Prescribed rate loan strategy for family trusts
Rock-bottom rate can yield big tax benefits
Income tax matters and Canada Revenue Agency publications are often viewed as dull until they directly apply to our own situation. This is likely true for most people in respect of the prescribed interest rate. However, the prescribed interest rate can be of benefit to you, especially since it has dropped back down to the rate of 1% as of July 1, 2020, reduced from the rate of 2%, which had applied since April 1, 2018.
The prescribed rate of interest is a rate set by the Government of Canada every quarter and published by Canada Revenue Agency (you can find it here). A loan at the prescribed rate can be used between non-arms’ length parties, such as spouses, parents and minor children, and someone who contributes property to a trust and the trust itself, to income split and avoid certain “attribution” rules under the Income Tax Act (ITA).
The attribution rules under the ITA limit or prevent income splitting in a variety of circumstances, including where property is gifted or lent at less than the prescribed rate by one spouse to the other spouse, by a parent to a child under the age of 18, by a spouse to a trust for the other spouse’s benefit, or by a parent to a trust for the benefit of a child under the age of 18. Where such gifts or loans are made, any income or capital gains arising from the property that is gifted or lent will be attributed back to the spouse or parent, preventing the income splitting. There are a number of other circumstances where “non-arms’ length parties” will be subject to the attribution rules; for more information about these and other estate and trust tax matters, please see our advisory “Estate and Trust Taxation: Important Considerations.”
A prescribed interest rate loan allows for income splitting among family members in lower tax brackets. Prescribed rate loans are commonly used for inter vivos family trust planning, where a family member, typically the high income earner, makes a loan to the trust. While the lent funds need to produce income at a rate higher than the prescribed interest rate for this planning to achieve overall family tax savings, typically this is achievable when the prescribed rate is only 1%. In this regard, it is important to remember that once a loan is made, the prescribed rate applicable at the outset of the loan applies for the entire life of the loan, regardless of whether the set rate increases or decreases later.
Funding a trust with minor children or grandchildren beneficiaries, who usually have a significantly lower marginal income tax rate than the person lending the funds, by means of a loan to the trust may be advantageous. The trust income can be flowed out to these minor beneficiaries, and used for such expenses as school tuition, education expenses, and camp fees. Each minor beneficiary will be taxed on the income used for their benefit at their lower marginal tax rate, effectively allowing many expenses to be paid using before-tax dollars instead of after-tax dollars. For more information on this and other types of trust planning, please see our advisory “Using a Trust in Your Estate Plan.”
Loans to a spouse or a trust for a spouse’s benefit at the prescribed interest rate can be used to split income with a lower-earning spouse (married or common law), allowing for tax savings based on the difference in marginal tax rates between the spouses. This is a very attractive option to anyone with investment funds earning more than 1% whose spouse is in a lower income tax bracket than themselves.
Anyone in a high tax bracket whose spouse is in a lower tax bracket or who has children or grandchildren with school and extracurricular expenses and who would like to reduce their overall family income tax burden could benefit from this type of trust and loan planning.
If you are interested, you should consult a professional advisor, as trusts should be carefully drafted and prescribed rate loans must be properly documented in writing in order to achieve the intended tax benefits. In addition, interest on the loan at the prescribed rate of interest must be paid for each year the loan is outstanding by January 30 of the following year, and payment of the interest should be documented.
As we have discussed before in our blog (see for example our blog about your estate plan check up here), it pays to stay informed regarding developments that can affect your personal and family estate planning, and to update your plan regularly to ensure you are achieving optimal results, no matter how challenging the times.
Susannah Roth is a partner at O’Sullivan Estate Lawyers, based in Toronto. Her practice focuses on estate administration, including cross-border and multijurisdictional administration, advising attorneys and guardians of property, executors, administrators and beneficiaries, real estate transfers and rectification, estate planning (including wills, powers of attorney, insurance and testamentary trusts), and estate litigation. This article originally appeared in the O’Sullivan Estate Lawyers blog. Reprinted with permission.
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The foregoing is for general information purposes only and is the opinion of the writer. It is not intended to provide specific personalized advice on any individual situation, including, without limitation, investment, financial, legal, accounting or tax advice. Before taking any action involving your individual situation, you should seek legal advice to ensure it is appropriate to your particular circumstances.