My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, July 18, 2011

1% Prescribed Interest Rate Loan- A great income-splitting opportunity

The Canada Revenue Agency (“CRA”) has set its prescribed interest rate for the third quarter of 2011 and it remains at 1%, unchanged from the first and second quarter of 2011. This continuing historically low interest rate, offers yet another opportunity to income split with your spouse and/or children.

Generally, the income attribution rules in the Income Tax Act restrict any attempts to shift income from a higher income individual to a lower income individual by attributing the income back to the higher income earner.

Thus, if you transfer assets to your spouse or minor children, any interest, dividends and capital gains, in the case of a spouse, and any interest and dividends, in the case of a minor child, are taxed in your hands as if you earned the income.

The exception to the above attribution rules applies where an individual makes a loan to a spouse or minor child and interest is charged on the loan at a rate at least equal to the CRA’s prescribed interest rate at the time the loan was made. Where the loan is made at the prescribed interest rate, the attribution rules will not apply. For the loan to be valid, the interest owing must be paid each year within 30 days after the end of the year (January 30th).

Income Splitting


 So why is this a great income splitting opportunity? Because, if your spouse or child is in a low income tax bracket and you are at the highest marginal tax bracket, there could be upwards of 46% in income tax savings on investment income if a prescribed rate loan is used.

If you make a loan to your spouse or minor child between July 1st and September 30th, 2011, the 1% rate is locked for the life of the loan. For example, say you loan your spouse $50,000 and he or she earns 3% on a long-term GIC; he or she will earn $1,500 and have to pay you $500 in interest, netting out $1,000. If your spouse has no other income and you are a high marginal rate taxpayer, you would save almost $500 in taxes. If interest rates recover over time, the benefit could become two or threefold. For those more adventurous, the money can be used to purchases stocks, ETFs, etc. and if you achieve an 8% return, you could be up to $1,500 ahead income tax wise.

Key points to consider


1. The loan agreement must be documented.

2. The CRA’s administrative position is if you have a current prescribed rate loan, you cannot repay it  and issue a new loan.

3. On loans to minors, any income earned legally belongs to the child.

4. The loan interest must be paid by January 30th of the following year.

It should be noted that trusts are typically used for income splitting with minors because minors generally cannot enter into an enforceable contract. Professional advice should be sought before setting up any type of prescribed loan.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

45 comments:

  1. In the case of a spouse, couldn't the loan just be avoided by purchasing investments directly from a joint account? How would attribution apply?

    ReplyDelete
  2. Hi Anon:

    Couple things:

    1. If the investments are purchased from a joint account, you are splitting and reporting the income 50/50. Using a prescribed loan allows one spouse to have a significantly greater income split. ie: if the rate of return is 5%, that spouse has $5 income to the $1 they must pay in interest expense, thus 5:1 as oppossed to 1:1

    2. Technically a joint account must actually be joint funds of equal contribution or there is attribution on the excess portion contributed by one spouse. Practically the reporting is sometimes another story.

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  3. Do you have an example of how to properly document the spousal loan agreement?

    Thanks!

    ReplyDelete
  4. Hi Anon, I wish I could provide one, but the copies I have are proprietary property of the lawyers who created them. I tried to find one on the net, but could not find an example.

    That being said, they are really just simple promissory notes with a couple small adjustments. So if you went to a lawyer, who is familiar with prescribed interest loans, the cost should not be prohibitive.

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  5. well, never mind loans or joint accounts, can't the higher income spouse just pay all the household expenses, and the lower one do the investing & reap the lower income tax rate? I recently realized we've been doing that inadvertently. Could this bring the wrath of CRA on us??

    ReplyDelete
  6. No wrath, just kudo's. That is actually good tax planning, especially if you have your own bank account and pay the bills from that account and your spouse has their own bank account and makes the investment from that account.

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  7. I was wondering if you can share your opinion on my situation. I am in >40% tax bracket (T4 employee) and for some time now I have been considering this kind of strategy, but I would have to implement it in increments of up to $2..3,000 a month (because I do not have $200,000 to lend her right away). The amount of paperwork and having to track so many loans would always stop me. And it would also take us a year or two to make a difference.
    At the same time, we have a paid off house and I have a $250,00 in my RRSP. This amount represents less than 50% of the value of our house.
    I have been thinking about putting a $250,000 mortgage into my RRSP and lending this amount to my wife for investing: I borrow against my (less than a) half of the house and lend it to my wife for investments.
    That should make the mortgage interest tax deductible and if I (my RRSP) take an open mortgage at 6.5% and I lend the money to my wife at 6.5..6.75..7%, then this becomes almost tax neutral to me: whatever I get from her as a loan interest is offset by a tax deductible RRSP mortgage payment.
    Would this work as far as CRA is concerned?

    ReplyDelete
  8. Hi Anon, I am having trouble following. You say you are thinking about putting $250k mtge into your RRSP. Do you have $250k in room and you are borrowing to get this $250k and making a $250k contribution or do you mean you are going to use the money in your RRSP to provide yourself a mortgage. I am confused, can you restate your question step by step. Thx

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  9. 1. I have 250K in my RRSP invested in balanced portfolio of ETFs; the house is paid off.
    2. I want to use income splitting strategy, but do not have funds to do it in one shot (only several thousand a month), but that is a lot of paperwork.
    3. I can sell my RRSP investments and put a mortgage in RRSP at 6.5% (one year open).
    4. I take the entire amount and lend it to my wife at 7% and she invests for dividends.
    5. 6.5% mortgage is now tax deductible in my hands and I pay taxes only on 0.5% interest (7%-6.5%=0.5%)
    6. My wife pays taxes on the dividends she earns using the loaned money and deducts 7% interest she pays me
    7. $250,000 is less than a half of the house worth, although although the house is in our both names...
    Thanks in advance for your comments

    ReplyDelete
  10. Hey Anon

    I don’t think your plan works:

    1.Only selected banks will permit self directed mortgages and as I understand it, they must be insured by CMHC. I think you would have a problem obtaining the mortgage from the institution and/or CMHC when you explain you are borrowing for investing and not to purchase a house or replace a current mortgage.

    2.I have not looked recently, but I don’t think an investment loan is a qualified investment.

    3.Even assuming you could do the above the interest your wife would pay is far greater than the return she would get on dividends and thus no income splitting is achieved unless she has capital gains on the stocks.

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  11. Can I loan my sister the $ to buy a house? Would the CRA rules permit me to save on interest income tax vs putting the money into a GIC?

    ReplyDelete
  12. Anon, you can loan your sister money to purchase a house. The loan can be interest free or with interest, but if with interest, you must report the interest income. The above rules relate to spouses and children

    ReplyDelete
  13. My wife and I build a house 2 years ago. It's worth approx 750,000.00
    We used 550,000.00 of our personal money, and needed 200,000 more. Our accountant suggested our holding company loan us the remainder at a rate of 4% instead of paying a bank interest with a traditional mortgage. We've done this the past 2 years..ie paying 8000.00 interest back (no principal)to our holding company at the end of each calendar year.
    This summer our accountant said we could refinance and issue a promissory note for 200,000.00 at a rate of 1%. So we paid our holding company back approx 205,000.00 (interest and principal) and took out the 200,000 once again at a rate of 1% with the intention of only repaying interest on it annually...so 2000.00 per year.
    We also just purchased a home in Arizona and were intending to do the same thing. Another promissory note at 1%. I was telling this to a friend of mine who is a stock broker and he thought there is no way this is ok to do. He phoned his tax guy and they said no. I then called my stock broker and he looked into it by calling someone and they also said absolutely not ok.
    My accountant mentioned KPMG had came out and said this was fine to do this.
    Any thoughts on this situation?

    ReplyDelete
  14. Anon

    I cannot provide specific advice on this blog and I do not have all the details of your situation, but I would ask your current accoutant the following question.

    Is he/she confident the original housing loan was made to you in your capaciaty as an employee and not a shareholder. Loans in your capacity as a shareholder can be problematatic.

    The refinancing is complex and I am not willing to comment

    As far as Arizona, the conservative position would be to not make this loan.

    ReplyDelete
  15. Hi MarK,

    I am a single mom who last year issued cheques payable to each of my 2 daughters for about $100K each... I have not yet decided if I want to "GIFT" or "LOAN" them this money. Since then, they have both issued cheques from thier respective bank accounts to purchase investments in their own names which are anticipated to pay "interest income" of +/- 10% (i.e. +/- $10K/year). I want to declare this interest income in their names for 2012 taxation year. By the end of 2012, my eldest shall be 18 but my younger daughter will only be 16.

    Question 1: Please confirm that the interest income for my eldest shall be taxed in her name/hands & exempt from CCRA's attribution rules & Do I need to worry about provincial attribution taxes (we live in Quebec)?

    Question 2: Please confirm that the interest income for my youngest shall ONLY be taxed in her name/hands & exempt from CCRA's attribution rules; I am comfortable preparing the loan agreement/contract/promissory note myself at CCRA's prescribed rate of 1% for 100 year term and get this agreeemnt sealed by a public attorney or notary.

    (Would the contract between myself and my 16 year old be valid, if not, what other suggestions do you have for me to ensure each of my daughters own and pay the taxes related to these investments?

    THANK YOU !!

    ReplyDelete
    Replies
    1. Hi Anon

      This will probably come off as rude, but I am being factual. Although I try and answer most simple questions and/or provide some direction, it is not my intention to provide tax planning advice on this blog. You should engage an accountant or lawyer to get this straightened out as the sums are substantial.

      I will tell you that since you loaned/gifted the money before your children were 18, the income technically will be attributed back to you under the Income Tax Act. However, there may be ways to sort this out, so again, I suggest strongly you get professioanl advice.

      Delete
  16. If an adult child or another beneficiary loans money to the estate of a deceased person (with many other beneficiaries) in order to pay off bills or other debts while the affairs of the estate are being settled, is there any rule about how much interest is eventually paid to the individuals loaning the money--even if it takes a couple of years to close the estate?

    I assume that when the individuals loaning the money finally get their money, that's when they'll report the interest income to the CRA.

    ReplyDelete
    Replies
    1. Anon, this is a loaded question, speak to the estate's accountant, there are multiple issues that need to be considered from attribution rules, to the terms of the estate, I cannot answer this question.

      Collins Barrow had this to say on the topic:

      "A testamentary trust can lose special tax benefits by borrowing money or receiving a loan guarantee from a non-arm’s length person. As an exception, when a testamentary trust borrows money from, and then reimburses, a beneficiary for trust obligations (e.g. funeral expenses, taxes), the testamentary status may be maintained in certain specific circumstances. Trustees and lawyers must be aware of these circumstances."
      (http://www.collinsbarrow.com/news_showArticle.asp?articleID=281&typeID=27)

      The interest issue is also complicated. Depending upon the final determination of the loan, if a loan can be made, the interest may need to be paid by jan 31st of each year or may need to be accrued on the anniversary date of the loan. As noted above, you need to speak to your advisor.

      Delete
  17. Hello Mark -

    I am thinking of taking advantage of the 1% prescribed rate loan and am having difficulty confirming that the loan would have to actually bear the interest rate at 1%... CRA's interpretation bulletin IT-510, Sec. 16(b)(ii), references an interest rate prescribed for the purposes of Subsection 161 (1) of the Income Tax Act. That subsection talks about interest on overdue taxes - which currently is at 5% (http://www.cra-arc.gc.ca/nwsrm/rlss/2012/m03/nr120314-eng.html). What am I missing or misreading?

    Thank you!
    Genia

    ReplyDelete
  18. Hi Genia

    There are several rates including the 5% for overdue taxes. The rates for loans is 1%, see attached CRA link

    http://www.cra-arc.gc.ca/nwsrm/rlss/2012/m03/nr120314-eng.html

    ReplyDelete
  19. Still confused... Sec. 16(b)(ii) of IT 510 says that the rate on the loan should be a minimum of the rate prescribed for Sec. 161 (1) of the Income Tax Act. SEc. 161 (1) talks about interest on overdue taxes, which is 5%... What am I missing?..

    ReplyDelete
    Replies
    1. I took this from Simpson Wigle LLP blog which hopefully apeases you

      The prescribed rate is determined in accordance with rules set out in Part XLIII of the Income Tax Regulations. The definition of the prescribed rate is found in section 4301. Subparagraph 4301(a)(i) of the Regulations defines a base rate, which is used to calculate the three types of rates used by the Act: the interest rate on amounts owed by a taxpayer, which is the base rate plus 4%; the interest rate on amounts owed by the Minister, which is the base rate plus 2%; and the rate for certain benefits that are taxed under the Act, which is the base rate.

      Delete
  20. Correct. The problem is, IT 510 (16(b)(ii))seems to suggest that the 'prescribed rate' on the loan should be the same rate the taxpayer owes on overdue taxes... Note the 'base rate'... Anyway..

    ReplyDelete
  21. Hi,

    Great post, this is exactly what I was looking for. I was thinking about borrowing money using my LOC to lend to my spouse (who has no income) to invest. If I am borrowing money at 6%, lending it at 1% and investing it at say 10%, would this be better then simply borrow and investing it myself under my name? I am at I believe a 37% income tax rate.

    Thanks!

    ReplyDelete
    Replies
    1. Hi Anon

      Typically prescribed loans are used where you currently have funds invested by a high tax rate spouse and that spouse loans those funds to a lower tax rate spouse, reducing the high rate spouses income and increasing the low rate spouses income.

      As I don’t provide specific personal income tax planning on this blog, I will point you in the right direction.

      Borrowing to make a loan complicates the issue, especially where you borrow at 6% and make a loan at 1%.

      I will not comment on your specific situation, however, if you go to IT-533 paragraph 10, the CRA says absent a sham, the courts should not be concerned with the sufficiency of the income expected.

      Delete
  22. Well, The funds are currently borrowed and invested by myself and I was looking at this as a way of reducing capital gains on those investments.

    I don't suppose you could roughly translate the lawyer mumbo jumbo into english? is it saying they don't care? or that it would be considered a sham?

    ReplyDelete
    Replies
    1. Translation

      Your situation would not be a sham

      The courts have condoned your situation

      The CRA references the court’s opinion in their Interpretation Bulletin

      I think that provides you enough info to make your decision, I cannot on this blog tell you yeah or nay.

      Delete
  23. I understand and I appreciate the information.
    Whether or not I will use borrowed money or not is still undecided. I was just looking to inquire about the legality of it. Thanks again for your time.

    ReplyDelete
  24. Any advice on how a spousal loan would work if spouse then contributes the loaned amount to his RSP (and claims the tax deduction himself)? My RSP room is maxed out so a 'spousal RSP' is out of the question, but he still has room.

    If I understand correctly, I can't just hand him $10000 or somehow, when we retire and start taking the $ out, CRA is going to find a way to make me pay the tax on it. Any clarity on this issue much appreciated!

    ReplyDelete
    Replies
    1. Hi Anon:

      A spousal loan for tax planning purposes is generally used to split taxable investment income and is not really meant for a RRSP. I cannot comment on the RRSP loan since I would incriminate myself. Read into that what you may.

      Delete
  25. thanks for that clarification. (BTW, I just discovered your blog, and it's got a lot of great info. Thanks for your efforts!)

    As we get closer to the time we'll have $ outside of TSFAs and RRSPs, what is the better strategy: spousal loan route or simply running all the bills through my credit cards, so that 'my' $ pays the bills and 'his' $ gets invested? (His gross income is about $30000/yr less than mine, plus he has a $16000 capital loss waiting to offset some gains.) Would we have to hang onto all bank and credit card records to the end of time?

    Also, does the fact we're common-law make any difference for tax purposes (we get the other risks about joint property, we have proper wills etc)? CRA is happy to treat us as if married when it benefits them, but are there any 'married' benefits that would not apply to us?

    ReplyDelete
    Replies
    1. Hi anon. Being common law is the same as married for purposes of the act. With the spread in salaries not that significant in my opinion paying bills with ur salary is probably the practical strategy in respect of the capital loss. Check out my capital gains blogs for a potential strategy to use the loss if u fit the fact situation

      Delete
  26. PS: My question(s) were intended to solicit general information only on whether either of those strategies are equally valid, not specific advice about my particular situation. :-)

    ReplyDelete
  27. Hi Mark - great blog. Thank you for all of this.

    I have a question re. attribution rules. My spouse has borrowed money for investment purposes. She pays the interest on those borrowings. If I were to repay the principal on those borrowings, would attribution rules apply (ie. would the earnings that up until now have been taxed in her hands, now be taxed in my hands)?

    ReplyDelete
    Replies
    1. Hi Anon:

      The earnings to date from the original loan would not be subject to attribution. Any earnings subsequent on the amount of the loan you paid off would likely be subject to attribution. You may want to speak to your accountant or an accountant to see if they can structure the repayment such that you end up making a spousal loan at 1%, paying off the original loan and lowering the borrowing cost to your spouse.

      Delete
  28. We have loaned our son over $200K for his education and don't plan to charge interest. Is this an issue?

    ReplyDelete
  29. Hi,

    For the spousal loan agreement, does it have to be drafted by lawyers? Or, can we just draft our own promissory note as long as it states the amount lent, the interest rate and the start date of the loan?

    Thanks

    ReplyDelete
    Replies
    1. Hi Anon:

      There is no requirement it be drafted by a lawyer. I don't provide legal advice on how to draft promissory notes therefore I will not answer your question. The only thing I will tell you is that if you decide to do it yourself, ensure you reference the fact interest will accrue to Dec 31 of each year and shall be payable by Jan 30th of the next

      Delete
  30. Hi,

    Does it matter in what currency the loan is made? Reason I ask is I have USD and do not wish to pay the bank spread to convert it to CAD if I don't need to.

    Thanks in advance.

    ReplyDelete
    Replies
    1. Hi Anon,

      I have never looked at whether it can be in $US, I dont see why not, but I cannot give you a definitive answer, sorry.

      Delete
  31. Hi Mark, great blog. Do you think that there would be a benefit in dividing the loan into separate promissory notes, e.g., two notes for $250K each rather than a single $500K note if there may be a need to liquidate some of the investments and use the funds for another purpose? Or would simply making a partial payment of the $500K note not cause a tax problem? Thanks.

    ReplyDelete
    Replies
    1. Hi Anon

      I have seen lawyers do it both ways.Up to you and your lawyer

      Delete
  32. Hello,

    I will be lending my brother money for a down payment on a house. I am planning on collecting interest on the loan but I wanted to know how this will affect my personal income taxes?

    Thanks

    ReplyDelete
    Replies
    1. Hi Anon

      Yes, you must report the interest income

      Delete