When the government introduced its new “Tax on Split Income” rules, many thought the days of splitting income with family members were over. But there are still ways to split income and the best time to consider one of these strategies, “prescribed rate loan planning," will be coming soon or may even be now.
Prescribed rate loan planning is a simple and effective strategy that allows high-income earners to split income with their family members who earn no, little or even less income, including spouses, children, grandchildren, more remote issue, parents and even minor nephews and nieces. The strategy involves a loan of money or assets by the high-income earning individual directly to one or more family members facing lower tax rates or, more commonly, to a trust established for the benefit of such family members. Where in-kind property is transferred, consideration must be given to the taxes that may arise on the transfer (discussed further at the end of the article.) To avoid the application of the attribution rules (which would cause all of the income earned by the loaned property to be taxed in the high-income earner’s hands), the loan must bear interest of at least the “prescribed rate,” a rate set by the government every three months and determined with reference to short-term government of Canada T-bill rates. The “prescribed rate” is set to fall to 1% (the lowest it can go) as of July 1, 2020-which may be the ideal time to implement (or top up) a prescribed rate loan.
Once the loan is made, the borrower (whether the family member(s) or a trust on behalf of such family members) can invest the funds, and any income earned in excess of the prescribed rate can be taxed in the hands of such family members. The tax-saving opportunity lies in the spread between the prescribed rate and the rate at which the invested funds earn income. In fact, once the loan is made, it can bear interest at the prescribed rate at the time of the loan forever and, as a result, as interest rates rise (and with it, the prescribed rate), so too should the spread and, accordingly, the tax savings.
The tax impact of this strategy can be best explained through an example.
A couple, both paying taxes at the top marginal tax rate, has three young children with no income, each of whom attends private school, summer camp, and participates in a number of extra-curricular activities. The annual expenses for each child in this regard total $10,000 and the parents have been funding these expenses with income they earn on their investments, the fair market value of which is assumed to be $1 million.
If the couple is earning 5% on its $1 million investments annually, they will be paying ~$26,765 of tax on their $50,000 of investment income (assuming such income is interest, dividends, etc. and not capital gains). If this income was used to pay for their children’s expenses, they would have to dip into their other income to come up with the ~$6,765 shortfall for their children’s expenses.
If prescribed rate planning is used instead, once rates go down to 1%, $10,000 (1% of $1 million) of income would be taxed in the couple’s hands, resulting in taxes in the range of $5,353, while $40,000 of income could be divided equally and taxed in the children’s hands, resulting in an aggregate of ~$500 of taxes (so long as the “kiddie tax” does not apply to any of the children while they are minors, which will depend on the nature of the investments). As a family unit, they will enjoy annual tax savings in excess of $20,000!
All of the income taxed in the children’s hands must be paid to, or applied for the benefit of, the children. Since children’s costs don’t typically start and end with private school, summer camp, and extra-curricular activities, the excess (i.e., $10,000) could be used pay for other expenses like the children’s portion of family trips, clothing and even groceries. (Strict record keeping is highly advisable in this regard.) Alternatively, the couple doesn’t have to allocate all of the income in each year to the children; a portion of the income could be allocated to the parents or even taxed in the trust (all taxed at top rates, though).
And you don’t need $1 million of investible assets to take advantage of the planning. It can be done on a smaller scale and still result in annual tax savings for the family. The planning also isn’t limited to just children. For example, grandparents who wish to pay for their grandchildren’s education, take their grandchildren on family trips, etc., can use this planning to fund these expenses using their grandchildren’s marginal tax rates instead of their own.
As a final thought, there may even be benefits to implementing the plan currently, even with prescribed rates at 2%. If you must liquidate investments to fund the loan, the taxes arising on such liquidation may be reduced in light of current stock prices. If you then, in turn, make a loan with the cash and the borrower re-invests those funds, any increase in value as stock markets recover can be taxed (when a stock is disposed of) in the hands of lower-income family members. In addition, it may be possible to re-finance the loan when/if rates reduce to 1%, if desired.
About the Author
Matthew Getzler, a 2019 Lexpert Rising Star: Leading Lawyer Under 40, is a Partner in the Tax and Wills & Estates groups at Minden Gross LLP. His practices focuses on corporate tax planning (primarily for business-owners and other private corporations), as well as personal tax and estate planning (including Wills and Powers of Attorney), with particular expertise in cross-border planning.