For the first time in more than two decades, the Canada Revenue Agency’s prescribed interest rate for overdue taxes has hit double digits — 10 per cent for the first quarter of 2024. The last time the prescribed rate was so high was back in mid-2001.
The prescribed rate is set quarterly and is tied directly to the yield on Government of Canada three-month Treasury bills, but with a lag. The calculation is based on a formula in the Income Tax Regulations that 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 “base” rate for the first quarter of 2024, you go back to the first month of the prior quarter (October 2023) and take the average of the three-month T-bill yields, which were 5.16 per cent (Oct. 10) and 5.16 per cent (Oct. 24). Since the prescribed rate is rounded up to the nearest whole percentage point, we get six per cent for the current prescribed rate.
The base prescribed rate applies to taxable benefits for employees and shareholders, low-interest loans and other related-party transactions. The rate for tax refunds is two percentage points higher than the base rate, meaning that the rate of interest is now eight per cent if the CRA owes you money.
But if you owe the CRA money, or if you’re late or deficient in one of your quarterly tax instalments, then the rate the agency charges is four percentage points higher than the base rate. This puts the interest rate on tax debts, penalties, insufficient instalments, unpaid income tax, Canada Pension Plan contributions and employment insurance premiums at 10 per cent for the current quarter.
Let’s review three potential scenarios on how the various increases in the prescribed rates could affect you.
Income-splitting loans
The base prescribed rate is the minimum rate that must be charged on income-splitting loans. Income splitting is the transferring of income from a high-income spouse (or family member) to a lower-earning spouse, or in some cases a “no-income” family member (such as a child), to reduce the family’s overall tax burden. Since our tax system has graduated tax brackets, the couple’s (or family’s) overall tax burden can be reduced by having income taxed in the lower-income earner’s hands.
Unfortunately, complex rules in the Income Tax Act block attempts to split income between spouses or partners by requiring any income, as well as capital gains earned on money transferred or gifted to a spouse, to be “attributed” or taxed back to the “transferor” spouse.
In other words, if a high-income-earning spouse gives money to their lower-income-earning spouse to invest, any income earned or capital gains realized upon the sale of these investments are taxed back to the higher-income spouse.
There is, however, an exception to this rule if, rather than gifting funds to a spouse for investment purposes, they are loaned, provided interest is charged at the CRA’s prescribed base rate on the loan. If so, then any investment return generated above that rate can be taxed in the lower-income spouse’s name, at their lower tax rate.
As well, the interest paid on the loan from the lower-income spouse to the higher-income spouse is tax-deductible since it’s being paid for the purpose of earning investment income.
Prescribed rate loans for income splitting were very popular back in 2020, when the prescribed rate hit an all-time low of one per cent. That historically low rate lasted from July 1, 2020, through June 30, 2022.
Taxpayers who set up those loans back in 2020, 2021 or 2022 are in great shape since they continue to benefit from the one per cent rate since it’s only the rate at the time of the loan’s origination that must be used. In other words, these couples can effectively split income without taking any equity risk by simply having the lower-income spouse purchase a guaranteed investment certificate yielding approximately five per cent. That’s a guaranteed spread of four percentage points of income (above the one per cent rate) that can be taxed at the lower spouse’s rate.
While I would have thought that prescribed rate loan planning was dead in light of the current six per cent prescribed rate, I recently learned of an investor who recently set up such a spousal loan, and is investing the funds in private mortgages with expected yields of between nine and 12 per cent. Even with a six per cent prescribed rate, he’s hoping to income split between three and six percentage points of income.
Taxpayers who expect a refund
If you’re one of those taxpayers who expects a tax refund each year, you’ll be pleased to know the CRA will pay your refund interest at eight per cent (assuming the prescribed rate remains the same for the second quarter for 2024.)
But filing your 2023 tax return early won’t necessarily get you that rate on your refund, because the CRA only pays refund interest on amounts it owes you after May 30, assuming you filed by the April 30 deadline.
Taxpayers who owe money
If you owe the CRA money or are disputing a tax assessment or reassessment from a prior year, it would be foolish not to pay your CRA bill as soon as you get it, even if you plan to object, since the prescribed rate is now at 10 per cent.
After all, arrears interest isn’t tax deductible, meaning that if you’re in the highest tax bracket of around 50 per cent, you’d have to find a guaranteed, safe investment that pays you 20 per cent to be better off than paying your tax debt.
One could even make the case for borrowing from your bank to pay off your CRA debt, assuming you can get a loan or line of credit at a rate below 10 per cent.