The Canada Revenue Agency’s low prescribed rate opens up income splitting opportunities – A Canadian tax lawyer’s tax guidance
The Canada Revenue Agency announced 1 percent prescribed rate starting July 1, 2020
The prescribed rate set by the Canada Revenue Agency (CRA) has been 1 percent since July 1, 2020 and will remain so until at least March 31, 2021. Although the current market seems volatile due to the covid-19 pandemic, the CRA’s newly prescribed rate can be a good opportunity for investment income splitting by transferring income from a high-income earning family member to a low-income earning member in order to take advantage of lower marginal tax rates.
However, the Income Tax Act has provisions called the “attribution rules” that prevent certain types of income splitting by attributing the income or gain earned on money transferred to a family member back to the transferor. There are several exceptions to the “attribution rules” and one of the most useful ones is for the high-income earner to make a loan to the low-income earner under the following conditions:
- The interest rate on the loan is at least equal to the lesser of
- The CRA prescribed rate at the time the loan was made, and
- The interest rate would apply on a loan between arm’s length parties;
- The interest that was payable on the loan is paid by January 30 of the following year.
To better illustrate the tax effect, let’s use the following example: H lives in Saskatchewan and is subject to tax at the highest combined federal and provincial marginal tax rate of 47.5% while his wife, W, is a stay-at-home mom who has no income. H lends $100,000 to W with an interest rate of 1% which is the CRA’s prescribed rate at the time of the loan. W then purchases securities using the borrowed money and earns $10,000 of dividend income in the year of 2020.
If H earned the dividend directly, he would have to pay tax of $2,964 (after the application of federal and provincial basic personal amount and the gross-up & dividend tax credits mechanism). As long as W pays H the loan interest of $1,000 before January 30, 2021, the attribution rule will not apply. As a result, H will only earn an interest income of $1,000 as opposed to the $10,000 of dividend income and pay tax of $475. Therefore, H would have saved $2964 – $475 = $2489 in tax. W, on the other hand, pays no tax on the dividend income since her total income is below the threshold for tax in Saskatchewan.
How to refinance a loan without triggering the Attribution Rules
The CRA has stated that simply repaying a higher prescribed rate loan with a lower prescribed rate loan could trigger the attribution rules on the investment income. Instead, the lower-income earner of the family should sell a portion of the investments that is just enough to pay off the original loan, and then the family members can enter into a new loan agreement with the current 1% prescribed rate. Let’s use the following example to illustrate the scenario:
H is a high-income earner family member and L is a low-income earner. A loan of $100,000 (Loan 1) was made from H to L at 2% which was the prescribed rate at the time. L then used the money from Loan 1 to acquire securities for investment purposes and the value is $200,000 at present. To take advantage of the new prescribed rate of 1 percent without triggering the attribution rules, L should sell half of the securities which are worth $100,000 and use the proceeds to pay off Loan 1. L should then borrow another $100,000 from H at the current 1% prescribed rate and use that money to purchase new securities for $100,000. Under this scenario, the only drawback is the possible captain gain triggered when L sold half of the portfolio to repay Loan 1.
Pro tax advice – income splitting requires careful tax planning to avoid triggering attribution rules
The current prescribed rate of 1 percent will remain at least through March 31, 2021, which offers a significant opportunity for income splitting. Having said that, the Income Tax Act has many general and specific anti-avoidance rules and it is highly recommended to speak with an experienced Canadian tax lawyer if you are considering tax planning for income splitting purposes. If you have any questions regarding income splitting or other tax planning questions, contact office to speak with an experienced Canadian tax lawyer.
Who are qualified for income splitting?
Income splitting is only applicable for certain types of income and comes with some conditions. The common-law partners or spouses and couples who live together and reside in Canada can be eligible for income splitting. They must live together for most of the tax year to be qualified for income splitting.
What are the benefits for income splitting?
The advantage of income splitting is evident and straightforward; it reduces the overall tax dues. The combined taxes of couples and their children are lessened, which means they can retain more money for their needs. In some cases, and when done strategically, it can also eliminate or lessen pension and Age-Old security drawbacks. In some cases, income splitting also allows the creation of a pension tax credit for a spouse. For effective income splitting, you can consult an accountant or a reliable tax expert.
What are the most common types of income that people can split with their spouse or partner?
Only specific types of income can be eligible for income splitting. The most common ones include money from a Registered Retirement Income Fund or RRIF, life annuity income, or a Registered Retirement Savings Plan or RRSP. Old Age Security or OAS payments, income from Quebec Pension Plan, and Canada Pension Plan are not eligible for splitting. It is best to consult an account, tax lawyer, or an expert to determine whether your income is suitable for splitting or not.