Tax Articles
Low Interest Rates Produce High Returns for Income Splitting
Stephen Meek
Enterprise
July 2009
With interest rates at historic lows, you might want to consider a loan to a family member as a way of generating impressive returns.
If you make an investment loan to your spouse, an adult family member or a family trust for the benefit of a minor child, for example, and you charge interest on the loan at the prescribed rate, then that family member, rather than you, will be taxed on income earned on the funds. When this individual is in a lower marginal tax bracket than you, your family ends up paying less income tax.
Thus the economic downturn provides an upside for income splitting, which involves redirecting income within a family to optimize the use of tax brackets, deductions and credits for each family member. You can achieve income splitting by transferring an income-producing asset, such as an investment or property, to your spouse or children who earn lower amounts of income.
While Canadian tax law has complex attribution rules designed to reduce income splitting opportunities, when you make an investment loan to a spouse, an adult family member or to a family trust for the benefit of a minor child, and charge interest on the loan at the “prescribed interest rate,” then the net income that individual earns will not be subject to the attribution rules.
The Canada Revenue Agency (CRA) applies prescribed interest rates to any amounts owed to the CRA and to any amounts the CRA owes to individuals and corporations. These rates are calculated quarterly and are based on 90-day Treasury bill rates. In the case of the attribution rules, as long as the interest rate on the loan you make to a family member is not lower than the prescribed rate at the time of the loan, then the attribution rules do not apply.
There is also another important proviso. The interest payable on the loan each year must be paid within 30 days after the end of the year. Therefore if you lend money to a family member this year, all interest must be paid by January 30, 2010. If an interest payment is late, the attribution rules would apply, the income would be attributed to you, and you would have to pay tax on it.
The best news is that due to recent interest rate reductions, for the third quarter of 2009 the prescribed rate to calculate taxable benefits on low interest loans is only 1%. This is the interest rate your family member would be required to pay on the loan. The CRA will announce in September the prescribed rate for the fourth quarter of the year.
Here’s an example of how this type of income splitting might work. Say you wish to invest in a mortgage. You lend the funds for the mortgage to your spouse who realizes a 5% return on the investment. Your spouse pays you interest of 1% on the loan and is left with a 4% return. Your spouse, who is in a low tax bracket, pays income tax on this 4% investment return. You, who are in the top tax bracket, pay tax on the interest payments you receive from your partner. Since the interest rate is only 1%, you won’t likely be claiming a large amount of income from the loan.
When the prescribed rate rises in the future you would still only have to charge interest at 1% for the term of the loan to avoid the attribution rules. The income splitting benefits of the loan will therefore almost certainly increase over time. So this makes it a good time to investigate income splitting strategies that might generate impressive returns for your family.
Stephen Meek, FCA, is a partner of BDO Dunwoody LLP (www.bdo.ca), one of Canada’s leading accounting and advisory firms. Stephen specializes in taxation issues for owner-managed businesses and professionals. You can reach him in the Markham office at 905-946-1066 or smeek@bdo.ca.
