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Is a prescribed rate loan right for you?

Prescribed rate loans

Prescribed rate loans can be an excellent financial planning tool for many Canadians. And while I’ve written about these before in the past, the rising interest rate environment we are in suggests a fast-approaching deadline to utilize this strategy before the prescribed rate changes on July 1 2022.

These loans are one of the few remaining income splitting strategies that could help you lower your family’s overall tax bill. While commonly used to split income between spouses, prescribed rate loans can also be used to efficiently split income with adult children or to fund family investment trusts.

The prescribed interest rate is set each quarter based on the average 90-day Government of Canada T-bill rate for the first month of the last quarter. Based on recent interest rate increases, the prescribed rate for the third quarter of 2022 will increase to two per cent.

This means that Canadian families have until the end of June to implement and lock in income splitting strategies using the current, and historically low, one per cent prescribed rate of interest.

First, it’s important to understand how “attribution rules” can affect income splitting.

Canada’s Income Tax Act has specific measures in place to limit income splitting opportunities. For example, if you were to gift or loan funds to your spouse or common-law partner without charging interest, any investment income and/or capital gains earned on an investment purchased with those funds would “attribute” back to you and taxed in your hands.

If the purpose of the gift or loan was to shift income to a lower income spouse, the attribution rules effectively eliminate any income splitting opportunities. Income attribution rules can also apply when loans bearing interest at less than the prescribed rate (including no interest loans) are made either directly to children or grandchildren, or indirectly through a trust.

However, attribution of income to the lender does not occur if interest is charged at a minimum of the prescribed rate on the date the loan is put in place. This is where a “prescribed rate loan” can become a simple and effective tax planning tool.

How do prescribed rate loans work?

A prescribed rate loan occurs when an individual loans money to their lower income spouse or common-law partner, adult child, or investment trust. Interest is charged at the prescribed rate in effect when the loan was made.

The borrower then takes these funds and invests the money to earn investment income and/or capital gains. Provided the loan is properly documented and interest on this loan is paid every year within 30 days of the end of the calendar year (i.e. by January 30th of the following year), the attribution rules should not apply.

However, if the interest is not paid by January 30th, the loan will not meet the requirements for exemption from the attribution rules in the particular year and for all subsequent years. This would mean that all investment income and, in some cases capital gains/losses, would attribute to the lending individual for the year in question and all subsequent years, even if the interest payments in subsequent years are made within the prescribed time period.

When prescribed rate loans work as planned, they effectively move any income earned in excess of the prescribed rate interest paid to a lower income family member, reducing the overall family tax bill. The lender would include interest at the prescribed rate in his or her income, while the borrower would include any investment income and/or realized capital gains/losses in his or her income and claim a deduction for the interest paid.

How should I set-up a prescribed rate loan?

When setting up a prescribed rate loan, it is important to seek assistance from both your legal and tax advisors to make sure your loan is documented correctly. In particular:

• There must be a written loan document that includes the details of the loan, and which is signed by both the lender and borrower.

• The agreement must clearly indicate that the funds have been loaned and that the borrower is legally required to repay the amount.

• The agreement must specify an interest rate (normally the prescribed rate that is in effect on the date the loan was made) and should indicate that interest is to be paid within 30 days of the end of the calendar year.

• Structuring the loan as a demand loan, which is repayable immediately at the request of the lender, provides the most flexibility.

When are prescribed rate loans most advantageous?

Any income splitting strategy, including a prescribed rate loan, is most beneficial when there is a significant difference between the marginal tax rates of family members and there are substantial funds available to lend and invest.

When considering a prescribed rate loan, many factors should be evaluated such as the expected investment performance as well as tax implications. I encourage you to speak with your professional financial planner or tax advisor for more information before making a decision.

This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.

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About the Author

Brett, designated as a chartered investment manager and certified financial planner, is the regional vice-president (Okanagan) for IG Wealth Management.

In addition to his “day job," Brett was appointed to the board of directors of FP Canada (the national professional body for financial planning) in 2014 and spent seven years on the board, including his final two as board chair. More recently, he was appointed to the Financial Planning Standards Board (FPSB) which is the international professional body for this industry with a three-year term beginning in April 2023.

Brett has been writing a weekly financial planning column since 2012 and provides his readers with easy-to-understand explanations of the complex financial challenges that they face in every stage of life.

Enhancing the financial literacy of Canadian consumers is a top priority of Brett’s and his ongoing efforts as a finance writer and on the regulatory side through the national and global boards focus on this initiative.   

Please let Brett know if you have any topics that you’d like him to cover in future columns or if you’d like a referral to a qualified CFP professional in your area by emailing him at [email protected]

The views expressed are strictly those of the author and not necessarily those of Castanet. Castanet does not warrant the contents.

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