After March 31, 2018, the prescribed interest rate set by the CRA for family income-splitting loans will double from the current rate of 1% to 2%.
This increase will affect the tax savings family members can achieve through the use of family income-splitting loans – one of the few remaining ways that allow a family member to take advantage of the lower marginal tax rate of a spouse, adult child or minor child through the use of a trust.
This permitted tax-saving strategy involves a loan from a high-income earning family member to a lower income earning family member with a lower marginal tax rate. The CRA currently permits a family member to make a loan to a spouse, adult child or trust for the benefit of a minor child to take advantage of that individual’s lower marginal rate on the interest income earned on the invested loan, if a written agreement is executed between the parties and certain conditions are met.
The family member who is making the loan must ensure that the loan carries interest at the prescribed rate set by the CRA for the quarter in which the loan is entered into, and that the previous year’s interest owing on the loan is repaid prior to January 30. If these two conditions are met, the interest income earned by the borrower on the loan will not be attributed back to the lender.
While the prescribed rate of interest may rise, it is important to note that the loan arrangement entered into continues to carry the rate of interest that was prescribed at the time the loan was made.
This means that the currently low interest rate of 1% can be carried into the next quarter and onward for the lifetime of the loan by entering into a family income-splitting loan arrangement prior to March 31, 2018.
How family income-splitting loan arrangements generally work is that a higher-income earning spouse enters into a loan arrangement with his or her lower-income earning spouse, who invests the loan and earns interest income on the investment of such loan. The lower-income earning spouse then pays to the higher-income earning spouse the interest on the loan prior to January 30 at the prescribed rate. This interest is a deductible expense to the lower-income earning spouse and therefore reduces the amount of interest income on which the lower-income earning spouse is required to pay tax. The lower-income earning spouse is required to pay tax on the remaining interest income at his or her lower marginal tax rate.
This results in less tax being paid by the family unit as a whole than would have been paid if the lending spouse had invested the loan property personally and paid tax on the income earned at his or her higher marginal tax rate.
This tax-saving strategy can also be applied to loan arrangements between parents and adult children and parents and minor children. However, in the case of a loan between parents and minor children, a trust must be established, naming the minor child or children as beneficiaries. The loan arrangement is between the parents and the trust, whose trustees manage the investment of the loan. The trust allocates any investment income earned above the 1% interest rate on the loan to the trust’s minor beneficiaries in each year. These minor beneficiaries then pay minimal or no tax on this income allocated to such minor beneficiaries from the trust. Income-splitting through the use of a trust does, however, involve additional documentation including documentation evidencing each allocation of income as well as the preparation of the trust’s tax returns.
It is important to bear in mind that these income-splitting loan arrangements are only advantageous if the interest income earned on the loan is greater than the prescribed interest rate (1%) and if the individuals entering into the loan agreement are in different marginal tax brackets.
If you have any questions regarding your ability to take advantage of family-income splitting loans, please contact one of our tax advisers. You can also view the CRA’s current prescribed interest rates online.
Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.