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Should Your Family Use a Prescibed Rate Loan?

August 31, 2022

While most Canadians would agree that we each need to pay our fair share in taxes, a study released last year by the Fraser Institute showed that the top 20% of Canadian earners earned 44.1% of income in Canada, but paid 54.7% of the income taxes.[i] Our belief at Momentum Financial has always been that when it comes to tax planning, our job as financial planners is to reduce unnecessary wealth-leak caused by taxes, regardless of the client’s income or stage of life.

One of the strategies that Canadians can use to split income and reduce their overall household taxes is a prescribed rate interest loan, which can be made to a spouse or a family trust. With a spousal loan, the higher income spouse lends money to the lower income spouse so the lower income spouse can invest the money and be taxed at a lower rate than the higher income spouse would be. The same can be done by lending money to a family trust with beneficiaries that are in lower tax brackets.

Prescribed rate loan strategies exist in Canada due to income attribution rules, which are in place to ensure high income earners do no shift taxable income to lower-income family members. As the Income Tax Act is written and interpreted so as not to provide an undue advantage to any Canadian, the Canada Revenue Agency (CRA) requires that interest is charged on the loan and taxes are paid on that interest by the lender. The rate that the CRA sets is based on the three-month average of short-term Government of Canada Treasury Bill rates. Currently, the prescribed rate is set at 2%, but this is changing to 3% on September 30, 2022.

Take the case of a couple named Minnie and Mickey. Minnie is a senior executive at a cheese factory in Ontario earning $250,000 a year in salary. Our progressive tax system means that Minnie’s top dollar is taxed at 53.53%. Minnie’s husband, Mickey, has his own business as a cheese consultant, but only draws $100,000 in income from the business each year. Mickey’s top marginal tax rate is 37.91%.

	No Prescribed Rate Loan	Prescribed Rate Loan from Minnie to Mickey
Top Marginal Tax Rate	53.53% (Minnie)	37.91% (Mickey)
10 Years Tax Savings	none	$155,900
Tax Savings Re-Invested at 3%	N/A	$183,307

If Minnie earns $100,000 of interest in her non-registered portfolio, she’ll pay the government $53,500 in taxes, and keep $46,500. If Mickey earns that same interest income, he’ll pay $37,910 in taxes - $15,559 less than Minnie paid. Over ten years, the simple tax savings to Minnie and Mickey’s household is $155,900. If we assume that Mickey earns a modest 3% return on that $155,900, it would worth $183,307 after 10 years.

 

This is a great strategy for households looking to reduce their overall tax burden.  For families where there is a significant income gap between spouses where the top earning spouse has maxed out their TFSA contributions and potentially their RRSP contributions as well.  If both spouses are earning in higher tax brackets, the prescribed rate loan strategy also works with a family trust. In this case, money is lent to the trust where income can be flowed-through to lower-income family members, such as children.

Since there is a bit of work at the initial set up to have the loan set up properly, you want to make sure that your household will benefit from this strategy.

There are generally three requirements for prescribed rate loans:

1. Written loan agreement (promissory note) with specific requirements
2. Interest rate that is the CRA’s prescribed rate or higher
3. Interest payments no later than January 30th of the for the previous fiscal year

 

There are other items you may want to have in place, such as amendments to a will or trust deed to accommodate forgiveness for the loan in the event of death of the lender or borrower.

Any tax planning strategy requires thoughtful financial planning with assumptions. A few of the initial variables that need to be considered include tax residency of the lender and borrower, how the promissory note or loan agreement is written, and expected future incomes (and therefore, tax situations) of the two individuals.

While the numerical benefits of tax planning strategies can sometimes be obvious, usually there are tertiary considerations such as the estate planning and the logistics of exiting a strategy, as well as the risk profile of the individual investors. If you are interested in a prescribed rate loan strategy, you should speak with a financial planning professional to determine if this strategy is right for your circumstances.