Are you thinking about how to lower your family tax bill? Wondering if there are other ways to income split with them? If so, you might consider whether a prescribed rate loan — a flexible, tax-wise family strategy — might be right for you.
Prescribed rate loans are a kind of income splitting
A prescribed rate loan is an income splitting strategy in which a high-income family member lends cash to a lower-income family member or to a family trust. The loan must be made under terms set out in a formal written agreement, charging interest at the “prescribed rate” set quarterly by the Canada Revenue Agency (CRA).
By establishing a prescribed rate loan this way, you ensure that any income earned on the borrowed funds is taxed at the borrower’s low tax rate, instead of the lender’s high tax rate. (The borrower and lender must be “related” parties in the eyes of the CRA, meaning they don’t operate at arm’s length.)
In contrast, an investment loan between related parties that doesn’t qualify as a prescribed rate loan can run afoul of the income-attribution rules under Canada’s Income Tax Act. That would mean income earned on the funds borrowed and invested would be attributed back to the lender, and then taxed in the lender’s hands as if he or she had earned that income themselves.
Depending on your situation, using a prescribed rate loan can be an effective way to shift income from a high-tax lender to a low-tax borrower — or, if the loan is made to a family trust, to several low-tax trust beneficiaries.
Extend the benefit: Make the loan to a family trust
While a prescribed rate loan can be established between an individual high-income lender and an individual low-income borrower, using a family trust means the loan can benefit even more family members.
There are three basic parts to this strategy:
- First, a high-income family member with surplus cash lends funds at the prescribed rate to a family trust, and the trustees invest the loaned funds to earn investment income. In exchange, the lender receives a promissory note, which they can use to recall the loan at any time.
- When investment income is earned, the trustees distribute it to the trust beneficiaries, who might include a low-income spouse, children, nieces, nephews or grandchildren — or some mix of these.
- Every year, the trustees must pay the lender the prescribed rate of interest on the loan. Note that this interest payment is income to the lender and must be included in the lender’s taxable income.
Let’s look at how this strategy might work in practice1:
Standard investment of $1 million: Let’s say a high-income family member invests $1 million, which earns 4% over the course of a year, or $40,000. Under normal circumstances, they would pay tax at their marginal rate on the $40,000 of investment earnings. Although tax rates vary from province to province, in eight provinces the highest rate is greater than 50%, meaning more than $20,000 of those yearly investment earnings would be lost to tax.
Same $1 million investment, using a prescribed rate loan to a family trust: Let’s say the same high-income family member decides to lend the $1 million to a family trust, using the prescribed rate loan strategy and charging the prescribed rate of interest, currently 1% per year. The loaned funds are invested to earn the same $40,000 per year. In this scenario, the high-income earner earns $10,000 in interest on the loan, and $30,000 is distributed to the trust beneficiaries. If the trust beneficiaries have little or no other income, there may be little or no tax payable on the distributed funds.
Beyond the tax savings, a prescribed rate loan strategy coupled with a discretionary family trust has several attractive features. (A discretionary trust means the trustees determine how distributions are made.)
- Flexibility: The beneficiary or beneficiaries of the family trust might include a spouse, adult children, parents, or even minor children, grandchildren, nieces and nephews. The trust distributions can change from year to year depending on the needs and tax situations of the beneficiaries.
- Low cost: The cost to establish a family trust is small relative to the potential income tax savings, particularly if the strategy is maintained over many years.
- Control: The lender retains control over the promissory note, which allows them to recall the loan at any time. This might be because the lender needs the funds, or the income-splitting strategy is no longer effective — for example, if young beneficiaries have grown up, started earning their own income, and are no longer low-income beneficiaries.
- Estate planning: Upon the death of the lender, the promissory note belongs to the lender’s estate and the loan would be recalled by the lender’s executor. The trust can be maintained if desired. This may minimize probate and estate administration costs.
CRA’s prescribed interest rate is at an all-time low
Now is a good time for a prescribed rate loan: effective July 1, 2020, the interest rate for prescribed rate loans is just 1%, which is the lowest it can be.2
What’s more, the rate in force when the loan is established will remain in effect for as long as the loan is outstanding, even if general interest rates rise. This means that if you establish a prescribed rate loan today, when the rate is just 1%, that low interest rate will be in effect for as long as the loan is in place.
In the right situation, a prescribed rate loan’s simplicity can make it an appealing strategy:
- Easy to implement: As long as the loan terms are documented, interest is charged at the prescribed rate, and the annual interest is paid by the borrower on or before January 30 of the following year, the loan will meet the CRA requirements for a prescribed rate loan and the income attribution rules won’t apply.
- Adaptable to many situations: The only requirements are to have a high-taxed family member with surplus cash available to lend, and a low-taxed family member, or low-tax beneficiaries of a family trust, to borrow the funds at the prescribed rate.
Is a prescribed rate loan right for you?
This strategy may be worth investigating if the following apply:
- You are in a high tax bracket, and your investment income is taxed at a high marginal tax rate.
- You have low-income or no-income family members, which can include minor children, with whom you could split income to lower your household or family tax bill.
- You have funds (in personally held non-registered accounts) available to lend.
If you think a prescribed rate loan strategy might fit your circumstances, it’s important to understand the CRA requirements and deadlines.
An MD Advisor* can help you figure out whether this strategy fits into your financial plan — including your personal estate strategy — to make sure all parts of your plan are working together.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.
1 The calculations in these two scenarios are provided for illustration purposes only. Investment returns may be subject to investment management fees and trustee fees. Before implementing a prescribed rate loan strategy, including one involving a family trust, consult with your legal and tax advisors.
2 The calculation formula is set out in regulations that accompany the Income Tax Act. The formula takes the simple average of interest rates paid for three-month Treasury bills in effect for the first month of the preceding quarter, rounded up to the next highest whole number — meaning 1% is the lowest possible rate.
Estate and trust services are offered through MD Private Trust Company.
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.