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The Canada Revenue Agency (the “CRA”) announced the prescribed rate for the third quarter of 2020 (“Q3”) on June 22, 2020. Starting July 1, 2020, the prescribed rate is 1% (reduced from 2% in the second quarter). The prescribed rate is set each quarter based on the average yield in the first month of the last quarter for Government of Canada three month Treasury Bills, rounded up to the next whole percentage. Accordingly, the Q3 prescribed rate of 1% is the lowest possible rate. The first quarter of 2018 (January 1, 2018 until March 31, 2018) was the last time the prescribed rate was 1%.
While investing in the current volatile market caused by the COVID-19 pandemic may seem daunting, some investors may consider it to be a buying opportunity on the basis that the COVID-19 situation is (hopefully) not going to last forever. It may therefore be a good time to consider prescribed rate loans as a method of splitting investment income, in both the public company and private company context, with a lower earning spouse or child.
Canada has a graduated tax system which means that individuals pay income tax at higher rates as their income increases. For example, in Saskatchewan, an individual who earns more than $214,368 in 2020 would be taxed at the highest marginal rate of 47.5%, whereas an individual who earns $100,000 would be taxed at a marginal rate of 38.5% and an individual who earns under $13,229 would not be subject to any income tax. As a result, there is a strong incentive for individuals to split income with a lower earning spouse or child so that the income is taxed at lower marginal tax rates. However, with the introduction of the tax on split income (“TOSI”), discussed in more detail below, income splitting opportunities have been severely limited.
Nonetheless, a prescribed rate loan remains a viable income splitting tool. Normally, when an individual transfers property, including money, to a spouse or minor child, under the so-called attribution rules, any income earned on the property (including capital gains in the case of a spouse) is included in the individual’s income for tax purposes.[1] However, where an individual loans money to a spouse or minor child, the normal attribution rules will not apply to any income or gains earned on the borrowed funds, provided that the following requirements are met:
- the interest rate on the loan is at least equal to the lesser of (i) the CRA prescribed rate in effect at the time the loan is made, and (ii) the rate of interest that would apply on a loan between arm’s length parties; and
- the interest that was payable in a year on the loan was actually paid by January 30 of the following year.
The same tax result arises whether property is transferred directly to the spouse or minor child or indirectly through a trust of which the spouse and/or minor child is a beneficiary. In this case, additional conditions must be met. Steps must first be taken to ensure that the income of the trust is allocated to the spouse and/or minor child before the end of the year and that amounts are properly paid or are payable on demand to beneficiaries under the trust.
Where these requirements are met, the lower earning family member will be taxed on any investment income (including capital gains) earned using the loaned funds at their lower marginal tax rates. In order to be effective as an income splitting strategy, the investment income earned in a year must be higher than the interest earned on the loan, since the interest must be paid in each year and included in the lender’s income for income tax purposes. The interest rate is locked in as of the date of the loan. Therefore, the lower the prescribed rate in effect on the date of the loan, the more tax efficient this type of planning becomes.
For example, Mrs. A, an individual resident in Saskatchewan, is subject to tax at the highest combined federal and provincial marginal tax rate of 47.5%. Mrs. A’s spouse, Mr. A, has no income and stays home to care for their two children. Mrs. A loans $100,000 to Mr. A in 2020 and charges him an annual interest rate of 1%, being the prescribed rate in effect on the date of the loan. Mr. A invests the loan proceeds and earns $10,000 of dividend income in 2020.
In this example, Mrs. A would earn $1,000 of interest income which would be taxed at 47.5%, resulting in income tax of $475. The interest paid by Mr. A should be deductible in calculating his income and Mr. A would pay no tax on the dividend income since his income for the year is below the threshold for taxation in Saskatchewan. The net tax on $10,000 of dividend income is therefore $475. If Mrs. A earned the $10,000 dividend income directly, she would pay tax of $2,964 (after the application of the gross up and dividend tax credit and the federal and provincial basic personal amount). Therefore, the tax savings realized by lending the money to Mr. A is $2,489 ($2,964 – $475).
The tax savings could potentially be multiplied if the loan was made to a trust having Mr. A and their two minor children as beneficiaries, provided the formalities discussed above are met.
In the case of a loan to a trust, having the lender’s spouse and/or children (both minor and adult) as beneficiaries, there is a risk that the TOSI will apply to any distributions of income or capital from the trust. TOSI applies at the highest marginal tax rate for individuals on “split income,” which includes distributions from a trust in certain situations. However, there is an exemption from TOSI where the only assets held by the trust are publicly listed shares, subject to certain factual considerations. Where investments are held through a trust, and in particular, where the trust holds assets other than publicly listed shares, advice from a tax specialist should be obtained.
Consideration must also be given to the alternative minimum tax (“AMT”), which is calculated at a rate of 15% on certain amounts that receive favourable tax treatment, including capital gains and dividends. Where such amounts are below $40,000, the AMT should not apply. AMT that is paid in a year may be recovered by way of credit against taxes payable in the subsequent seven years.
Unwinding a higher rate prescribed loan that is currently in place would require the borrower to pay the balance of the loan in full before a loan can be made at the lower 1% prescribed rate using the same funds. Additional considerations also apply when seeking to access the lower prescribed rate for existing loans.
When implemented at a time when the CRA prescribed rate is low, a prescribed rate loan may be a way to have investment income earned in a tax-efficient way. Given the many highly technical rules and nuances that must be considered under the Income Tax Act (Canada), individuals are urged to consult their professional tax advisors before any prescribed rate loan structures are implemented. If you have any questions or would like to discuss prescribed rate loans, please contact a member of the Miller Thomson LLP Corporate Tax and/or Private Client Services Group.
[1] Similar attribution rules apply where a loan is made to a non-arm’s length adult individual or a trust of which an adult non-arm’s length person is a beneficiary when one of the main reasons for the loan is income splitting.
