A prescribed rate loan allows a high income earning spouse to move income-producing assets (like an investment portfolio), that would be subject to the highest marginal tax rates, to a low income spouse who is subject to lower marginal tax rates. When done correctly, the income earned on the transferred assets will not attribute back to the high income spouse.
To give an example, consider Tom, a taxpayer who has a $1,000,000 portfolio of fixed income securities generating a 3% return. Because Tom has other sources of income, the $30,000 earned on his securities is taxed at the highest marginal tax rate of 43.7% resulting in taxes of $13,110. Tom’s wife, Sue, on the other hand has limited sources of income and has a marginal tax rate of 20% (her annual income is less than $35,000). If Sue were to be taxed on this income, she would pay $6,000 in taxes. Tom could transfer his portfolio to Sue (any gain or loss on the securities has to be taken into consideration). In exchange, he would take back a loan at the current prescribed rate of 1%. Sue would now earn the $30,000 and would pay Tom 1% or $10,000 annually. Effectively, Tom has transferred $20,000 of his income to Sue. The net taxes saved in this transaction are equal to the difference between their marginal tax rates (23.7%) multiplied by the net amount transferred. In this example, a total savings of $4,740 is the result.
Although the savings might seem somewhat negligible in this example, consider that the prescribed rate is a locked-in rate. Once the loan has been made, the 1% interest that Sue will pay Tom does not change over the life of the loan. At the same time, if interest rates climb, the 3% return could increase. The prescribed rate floats with interest rates. The current 1% prescribed rate is in effect until June 30, 2010 and could increase after that time.
To implement a prescribed rate loan, it is important that proper documentation exists and that a bona fide loan arrangement has been made.
The interest on the loan must be physically paid before 30 days after the end of the calendar year each year in which the loan is outstanding. Failure to properly establish the loan can make it an ineffective income splitting tool. For this reason, it is critical that professional legal and accounting advice be sought before implementing such a plan.
This is just one example of how a prescribed rate loan can be used to reduce taxes at minimal cost. There are a variety of other techniques that your Chartered Accountant may be able to use in the right circumstances. If you or someone you know could benefit from this type of planning, it should be pursued before interest rates rise.
This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.