May 11, 2022

Time to Call Your Accountant: CRA Doubling "Prescribed Rate" for Loans July 1

The following is a guest post by Jeff Brockman, CPA CA, Partner at Fruitman Kates LLP Chartered Professional Accountants. 

In the summer of 2020, I contributed to Leith Wheeler’s Planning Matters client newsletter, writing about the merits of “prescribed rate loans.”  A quick recap is a good place to start.

Prescribed Rate Loan Planning can be a compelling way to reduce a family’s overall income tax burden as it essentially allows for income to be split away from an income earner at the top rate of tax to another family member who may pay little to no tax. Tax savings per individual could be as much as $35,000 per year depending on the type of income earned. It is safe to say the tax savings can be over $30,000 per year across most provinces in Canada.

So how does it work? A formal interest-bearing loan is made by the lender to the borrower. The borrower can be a spouse/common law partner or a trust for under-aged children. Of course, proper documentation does need to be put in place. The key to the impact of income splitting is the rate of interest required to be paid on the loan. The rate must be at least the “prescribed rate” as set by the Canada Revenue Agency (CRA) on a quarterly basis. With the historically low interest rate environment we have enjoyed, that rate has been set at 1% for the past two years. Accordingly, if a portfolio returns say 6% per year, 1% of that is taxed in the hands of the lender, the high-income earner, and the balance, 5% in this case, is now able to be taxed at the lower marginal tax rates of the borrower. If using a trust structure, the trust can elect to allocate all the income out to its named beneficiaries, thus avoiding tax in the trust – which would otherwise be at the top rate generally.

Consider the following example where a trust is created so that the income can be split with minor children (generally under 18 years of age):

Assume that Mrs. X, the mother of Mrs. Y, settles a family Trust for the benefit of Mrs. Y’s five children. Mrs. Y lends the trust $1,000,000. In the first year of the Trust, the income earned with Leith Wheeler is $60,000. The Trust pays Mrs. Y $10,000, being the 1% interest charged on the loan. This leaves $50,000 of net income in the Trust. Mrs. Y, being the trustee of the Trust, causes the Trust to allocate $10,000 to each of her five children. Therefore, the Trust pays no tax and absent any other income, each child would pay no tax, assuming this is their only source of income. Had Mrs. Y earned that additional $50,000 personally she would have owed just over $25,000 of tax on that income. This can continue year over year. Just like the documentation is important, it is very important that trust pays the interest annually within the prescribed period.

Finally, it also matters where the “excess” accumulated wealth is invested. If you have large RRSPs, or tax-free registered accounts I would not suggest withdrawing funds to implement this. Where the wealth is invested corporately and if tax were needed to be paid to extract the funds from the corporation, that too would not be preferential. The plan works best where the high-income earner has the personal cash in either bank accounts or relatively liquid assets held in non-registered brokerage accounts. Simply put, I would not suggest incurring a large tax bill to implement this.

So, why am I revisiting this now – after implementing numerous plans over these past few years? The CRA announced in April that it will be increasing the prescribed rate from 1% to 2% effective July 1, 2022. I’d say 2% is still historically low but knowing this, and if the fact scenario fits, I would do my level best to get the structure and documentation in place prior to the July 1 rate increase. In the example above, an additional $10,000 – or double the previous amount – will now be taxed in the hands of Mrs. Y. That’s an approximate bump of $5,000 to her tax bill.  

Once the rate is set on a prescribed rate loan, it does not change with increases set by the CRA. So, this could be your last opportunity to implement a prescribed rate loan at the lower 1% interest rate. With July 1 just around the corner, I’d suggest contacting your tax planner sooner than later. 

The contents of this article are not intended to represent legal or tax advice. Please consult your adviser before employing any strategies discussed here.

By Jeff Brockman, CPA CA
Partner, Fruitman Kates LLP Chartered Professional Accountants