Tax Alert

It can be hard to find time for tax planning when there are so many issues of immediate concern. 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 and is especially attractive in the current environment where interest rates have been at an historic low and are now rising.

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 then taxed at the higher marginal tax rates of the taxpayer.

The most important rules to keep in mind are as follows:

• If a taxpayer makes an interest-free or low-interest loan, or gifts 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 gifts 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 to 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. In such situations, a net benefit will be realized because the income earned on the rate differential will be taxed at the lower 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. Instead, the applicable prescribed rate for the loan is the prescribed rate in effect at the time the loan is entered into.

Currently, the prescribed interest rate is at 1%, but is expected to increase to 2% on July 1, 2022 due to recent interest rate increases. Therefore, if a loan arrangement is established before July 1, 2022, the lower 1% prescribed interest rate will apply as long as the loan stays in good standing. Any return on investment on the invested funds made with the loan, whether that be capital gains, interest, dividends, or other income, that is more than the 1% interest that must 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 the loan is repaid.
• It is also important that the loan be documented. It's recommended that repayment terms be included, or the loan be documented as a demand loan.

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.