Lowering your overall income tax bill is important during tough economic times, and setting up a prescribed rate loan with family members is one way to achieve this.
This type of loan effectively transfers income from high-income earners to lower income family members, hence the term ‘income splitting.’ Interest on the loan made to family members (or family trust) is charged at the prescribed interest rate (which is set by the Canada Revenue Agency quarterly), and then any income on the funds is taxable to the recipient family member instead of the taxpayer.
The tax-saving opportunity is in the spread between the prescribed rate and the rate at which the invested funds earn income. Once the loan is made, it can bear interest at the prescribed rate forever, and as interest rates and the prescribed rate rise, so too does the spread and the tax savings.
On June 30th, 2020 the CRA lowered the prescribed interest rate to 1 percent from 2 percent, which means any return on the invested funds made with the loan, whether that be capital gains, interest, dividends or other income, that is in excess of the 1 percent interest that must be paid on the loan, will be taxed to the family member.
In addition to tax savings, prescribed rate loans can be used to help fund minor expenses, such as paying for private school and extracurricular activities, by making a prescribed rate loan to a family trust with the minor children as beneficiaries.
As with any tax-lowering strategy, strict rules apply: it is imperative that the prescribed rate of interest is actually paid to the lender each year by January 30th of the following year. If even one payment is missed, the benefits of the prescribed rate loan will be permanently undermined.
Be sure to consult a qualified financial advisor to obtain tax and legal advice before implementing a prescribed rate loan: this will help you determine the best way to structure and operate this type of loan in addition to assessing your particular circumstances.