LL.M. Fisc., F.Pl.
What is the prescribed rate used for?
From a tax standpoint, a prescribed rate of 1% offers opportunities for tax optimization. Since this is the rate used for a loan between spouses or between family members, it can allow income splitting.
As you are no doubt aware, the possibilities for income splitting between spouses have almost disappeared over time due to the tightening of several tax rules, particularly those affecting trusts.
Last June, the Canada Revenue Agency announced a drop in the prescribed rate for the third quarter of 2020, from 2% to 1%. This drop is obviously linked to the reduction in the Bank of Canada’s policy rate and the current economic situation.
Reducing the tax bill
However, it is still possible to make an interest-bearing loan to a spouse. In this case, the spouse could invest the borrowed capital, which would have the effect of generating income in his or her hands.
If the marginal tax rate of the loan debtor spouse is lower than that of the loan creditor spouse, it would be possible to achieve income splitting, which would then reduce the couple’s overall tax bill.
A word of caution: pay particular attention to the scope and application of the attribution rules in such a situation.
The interest rate is key
If the amounts lent to the spouse (or to the family trust) are part of a loan that will bear interest at a rate equal to or greater than the prescribed rate, the income attribution rules don’t apply. The interest will then have to be actually paid before the end of the first month following the end of the year, i.e. January 31.
The rule stipulates that if the income generated on the capital borrowed by the loan debtor spouse is at an interest rate higher than the prescribed rate, the “profit” thus generated will be taxed in his or her hands.
If the debtor spouse has a lower tax rate than the creditor spouse, income splitting can then be achieved for the couple.
Another benefit is that if the prescribed rate increases in the years to come, the applicable rate on a loan made when the rate was 1% will remain unchanged for the duration of the loan.
If you had already considered using the prescribed rate strategy, the current environment, with a rate of 1%, is particularly favourable. Compared to a prescribed rate of 1.5% or 2%, the splitting effect might be the same, but the capital required to achieve it will be less.
For more information on the prescribed rate and particularly on its suitability in your situation, contact your advisor and talk about it with him. We work as a team and we want to share our financial intelligence with you to optimize your wealth.
Alexandre Hunault, LL. M. Fisc.
The information contained herein has been obtained from sources deemed reliable, but we do not guarantee the accuracy of this information, and it may be incomplete. The opinions expressed are based upon our analysis and interpretation of this information and are not to be construed as a recommendation. For any questions, don’t hesitate to contact your wealth management advisor or your tax specialist, accountant or legal advisor.