not have another source for this payment, the investment should be structured to provide sufficient liquid funds to make the interest payment by the deadline. 
• To see a positive benefit from this strategy, the rate of return earned by the lower income spouse must be greater than the interest rate payable on the loan. Care should be taken in the investment portfolio regarding the types of investments and related risks. If the rates are not adequate or the stock portfolio has accrued losses that the lower income spouse cannot use but the higher income spouse could benefit from, it is possible to ‘opt’ back in to the attribution rules by having the lower income spouse stop paying the interest. In such a case, the income and capital losses would attribute back to the higher income spouse. However, if the prescribed rate has risen when this occurs, the benefit of the current low rate will be lost and it may not be beneficial to set up a new prescribed rate loan to re-start the process. 

Though we cannot know for sure, most analysts are confident that the prescribed rate will rise at some point in the future. Each quarter, the CRA announces the prescribed rate for the upcoming quarter. The announcement has generally been made at least two weeks prior to the date of the change (e.g. on June 13, 2013, the CRA announced that the prescribed rate for the quarter starting July 1, 2013, would remain at 1%). However, on some occasions (i.e. June 2010 and June 2012), as few as two days notice were given between the announcement and the effective date of the new rate.

Some taxpayers may feel they can wait for the quarterly announcement, and if the prescribed rate is scheduled to rise they would quickly undertake a transfer of funds and set up the promissory note before the new rate becomes effectives so as to lock in the current 1% rate. While this may be possible in some months, there is no guarantee that that there will be sufficient time to do so. The opportunities of the current low prescribed rate could be lost.

If you are interested in implementing a prescribed loan with your spouse, or if you would like more information, contact your Collins Barrow advisor.

Robert Boser, B.Comm., CPA, CA, is a Partner in the Red Deer office of Collins Barrow.