How to take advantage of the CRA’s 1% prescribed interest rate for decades to come

National Post

2015-09-25


Last week the Canada Revenue Agency announced that its prescribed interest rate would remain at one per cent until the end of the year. This means that a popular income splitting strategy can still be put into place until at least Dec. 31, allowing you to benefit from this historical low rate for years to come — even when rates go up.

The strategy involves loaning money to a spouse, partner (or even your kids, as we’ll see later), to split investment income and to get around the attribution rules, which are designed to prevent most attempts at income splitting among family members. Basically, the rules say that if you give your spouse or partner money to invest, any income, dividends or capital gains earned from the money so invested is attributed back to you and taxed in your hands.

But the Income Tax Act contains an exception to the rule, saying that instead of “giving” your spouse the money you loan it to him or her. Provided you charge the prescribed interest rate, any income or gains you earn above that rate can be taxed in the other spouse’s hands.

The advantage of setting up this loan when the prescribed rate is one per cent is that the Tax Act only requires you to use the prescribed rate at the time the loan was originally extended. So, let’s say you make a demand loan to your spouse today, you can use the one per cent rate for the entire duration of the loan, which could be years or even decades. The only caveat is that the interest on the loan must be paid by Jan. 30, 2016 (and each future Jan. 30) otherwise the strategy falls apart for 2015 and all future tax years.

Here’s how the income splitting strategy works, using an example of Chris, who is in the top tax bracket, and Anna, who is in the lowest bracket. Let’s say Chris loans Anna $200,000 at the current prescribed rate of one per cent secured by a promissory note. Anna invests the money in a portfolio of Canadian dividend paying stocks with a current yield of four per cent. Each year, she takes $2,000 of the $8,000 in dividends she receives to pay the one per cent interest on the loan to Chris.

The net tax savings to the couple would be having the dividends taxed in Anna’s hands at the lowest rate instead of in Chris’s hands at the highest rate. This benefit would be offset slightly by having the $2,000 of interest on the promissory note taxable to Chris, but it would still be tax deductible to Anna, since the interest cost was incurred for the purpose of earning income.

When it comes to income splitting with minor kids, capital gains earned on money gifted to those under age 18 are not attributed back but the above strategy can be used to income-split interest or dividend income or for funds that you don’t want to gift to them outright.

While it’s generally problematic to lend funds directly to minor kids, investors who want to take advantage of this strategy will often use a discretionary family trust, naming their minor kids as beneficiaries. In this case, a loan is made to the family trust at the one per cent prescribed rate, and the trust invests the funds. Anything the trust earns above the one percent interest it pays on the loan can be distributed to the minor kids, either directly, or to pay their expenses. In most cases, the kids will likely have no or minimal tax to pay on this income.