The rate for prescribed loans will increase on July 1
“This 1% rate, if set now, will apply for the life of the loan,” said Wilmot George, vice president of tax, retirement and estate planning at CI Global Asset Management. in Toronto. “Therein lies the opportunity if you are able to generate income from investments in this arrangement that exceed this prescribed rate.”
Aaron Hector, vice president and financial consultant at Doherty & Bryant Financial Strategists in Calgary, agreed that talking to affected clients — usually a couple or family with a big difference in marginal tax rates — is a good idea.
“You don’t want to miss a date like this and suddenly be back in 2% [as the prescribed rate]and say “I wish I had pitched this idea sooner,” Hector said.
A prescribed rate loan strategy involves someone in a higher tax bracket lending money for investment to a spouse, common-law partner or adult child in a lower tax bracket so that the investment income is taxed at this lower rate. The loan must be executed with a minimum interest rate as dictated by income tax regulations, known as the prescribed rate.
“Since we don’t allow income splitting or joint filing, you should look for ways to reduce your overall family unit tax bill,” said Armando Minicucci, a tax partner at Grant Thornton LLP in Toronto. . Prescribed rate loans are “one of the measures legitimately permitted under our tax laws”.
Interest deductibility is a key part of a prescribed rate lending strategy, George said.
“If a prescribed rate loan strategy is put in place, but the borrower does not deduct the interest cost, there is double taxation,” he explained. “The lending spouse must report (and pay taxes on) the interest income received from the borrower, and the borrower will also pay taxes on this amount if he does not deduct it.”
To qualify for the interest deduction, the full amount of the loan must be used to invest in “any investment that will generate income,” George said, such as dividends and interest. He cautioned that for tax purposes, capital gains are not defined as income. In addition, “interest is not deductible when you borrow to invest in RRSPs and TFSAs”.
“Now is the time to act, seek professional advice, arrange financing and document the loan in writing,” said Jamie Golombek, managing director of tax and estate planning at CIBC Private Wealth.
This is because the family must follow certain rules to ensure that the prescribed rate loan works as intended.
When set up, the loan can be repayable on demand or have a fixed term. Interest on the prescribed rate loan must be paid by January 30 of the following year. Otherwise, the attribution rules apply and income earned on the loan amount will be attributed to the lending spouse – and the loan will cease to function as an income splitting tool. (The existing loan will need to be repaid and a new loan issued, which may carry a higher prescribed interest rate.)
Hector said the loan administration required for this strategy may not be worth it when the loan amount or tax savings are relatively small.
“It can be an aggravation. You have to stay on top of it, make the interest payments, understand how to report the interest income for one spouse and the deduction for the other,” Hector said, adding that his company automates payments for clients who have prescribed rate loans. “With any strategy, you have to weigh the complexity against the benefits it will bring.”
Hector said he’s moved to prescribed rate loans with smaller amounts (eg, $50,000) when the customer expects to have more to lend in future years.
“If you have a higher income and a parent who doesn’t work at all, and every year there’s an additional $50,000 to save, you could gradually turn that $50,000 into loans,” he said. , noting that at a later date, it may consolidate the loans for easier management. “But if all you had was $50,000 more and [both spouses are] in retirement,” he said, the strategy would make less sense.
Hector also advised taking into account the difference between the loan interest rate and the expected return on the investment. This difference “shouldn’t distort what you choose to invest in,” he cautioned, but may influence who owns the asset. For example, investments with higher expected income could be held by the spouse receiving the loan.
Locking in a low-rate loan becomes more valuable as the prescribed rate rises, said Carol Bezaire, senior vice president, tax, estate and strategic philanthropy at Mackenzie Investments in Toronto.
“If you look at the possibility of income splitting and the tax savings, the longer the loan is in place with high income and low income, the after-tax yield mix [becomes] bigger,” she said. “If you invest what you would have paid in taxes, you can significantly increase wealth over time.”
The prescribed rate is 1% until June 30, but one-year rates for guaranteed investments like GICs are well above 1%. According to RateHub.ca, eight banks offer one-year GIC rates of 2.50% and higher, going as high as 3.10%.
These rates will likely rise if the Bank of Canada raises the key rate again on June 1, as Governor Tiff Macklem has hinted.
Until the prescribed loan rate catches up on July 1, clients with a spouse or child in a much lower tax bracket can “arbitrate” the difference between the loan rate and the GIC rate, Minicucci said.
The low-income family member could invest in vehicles other than GICs and earn higher returns, but those returns would not be guaranteed. Either way, Hector said advisors should determine if GICs (or any other investment) are right for their client before adopting this strategy.
Potential tax savings
George gave the example of a married couple, Bill and Claire. Bill is taxed at 25% while Claire is taxed at 54%. Claire lends Bill $150,000 at 1% interest.
If Bill can invest the proceeds in a non-registered account and earn 5% in interest income, he will earn $7,500 and pay Claire $1,500 in interest, for a net income of $6,000. Claire must receive the $1,500 in interest income by January 30 of each year and will be taxed on this amount. Bill will deduct the interest paid on his return because he borrowed to invest.
Without the prescribed rate loan strategy, Claire investing the $150,000 at 5% would have paid $4,050 in taxes ($7,500 at 54%).
With the strategy, Bill pays 25% tax on $6,000 (since he can deduct the $1,500 of interest paid), which equals $1,500. Interest of $1,500 is taxed in Claire’s hands at 54%, which equals $810. In total, the couple pays $2,310 in taxes.
That’s a tax savings of $1,740.
However, if the expected return is less than 5% or if the amount invested is less than $150,000, the savings decrease. For example, an expected return of 3%, all other things being equal, results in a tax saving of only $870.
Why is the prescribed rate increasing?
According to section 4301 of the Income Tax Regulations, the prescribed rate is based on the average yield of three-month Government of Canada treasury bills auctioned during the first month of the preceding quarter, rounded to the percentage upper integer.
In April, the auction yields for three-month Treasury bills were 1.02% on April 12 and 1.38% on April 26, an average of 1.20%. Since the next highest whole percentage is 2.0%, the third quarter prescribed rate should also be 2%.
The prescribed lending rate has been 1% since July 1, 2020.