Prescribed Rate Loans for Family Income Splitting - FEI Canada

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Annual tax impact of the Spousal Loan StrategyWalter JaneIncome $2,000 $14,000Interest expense -- ($ 2,000)Net income from loan $2,000 $12,000In order to take advantage of thecurrent lower prescribed interestrate, it may be advantageous foryou to repay an existing loan andarrange for a brand new loan atthe lower rate.Walter, who is in the top tax bracket, is able to shift $12,000 of taxableincome to Jane, who is in a lower tax bracket. If there is a 20% differencebetween their tax brackets (e.g. 45% versus 25%), then the family willsave $2,400 on their total tax bill ($12,000 x 20%) in the first full year thatthe loan is established. If Walter simply transfers the funds to Jane ormakes a low or no interest loan to her, family income splitting will not besuccessful since all the income will be attributed back to him.Important factors to keep in mindIt is important to ensure that your spouse, adult children or the trust,in the case of minor children, have sufficient funds to make interestpayments on the loan. Not only should the invested funds generate areturn at least equal to the interest expense in order to make the loanmechanism worthwhile, but the family member to whom you make theloan must also be able to pay the interest to you each year. In the firstyear of the loan, the amount of interest payable has to be prorated basedon the number of days in the year during which the loan is outstanding.If the required interest payments are not made to you within 30 daysafter the end of the year, the attribution rules will apply. Not only willattribution apply for the year the loan interest payment is missed, itwill also apply for all subsequent years, regardless of whether or not themissed interest payment is subsequently made up. Simply put, once aloan interest payment is missed for a given year, the attribution rules willpermanently apply to the entire capital amount that was loaned for theremaining lifetime of the loan.The prescribed rate is set quarterly by the CRA based on the average90-day T-bill rates of the first month of the previous quarter. Therefore,confirm the prescribed interest rate in effect each time prior toformalizing a new prescribed rate loan.In order to take advantage of the current lower prescribed interest rate,it may be advantageous for you to repay an existing loan and arrange fora brand new loan at the lower rate. However, the process of refinancingan existing spousal loan requires careful consideration since the incomeattribution rules could be triggered if the refinancing is not executed4 | RBC WEALTH MANAGEMENT SERVICES
correctly. For more information, ask your advisor for a copy of the articletitled, “Modifying a Prescribed Rate Loan.”Once you formally establish a prescribed rate loan, the rate applies forthe life span of the loan, even if prescribed rates subsequently increaseor decline. There is no maximum or minimum amount restriction onthese loans. You can create the loan for any length of time and a simpledemand loan is sufficient to lock in the prescribed rate. To keep thedemand feature of the loan in effect, however, you’ll need to renew yourpromissory note as required.If you are disposing of securities to fund the loan, any capital gains orlosses accrued at the time you sold the securities will be recognized onyour tax return in the year of the sale.Attribution rulesAs we discussed earlier, a simple transfer of funds to your spouse orminor children, or a low or no-interest loan to your adult children orminor children through a trust, does not achieve maximum familyincome splitting due to CRA’s enforcement of the income attributionrules. The following sections explain how the income attribution rulescould render these strategies ineffective.Once you formally establish aprescribed rate loan, the rateapplies for the life span of theloan, even if prescribed ratessubsequently increase or decline.Spousal attributionIf you gift any capital to your spouse (or if you lend it without chargingat least the CRA’s prescribed rate of interest), your gifted capital will betransferred at your adjusted cost base (ACB) and any future investmentincome and capital gain/loss on the eventual sale of the investmentswill be taxable in your hands. This is why you cannot simply change thename on an investment account to that of your lower income spouse inthe hope of having the income taxed in your spouse’s hands. However,you can avoid the income attribution rules by implementing the SpousalLoan Strategy in accordance with the CRA’s terms and conditions, asdescribed earlier.Attribution and minor childrenIf you gift an amount to your minor child to invest, typically througha trust arrangement, any interest and dividends earned on the giftedinvestment, that is paid out or allocated to that beneficiary, will attributeback to you and be taxed in your hands. Capital gains earned on thegifted amount are not subject to the attribution rules in this case and willbe taxed in your minor child’s hands.If you are the settlor and trustee of a trust and the transfer to the trustis revocable (i.e. you can retrieve the assets that were transferred to theRBC WEALTH MANAGEMENT SERVICES | 5
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Prescribed Rate Loans for Family Income Splitting - FEI Canada

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