Taking advantage of a rare planning opportunity
The prescribed rate increased to 2% on July 1, 2022, and will increase to 3% on Oct 1, 2022. The information on restructuring applies when the prescribed rate is being decreased.
While “attribution rules” in Canada’s tax laws generally restrict the ability to income split between family members, there are strategies that are permitted. One common strategy is the prescribed rate loan, which allows funds to be lent from a high-income individual to a lower-income individual to be invested in non-registered assets. This loan will then be taxed at the lower-income individual’s marginal rates instead of the high-income individual’s marginal rates, leading to significant and cumulative tax savings.
The prescribed rate is published by the Canada Revenue Agency (CRA) on a quarterly basis. As long as an income-splitting loan carries interest equal to or greater than the prescribed rate at the time it is entered into, it is locked in for the duration of the borrowing, even if the rate increases in a future quarter.
The prescribed rate has been 2% since April 1, 2018 but with recent interest rate cuts, the prescribed rate has dropped to 1% (from July 1, 2020 to at least until July 1, 2022). This provides a rare planning opportunity not only to those who may wish to enter into new income-splitting loan arrangements, but also to those with existing loans at the 2% prescribed rate.
Entering into an income-splitting loan
If you would like more information on the income-splitting loan strategy and its benefits, please ask your Richardson Wealth Investment Advisor for a copy of our “Spousal Loans” education article.
Restructuring options for existing income-splitting loans
If you have an existing 2% loan, you may be able to restructure it so that you take advantage of the 1% prescribed rate on a go-forward basis. However, careful review of appropriate restructuring strategies must be done, in consultation with your professional tax and legal advisors and your Richardson Wealth Investment Advisor. The following is a summary of commonly-proposed options and their effectiveness.
What option works?
The borrower sells the investments acquired with the 2% loan, repays the loan, and enters into a new loan at 1%.
This option should not result in attribution rules applying to any of the investments acquired with the new 1% loan, if implemented properly.
Costs include: Capital gains may be realized by the borrower when the investments are sold to generate the cash needed to repay the original loan; transaction fees may be incurred on investment sales.
If the investments are transferred in-kind to the lender as repayment and the lender is a spouse or common law partner, the borrower should elect out of the automatic tax-deferred rollover so that the borrower is forced to recognize any accrued capital gains on the transfer. Electing out of the automatic tax-deferred rollover in this scenario should prevent issues surrounding other attribution rules.
What happens when the value of the investments acquired with the original 2% loan is lower than the balance of the loan?
A decrease in the prescribed rate often correlates with a decrease in portfolio investment values. Therefore, the borrower may want to restructure an existing 2% loan by paying it off in full and entering into a new 1% loan, but the market value of the investments acquired from the existing loan is insufficient to repay the outstanding balance. If this is the case, the following options can be considered:
- The borrower can obtain funds from other assets to make up the shortfall.
- The borrower and lender can agree to keep the shortfall outstanding (i.e., the borrower is still liable for the remaining balance of the original loan).
- The lender can forgive the shortfall.
If the lender will forgive the shortfall, complex “debt forgiveness” rules need to be analyzed in detail to determine the tax consequences of such relief to the borrower.
What options do not work?
- Revising the terms of an existing loan to reduce the required interest rate from 2% to 1%.
- Entering into a new 1% loan and using it to repay the original 2% loan, while keeping the investments acquired with the original loan intact.
Under both options, income splitting will fail because the attribution rules will apply at the time of the restructuring.
The reduction of the prescribed rate from 2% to 1% (from July 1, 2020) is a rare opportunity that should be explored if you are looking to achieve significant and cumulative income tax savings within your family through income splitting. You should consult with your professional tax and legal advisors and your Richardson Wealth Investment Advisor on whether it makes sense to utilize this strategy, or if you already have such a loan, whether you can restructure it so that the income-splitting advantages are amplified.
If you would like more information, please ask your Richardson Wealth Investment Advisor for a copy of our “Restructuring Prescribed Rate Loans” education article.