CRA Prescribed Interest Rate Increase

Overall taxes for a family can be significantly reduced where income is transferred from an individual in a high tax bracket to family members in a lower tax bracket, typically a spouse or minor children.

As a simple example, if mom is in the highest tax bracket and could transfer say $10,000 of income to a child with no other income, the savings would be in excess of $5,000. Mom’s taxes would be reduced by $5,350 and the child would pay no tax.

Obviously, this result holds little appeal for the CRA and so the opportunities for income splitting are limited and technical. They also hinge on the prescribed interest rate, which is why the upcoming rate increase is significant. The prescribed interest rate is set quarterly based on a formula in the Income Tax Act, which is tied to the yield on Government of Canada three-month Treasury Bills. The rate has been at a historic low of 1% since July 2020.

The way in which income splitting can be accomplished without running afoul of the rules is by making a bona fide loan from the higher taxed individual to a spouse or to a family trust where the beneficiaries include the spouse and children. The loan must carry interest at the prescribed rate – 1% until the end of June – and must be paid by the borrower by January 31 of each year. The prescribed rate in effect when the loan is made remains in effect for the life of the loan and is not impacted by subsequent changes in the prescribed rate.

An example would better serve to illustrate the concept.

Assume dad is in the highest tax bracket and has a non-registered investment portfolio of say $3M. The income generated by the investments is taxed on dad’s tax return at the highest rate of tax, 53.5% on interest and ordinary income. Assume mom has no taxable income.

The strategy works as follows: dad would loan mom say $1M, taking back a promissory note bearing interest at 1%. Mom would invest the money and assume earn a 6% return, or $60,000 each year. By the end of January of the year after the loan was made, mom would pay $10,000 in interest to dad.

What have we accomplished by this?

Without the loan, the 6% return would have been taxed in dad’s hands at a tax cost of roughly $32,000. Dad now has to pay tax on the $10,000 interest received from his wife, at a tax cost of $5,350. Mom reports the $60,000 of investment income, but can deduct the $10,000 of interest paid, resulting in taxable income to mom of $50,000 and tax payable of approximately $8,200. Therefore, in total mom and dad pay $13,550 in tax, instead of dad paying $32,000 in tax – a savings of over $18,000.

This same concept can be used to put income in the hands of minor children using a loan to a family trust, however, there are a number of additional technical issues that needs to be considered.

Using the same figures in the forgoing example, but after the increase in the prescribed rate, the total savings is reduced to roughly $15,000 – still meaningful, but $3,000 less than with the lower prescribed rate. And remember, because the rate is locked in, this is an ongoing cost.

There is still time to act, but not much time, to put an effective income splitting strategy in place before the rate increases.

Please do not hesitate to contact us if you have an interest or questions regarding this strategy.