The government’s prescribed interest rate will drop to 1% on July 1, providing a significant opportunity for clients who wish to split income.
Here’s how clients can use the drop in the prescribed rate to their advantage, either by making a loan directly to family members or, where minors are involved, using a family trust to do so.
What is the prescribed rate?
The prescribed rates are set by the Canada Revenue Agency (CRA) quarterly and are tied directly to the yield on Government of Canada three-month Treasury bills, albeit 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. As a result, the prescribed rate can never be zero — 1% is the lowest possible rate.
To calculate the rate for the third quarter (July through September) of 2020, we look at the first month of the second quarter (April 2020) and take the average of April’s Treasury yields, which were 0.24% (April 7), 0.30% (April 14), 0.27% (April 21) and 0.27% (April 28). The average is 0.27% but, when rounded up to the nearest whole percentage point, we get 1% as the new prescribed rate for the third quarter of 2020.
This upcoming decrease marks the first time the prescribed rate has dropped since it increased to the current rate of 2% on April 1, 2018. For loans put into place between July 1, 2020 and the end of September 2020 (and possibly longer, depending on what happens to the prescribed rate in future quarters), the lower 1% rate would be locked in for the duration of the loan without being affected by future increases.
How does income splitting work?
Income splitting is the transfer of income from a high-income family member to a lower-income family member (including a spouse or common-law partner, children or grandchildren). Since our tax system has graduated tax brackets, having the income taxed in the lower-income earner’s hands reduces the family’s overall tax.
Prescribed rate loans can also be used to help fund minor children’s expenses — such as paying for private school and extracurricular activities — by making a prescribed rate loan to a family trust with the minor children as beneficiaries.
The attribution rules in the Income Tax Act prevent some types of income splitting by generally attributing income or gains earned on money transferred or gifted to a family member back to the original transferor.
The act provides an exception to this rule if funds are loaned, rather than gifted, at the prescribed rate in effect at the time the loan was originated, and the interest is paid annually by January 30 of the following year.
So, if the loan is made when the prescribed rate is 1%, the net effect will generally be to have any investment return generated above the 1% prescribed rate taxed in the hands of the lower income family member. Note that even though the prescribed rate varies by quarter and may ultimately rise, one only needs to use the prescribed rate in effect at the time the loan was originally extended.
Refinancing a 2% loan at 1%
The question on many advisors’ minds right now is what can be done if a prescribed rate loan was entered into when the rate was 2% (or higher) and the family member invested the proceeds? To be eligible to use the lower prescribed rate for determining if there will be attribution of income from the investments, the family member should sell the investments and repay the loan. They could then enter into a completely new loan agreement using the 1% prescribed rate starting July 1.
But what if this results in unwanted tax consequences (such as triggering tax on capital gains) or brokerage fees? Furthermore, given the recent market decline, what if the fair market value of the investments is insufficient to pay off the original loan?
In these cases, while clients may be tempted to either adjust the rate on the loan or refinance it at 1%, both of these alternative measures can put the loan offside. The client must enter into a new loan in order for the lower prescribed rate to apply. In fact, the CRA has stated that simply repaying a higher prescribed rate loan with a lower-rate loan could trigger the attribution rules.
Next steps
Advisors may wish to reach out to clients who have a prescribed rate loan to determine whether it makes sense to refinance it, using the steps above. It’s also an opportunity to reach out to other clients before July 1 to discuss this income splitting opportunity.
As always, clients should be encouraged to obtain tax and legal advice before implementing a prescribed rate loan — to determine the best way to structure and operate this type of arrangement, as well other implications unique to the client’s own situation.
Jamie Golombek, CPA, CA, CFP, CLU, TEP is the managing director, Tax & Estate Planning, with CIBC Private Wealth Management in Toronto. jamie.golombek@cibc.com