Why now might be the right time to consider a prescribed rate loan strategy

April 2022

The current low interest-rate environment has prompted many Canadians to consider the benefits of using a prescribed-rate loan as part of a broader income-splitting strategy to help lower their household tax bills. A prescribed-rate loan can be used in lending strategies between spouses or with a family trust to achieve income-splitting with lower-income family members (e.g., children).

 

Prescribed rate loan strategies came to exist in Canada because of income attribution rules. Income attribution rules essentially prevent a high-income individual from shifting taxable income to a lower-income family member to reduce the household tax burden. As the name suggests, the rules would result in income being attributed back to the high-income taxpayer from which the funds originated.

Jonathan McMurrich, a senior wealth planner at Gluskin Sheff, says “Determining the impact of the income attribution rules depends on who the recipient is and the type of income earned. “

 

In situations where the income attribution rules are preventing income-splitting amongst family members, we want to consider whether a prescribed rate loan strategy would otherwise make sense.”

It has since signaled more rate hikes are coming. With concerns about rising interest rates in the future, the prescribed rate loan strategy is attractive because the prescribed rate set by the Canada Revenue Agency (CRA) is locked-in at the time the loan is made and won’t rise, even if the CRA increases the prescribed rate.

 

The CRA’s prescribed rate has been at one percent (the lowest it can go) since July 1, 2020. This rate is expected to rise as it’s based on the Government of Canada’s three-month Treasury Bill rate, which in turn, may be impacted as the Bank of Canada continues to increase its benchmark rate to help manage surging inflation. The central bank started a monetary policy tightening cycle in early March after raising its policy interest rate to 0.5 percent from 0.25 percent. It has since signaled more rate hikes are coming.

 

The prescribed-rate loan strategy is “a hot topic” in the current rising interest-rate environment, says Mark Chan, vice-president of wealth planning at Gluskin Sheff.

 

“More investors are looking to take advantage of this income-splitting strategy now, to lock-in the current prescribed rate for the long-term.”

 

Below is a closer look at how a prescribed-rate loan can be used in different income-splitting circumstances:

 

Spousal loans

 

A spousal loan is a strategy that can be used between spouses who are in different tax brackets and looking to invest significant funds in personal, non-registered investment accounts.

 

In this scenario, the higher-income-earning spouse lends money to the lower-income-earning spouse at the prescribed rate.

 

The borrowed funds can be used by the lower-income spouse to purchase investments. The idea is that the lower-income spouse will have a more attractive tax rate on the investment income than if the higher-income spouse invested the funds. Chan notes those investments need to be in a separate investment account in the lower-income spouse’s name for the strategy to be effective.

 

Jonathan McMurrich, a senior wealth planner at Gluskin Sheff, says careful consideration needs to be given to how the borrowed funds are invested, as the objective with this strategy is to shift income to the lower income spouse.”

 

“Understanding the expected income distributions of the investments should be part of the conversation when exploring the feasibility of this strategy” he says.

 

Investors engaging in spousal loans also need to make sure they pay the interest on the loan by Jan. 30 of the following calendar year, Chan adds, otherwise the investment income earned by the lower income spouse may be attributed back to the higher income spouse.

 

“It’s important that this payment is made on time, or the strategy falls apart,” Chan says.

 

He also notes the higher-income spouse will need to pay tax on the interest income received on the spousal loan.

 

“Everything else that’s earned on those investments is taxed in the lower-income spouse’s name, which effectively reduces the household’s tax liability,” he says.

 

Chan adds the loans are particularly useful when a spouse has a lot of available non-registered funds in their personal accounts.

 

Family trust

 

Prescribed-rate loans can also be used to set up a family income-splitting trust. In this scenario, the prescribed-rate loan would be made to a trust, often with children and/or grandchildren as discretionary beneficiaries.

 

Like spousal loans, Chan says the trust option is best for family members subject to tax at the highest marginal rates looking to fund the education and expenses of children and grandchildren in a more tax-efficient manner. The income earned in the trust is then allocated to the child and taxed in their hands, which generally would be at a lower marginal tax rate.

 

“The high-income spouse can loan funds to the family trust, and the family trust can invest those funds on behalf of the beneficiaries,” Chan says. However, he notes the funds must be used for qualifying expenses for the support, maintenance, care education, enjoyment and advancement of the beneficiary.

 

“There has to be a need and, of course, a tax-rate differential to make this work,” he says.

 

Also, Chan notes there are legal and administration costs to setting up and maintaining a trust.

 

“Still, for some, it’s a cost-effective and tax-efficient way to cover these big expenses for children or dependents,” Chan says.

 

He says the family trust and/or spousal loan strategy isn’t for everyone.

 

“If you live in a household where both spouses are both in a very high tax bracket, it doesn’t really make sense to do it,” Chan says with respect to a spousal loan strategy. “There has to be a difference in their income levels to make it worthwhile.”

 

McMurrich says investors interested in a prescribed-rate loan—either between spouses or to a trust—should consult with a wealth professional to see if it’s right for them.