Divide and conquer your taxes!
How to use the Prescribed Rate Loan strategy to lower your tax bill.
For the 2009-2010 fiscal year, Canadians paid over $150 billion in personal income taxes. Most of us would agree that Canada has very high rates, which is motivation enough for families to use every tax planning opportunity available to reduce their overall tax bills.
Income splitting is a strategy of shifting income from a higher income earner to a lower income earner in order to reduce the overall tax paid by the family. It can also leave more money for investment purposes or to pay living expenses.
While income splitting is a great strategy, it isn't always easy to implement. The government limits income splitting by imposing "attribution rules." Generally speaking, these attribution rules operate by attributing investment income back to the higher-rate taxpayer from money or property that is loaned or transferred to a lower-rate taxpayer, where the taxpayers are related — for example, spouses or common-law partners and minor children.
If the attribution rules apply, all investment income is attributed back to the higher rate taxpayer if the income splitting involves spouses or common-law partners. When the income splitting involves minor children, all investment income (but not capital gains) is attributed back.
One exception to the attribution rules is the use of a Prescribed Rate Loan (PRL) for the money loaned or property that is loaned or transferred. The CRA announces the prescribed interest rate on a quarterly basis. This rate generally follows the interest rate on 90-day Government of Canada Treasury bills (T-Bills) sold in the first month of the previous quarter. For example, the current prescribed rate of one percent for October 1 to Dec. 31, 2011, is based upon the 90-day T-Bills that were sold in July 2011.
While TD Economics does not expect the Bank of Canada to raise the benchmark overnight lending rate till 2013, they expect the rate on the 90-day T-Bills to start rising from the middle of next year. Today's low interest rate environment has made this an especially good time to consider a PRL.
How does it work?
The higher income-earning spouse lends a sum of money to the lower-income spouse. Under a written loan agreement, the lower-income spouse agrees to pay interest at the current prescribed rate of one per cent. The lower-income spouse then invests the borrowed funds at a rate greater than one per cent to make this strategy as tax effective as possible.
Here's an example:
Let's assume Homer and Marge, whose marginal tax rates are at 45 per cent and 20 per cent respectively, decide to avail themselves of the prescribed rate loan strategy. If Homer loaned $100,000 to Marge to invest at the current prescribed rate of one per cent, and Marge earned five per cent (or $5,000) on this amount, Marge would be left with $4,000 of taxable income after deducting the one per cent interest (or $1,000) paid to Homer. The tax payable by Marge in this example is $800 ($4,000 investment gain, taxed at 20 per cent). Homer would pay $450 (marginal tax rate of 45 per cent) on the $1,000 in interest received from Marge. The total taxes paid by both spouses would be $1,250 ($800 + $450).
However, if Homer had invested the $100,000 and earned the same amount, Homer would be subject to $2,250 ($5,000 in gains taxed at 45 per cent) in taxes. Similarly, if Homer had loaned the $100,000 to Marge at less than the prescribed rate, or had simply gifted the $100,000 to Marge to invest, the tax rules would attribute all income (including capital gains) earned by Marge to Homer. By establishing a prescribed rate loan, Homer and Marge would save $1,000 ($2,250 - $1,250) in taxes in this example.
The prescribed rate can be locked in under a PRL. For example, if the current prescribed rate is one per cent, this rate can be locked in for as long as the loan is in existence, regardless of whether the prescribed rate rises. However, if the prescribed rate declines, the PRL can be renegotiated to lock in the lower prescribed rate.
To be legally effective the PRL agreement should be in writing and stipulate the names of the borrower and lender, the amount of the loan, and the prescribed interest rate. It is important that interest for the year be paid on or before January 30 of the following year, or the income earned by the lower income spouse for that and subsequent years may be attributed back to the higher income spouse.
Finally, it is important, as with any tax-related planning, to consult with a tax professional prior to implementing this strategy. Legal advice may also be required in the drafting of the PRL Agreement.
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