Investors who wish set up a prescribed-rate loan to split investment income with a spouse, common-law partner or even their kids need to act quickly as the prescribed interest rate is set to double to two per cent on April 1, 2018 as a result of Tuesday’s Treasury Bill auction yield.
The prescribed rates are set by the Canada Revenue Agency (CRA) 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 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 (April through June 2018), we look at the first month of the current quarter (January) and take the average of January’s T-Bill yields, which were 1.17 per cent (Jan. 9, 2018) and 1.20 per cent (Jan. 23, 2018). That average is 1.185 per cent but when rounded up to the nearest whole percentage point, we get 2 per cent for the new prescribed rate for the second quarter of 2018.
This upcoming increase marks the first time the prescribed rate has gone up since it dropped to the current historic low of 1 per cent back in January 2014.
Historic low rate
If you act before March 31, you can take advantage of the all-time historic low prescribed rate of 1 per cent to split income for the duration of the loan, even once the rate increases to 2 per cent (or higher) in the future.
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 per cent secured by a written promissory note. Dianne invests the money in a portfolio of Canadian dividend paying stocks with a current yield of 4 per cent.
Each year, she Diane takes $5,000 of the $20,000 in dividends she receives to pay the 1 per cent interest on the loan to Jack. She makes sure to do this by Jan. 30 of each year following 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. The savings are offset slightly by having the $5,000 of interest on the promissory note taxable to Jack at the highest rate for interest income. This interest paid, however, is tax deductible to Dianne at her low tax rate as the interest was paid for the purpose of earning income, namely the dividends.
The rush to beat the March 31st deadline is that in order to avoid the attribution rules from applying to a spousal loan such as this one, you need only pay interest at 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 per cent, as it currently is, you can use that rate for the duration of the loan, even if the prescribed rate rises in the future. Note that there need not be an end date to the loan, which could be simply repayable upon demand.
So for loans granted as of April 1st, 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 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.