Split decisions

In Canada, tax returns are filed on an individual‑by‑individual basis, including for married or ‘common‑law couples’. This unconsolidated filing regime, combined with a progressive tax system whereby individuals in low‑income brackets are subject to lower marginal tax rates than higher‑income individuals, creates an incentive to ‘split’ income between family members.

Rules

In order to police income splitting, the Canadian tax system primarily relies on the following:

• Income attribution rules: income and capital gains generated from properties that were transferred from an individual to a family member are usually attributed back to the transferor.
• Tax on split income (TOSI) rules: dividends, interest and capital gains derived from private companies and, in some situations, trusts and partnerships, are automatically subject to the top marginal tax rate, irrespective of the income level of the recipient, in most situations where the recipient did not contribute to the underlying activities that generated such amounts.

These rules significantly narrow a family’s ability to split income with family members outside of a few sanctioned approaches. One of these has recently surged in popularity due to macroeconomic conditions: so‑called ‘prescribed rate’ loans. When the Canadian tax rules were first drafted, it was decided that if an individual transfers cash or other properties to a non‑arm’s length person (i.e., spouse, common‑law partner or children) under a loan arrangement that charges at least the ‘prescribed’ rate of interest, the attribution rules should not apply. The concept being that the individual reports and pays tax on this interest income, which represents an acceptable return on the loaned amounts, so any excess return earned by the borrower should not be attributed back to the lender.

The prescribed rate

The ‘prescribed rate’ is an interest rate set by the Canadian Income Tax Regulations and is based on the yield of the Canadian government treasury bills. Due to the current low‑rate environment, the prescribed rate of interest has, since 1 July 2020, returned to its historical low of 1 per cent. To properly qualify for the prescribed rate loan exception, the loan arrangement must:

• charge interest at a rate equal to or greater than the prescribed rate in effect at the time the loan was made (which, at the time of writing, is still 1 per cent); and
• be paid no later than 30 days after the end of each taxation year.

Even if the prescribed rate increases in the future, the current 1 per cent rate can be used for the entire period the loan is outstanding. This makes the prescribed rate loan a very attractive option in the current landscape.

This strategy is particularly powerful when combined with the use of a family trust.

Example

B is in the top‑income bracket and has USD2 million cash to be invested. Her husband and minor children are in low‑income brackets. B may choose to make prescribed rate loans directly to her husband and her minor children, but she does not want to give her children a large sum of cash. Therefore, the family establishes a family trust with the beneficiaries being her husband and children, and B transfers the USD2 million cash to the trust, taking back a promissory note bearing interest at the current prescribed rate of 1 per cent. B retains control of the cash as trustee of the trust.

Going forward, the trust invests in publicly listed securities and the 1 per cent interest on the loan is paid to B before 30 January of each year. Each year, the trust distributes its investment earnings and taxable capital gains to the beneficiaries, with the minors receiving their income distributions in the form of cash distribution, payments to a third party for their expenses or promissory notes that are enforceable on demand. It should be noted that the TOSI rules should not apply to the beneficiaries because the investment income and capital gains all derived from publicly listed securities. As a result of this strategy, the family successfully utilised the lower marginal tax rates of the low‑income family members, with B retaining control over the trust property.

Conclusion

The prescribed rate loan can be a powerful tool for families that have wealth held personally and with family members in low‑income brackets. However, other factors must also be considered, such as how these arrangements fit into overall estate planning and family dynamics, whether the income distribution will adversely impact the recipients and so on. Further, if the family contains members subject to US tax, significant complications may arise from such strategies.