Using a prescribed rate loan to split investment income with a spouse, common-law partner or even your kids is one of the most recommended tax planning strategies available to families. Yet the window for locking-in an income splitting loan at the lowest possible historical prescribed rate of 1% is quickly coming to an end as the prescribed rate is set to rise to 2% on October 1, 2013.
Here's how the income splitting strategy works, using an example of Jack, who is in the highest tax bracket, and Dianne, who is in the lowest bracket.
Jack loans Dianne $500,000 at the current prescribed rate of 1% secured by a written promissory note. Dianne invests the money in a portfolio of Canadian dividend paying stocks with a current yield of 4%. Each year, she takes $5,000 of the $20,000 in dividends she receives to pay the 1% interest on the loan to Jack. She makes sure to do this by Jan. 30 each year starting the year after the loan was made, as required under the Tax Act.
The net tax savings to the couple would be having the dividends taxed in Dianne's hands at the lowest rate instead of in Jack's hands at the highest rate, offset slightly by having the $5,000 of interest on the promissory note taxable to Jack at the highest rate for interest income while tax deductible to Dianne at her low rate as the interest was paid to earn income, namely the dividends.
The rush to beat the Oct. 1 deadline is that in order to avoid the attribution rules from applying to a spousal loan such as this one, you need only use the prescribed rate in effect at the time the loan was originally extended. In other words, if you establish the loan during a quarter in which the prescribed rate is 1%, as it currently is, you can use that rate for the duration of the loan, which could be unlimited if there is no fixed term and it is simply a demand loan.
So after Oct. 1, Dianne would have to pay $10,000 back to Jack to be taxed at the highest rate, instead of $5,000.
This strategy can be expanded to help fund minor children's expenses, such as private school and extracurricular activities, by making a prescribed rate loan to a family trust. The trust then invests the money and pays the net investment income, after the interest on the loan, to the kids either directly or indirectly by paying their expenses. If the kids have zero or little other income, this investment income can be received perhaps entirely tax-free.
The prescribed rates are set by the Canada Revenue Agency quarterly and are tied directly to the yield on Government of Canada 90-day Treasury Bills, albeit with a lag. The calculation is based on a formula in the Income Tax Act regulations which takes the simple average of three-month Treasury bills for the first month of the preceding quarter rounded up to the next highest whole percentage point (if not already a whole number).
To calculate the rate for the upcoming quarter (October to December 2013), we go back to the first month of the current quarter (July) and take the average of July's T-Bill yields, which were 1.0241% (July 3), 1.0193% (July 17) and 1.0132% (July 31). That average is 1.0189% but when rounded up to the nearest whole percentage point, we get 2% for the new prescribed rate for the fourth quarter.
This upcoming increase marks the first time the prescribed rate has gone up since it dropped to the current historic low of 1% back in April 2009.