The use of a prescribed rate loan between spouses, or between a parent and minor child (including a grandparent and minor grandchild), may provide tax savings on investment earnings.
What is a Prescribed Rate Loan?
A prescribed rate loan is a loan which carries interest at the prescribed rate. The prescribed rate is set quarterly by the Canada Revenue Agency (the “CRA”) and is based on the three-month average government treasury bill interest rate. With interest rates recently at or near historical lows, the prescribed rate has followed and currently sits at one per cent until at least March 31, 2022.Interest on a prescribed rate loan must be paid within 30 days after the year-end in which the loan was made. As individuals follow a calendar year-end, this means the interest must be paid by January 30 of the following year. It is important to keep documentation of the interest payments in the event the CRA were ever to request proof of payment.
Benefits of a Prescribed Rate Loan
The investment income earned on funds that originated from a gift or a loan that carries no or a low interest rate (i.e., below the prescribed rate) between spouses and between parents and minor children can result in the application of the attribution rules in the Income Tax Act (the “Act”). In these situations, the investment income earned will be attributed back to the spouse or parent who provided the loan and taxed in their hands, rather than in the tax return of the spouse or minor who is presumably in a lower tax bracket. The purpose of the attribution rules is to prevent the transfer of income to related parties subject to a lower tax rate with the objective of minimizing or reducing a family’s overall tax burden.
However, charging interest on a loan at a rate no less than the prescribed rate avoids the attribution rules such that investment income earned by the spouse or minor remains taxable to the individual that received the loan. If used correctly, it will permit the investment income earned to be included in the spouse’s or minor’s income and subject to a lower tax rate.
Consider the following example:
Mr. and Mrs. A are both residents in Ontario. Mr. A’s marginal tax rate on investment income is 53.53 per cent (the highest marginal tax rate), while Mrs. A’s effective tax rate is 20.05 per cent. Mr. A will make a loan of $800,000 to Mrs. A so she can invest the funds which will generate interest income at an annual rate of return of five per cent. Mr. A is deciding between an interest-free loan or a prescribed rate loan at one per cent
The following tables summarize the couple’s tax liability under each scenario.
Table 1: Interest-free Loan
Table 2: Prescribed Rate Loan (1%)
The couple will benefit from tax savings of approximately $10,714 ($21,412 - $10,698) through the use of a prescribed rate loan which will allow the investment income earned to be taxed in the hands of Mrs. A rather than Mr. A.
Final Thoughts
To the extent that an investment portfolio can generate more than a five per cent annual return, or multiple prescribe rate loans can be extended to a spouse, minor children and/or grandchildren, the combined family tax savings can be much higher than illustrated in the example. Transactions between related parties can result in unexpected and undesired tax consequences though, especially if transactions are not properly documented or interest is not paid within 30 days after the end of the calendar year. If you would like to learn more about prescribed rate loans and explore whether they are right for you, we encourage you to contact a member of Crowe Soberman’s Tax Group.This article has been prepared for the general information of our clients. Please note that this publication should not be considered a substitute for personalized advice related to your situation.
