Time is Running Out for This Tax Saving Method

Canadians are always on the lookout for strategies to lower their family tax burden. While many deductions and tax credits advertised on the Canada Revenue Agency’s website are targeted to a limited number of taxpayers, other strategies are available to those who get the right advice.

One of the most common strategies to lower a taxpayer’s income tax bill is to split income with a lower‑income family member, most commonly a spouse, using a prescribed rate loan. But the maximum benefit from this strategy is time‑sensitive, and time is running out right now.

What is it?

A prescribed rate loan is a loan made to a family member where the loan meets the following conditions:

• The face value of the loan must be equal to the funds transferred.
• There is a legal obligation to pay interest on the loan at a “prescribed rate” in effect when the loan is made, which is currently one per cent (more on that below).
• Interest for a year must be paid by January 30 of the following year. For example, interest on a prescribed rate loan for 2022 must be paid by the borrower to the lender by January 30, 2023, ideally via electronic transfer. This condition must be met in each year in which the loan is outstanding.¹

The ideal candidate for this strategy is someone with a high income who has maximized contributions to their registered accounts (i.e., RRSP, RESP, RDSP, TFSA), has cash available in their personal accounts,² and has a close relative with a low income who will ultimately keep the investment income earned using the loaned funds. The prescribed rate loan strategy results in tax savings when the rate of return exceeds the interest paid to the higher‑income spouse on the prescribed rate loan, generating a profit that is taxable at lower rates.

As an example, assume that Spouse 1 (the higher‑income spouse) lends $200,000 to Spouse 2 (the lower‑income spouse), and charges them the one per cent prescribed rate of interest. Spouse 2 uses the funds to earn a five per cent annual return, which would otherwise be earned by Spouse 1. The potential savings³ can be illustrated as follows, using the highest and lowest tax rates applicable in Ontario:

	Spouse 1	Spouse 2	Total
Without a prescribed rate loan:
Taxable income ($200,000 x 5% rate of return)	$10,000	–	$10,000
Tax rate	53.53%	20.05%
Income tax payable	$5,353	–	$5,353
Using a prescribed rate loan:
Return on investments ($200,000 x 5% rate of return)	–	$10,000	$10,000
Prescribed rate loan interest ($200,000 x 1%)	$2,000	($2,000)	–
Taxable income	$2,000	$8,000	$10,000
Tax rate	53.53%	20.05%
Income tax payable	$1,071	$1,604	$2,675
Annual savings ($5,353 – $2,675)	$2,678

While the example above shows the benefit of splitting income with a spouse, this strategy can be implemented with other family members. Making loans to minor children directly may not be possible or practical; however, investment income from mutual funds, ETFs, and public company stocks may be split with minor children using a prescribed rate loan to a family trust.⁴

When implementing this strategy, best practices include getting tax advice first to be certain of the benefits, having a short loan agreement or promissory note drawn up, and setting up automatic payments in online banking to help ensure that no interest payments are missed. People contemplating this option might ask, “Why can’t I do away with this prescribed rate loan nonsense and just give the money to my spouse to invest, or lend it to them interest‑free?” The answer is: the attribution rules.  By default, the income the spouse would earn on those gifted or loaned funds would attribute back to the spouse who made the gift or loan.⁵ The exception to this is where a loan meets all of the required conditions of a prescribed rate loan as detailed above.

Timing is important

The prescribed rate loan strategy is nothing new; it has been around for years. So, why are we talking about this today?

The prescribed rate that is in effect when the loan is created remains in effect for the life of the loan. That rate currently is one per cent. Consequently, a loan made today, in accordance with the conditions listed above, would carry a one per cent interest rate as long as the loan is outstanding and not repaid, even if the government’s prescribed rate increases in the future. This low interest rate maximizes the net return earned on investments that will be taxable to the lower‑income family member. However, the rate is set to rise to two per cent effective July 1, 2022. (The prescribed rate is tied to the yield of Government of Canada Treasury Bills, which is increasing.)

While a one per cent increase in the rate to two per cent overall might not sound too bad, in the example above it would result in a reduction in tax savings of $670 annually if Spouse 1 made the prescribed rate loan on or after July 1, 2022, rather than by June 30, 2022. Furthermore, widespread expectations that interest rates will continue to rise mean that further increases to the prescribed rate of interest are expected. Rates are set each calendar quarter. In recent decades, the highest prescribed rate was 13 per cent in the first quarter of 1991, and it has fluctuated between one per cent and two per cent since the financial crisis of 2007‑2008. While we are a long way from seeing 13 per cent again, the strategy is only beneficial if there is a significant spread between the rate on the loan and the rate of return earned on the loaned funds. For example, if the rate of return is six per cent and the prescribed rate is six per cent, the strategy results in no tax savings.

Time is running out to take advantage of the lowest prescribed rate in history. Contact your Baker Tilly advisor for assistance with this and other strategies today.