Tax planning may not be top of mind while facing challenges from the COVID-19 pandemic. However, a relatively simple strategy can be particularly effective during tough economic times and can help lower your overall income tax bill for your family. Setting up a prescribed rate loan with family members can allow you to effectively transfer income from high-income earners to lower income family members. This planning can result in reduced total income taxes for the family unit. This tax planning strategy is especially attractive in the current environment where the interest rate is low and a stock market rebound is anticipated.
To understand how this type of tax planning works, taxpayers should be aware of the “attribution rules” that can prevent the redistribution of income among family members where income-earning assets are transferred from high-income earners to lower-income family members.
Income and capital gains attribution
The attribution rules potentially apply whenever a property is transferred or a loan is made at little or no interest to a family member. This means that income and capital gains can be attributed back to the taxpayer who transferred the property and is taxed at the higher marginal tax rates. The most important rules to keep in mind are as follows:
- If a taxpayer makes an interest-free or low-interest loan, or gift property, to a spouse or common-law partner, any income or capital gains from the transferred assets will be attributed to the taxpayer.
- If a taxpayer makes an interest-free or low-interest loan, or gift property, to a minor child (i.e. a son, daughter, niece or nephew, or other minor child not at arm’s length), income from the funds will be attributed to the taxpayer. Any capital gains arising from the property will be taxed in the hands of the child.
- If a taxpayer makes an interest-free or low-interest loan to an adult child or other adult relative, income from the funds may be attributed to the taxpayer if the purpose of the loan was to reduce taxes. Any capital gains arising because of the loan will be taxed in the hands of the relative. Gifts to adult family members who are not your spouse or common-law partner are not subject to these rules.
Prescribed rate loans
A simple method to avoid these attribution rules is to use a prescribed rate loan. If a taxpayer makes an investment loan to a spouse, adult family member, minor child or family trust, and charges interest on the loan at the prescribed interest rate, then any income they earn on the funds will be taxable to the recipient family member and not the taxpayer. These plans work effectively when the investment rate of return earned is higher than the prescribed rate of interest charged on the loan, as a net benefit will be realized because the income earned on the rate differential will be taxed at thelower marginal tax rate of the family member.
The Canada Revenue Agency sets the prescribed rate quarterly. The interest rate on the loan does not have to be adjusted each time the prescribed interest rate changes. Currently, the prescribed interest rate is at 2%, but is expected to decrease to 1% on July 1, 2020 due to recent interest rate reductions. Therefore if a loan arrangement is established in the third quarter (i.e. after June 30, 2020), the lower 1% prescribed interest rate will apply when the reduction takes effect. Any return on investment on the invested funds made with the loan, whether that be capital gains, interest, dividends or other income, that is in excess of the 1% interest that has to be paid on the loan, will be taxed to the family member. The interest rate on the loan can remain at 1% when the loan is established properly in the event interest rates rise in the future.
There are some important details to ensure that a prescribed rate loan is set up properly. It is important that the interest on the loan must be paid no later than 30 days after the end of the calendar year.
When the interest is not paid on time, the loan will be subject to the attribution rules until repaid.
Consideration will need to be given to the tax on split income (TOSI) rules where trusts, partnerships, or private corporations are part of the plan. These rules are complex and there may be no benefit of the plan if they apply.
Contact your BDO Tax advisor today to see if this type of planning can benefit you and your family.
Dave Walsh, Partner, Tax Service Line Leader, Canada
Bruce Sprague, Partner, Western Canada Tax Leader
Greg London, Partner, Eastern Canada Tax Leader
Peter Routly, Partner, Southern Ontario Tax Leader
Rachel Gervais, Partner, GTA Tax Leader
The information in this publication is current as of April 29, 2020.This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.