Tax Managed Strategy 6
People often consider tax saving strategies on an individual basis but overlook family strategies that can save significant tax dollars. The use of intra-family loans to split income and save taxes is a good example.
Income splitting involves the transfer of income from a high-income earner to a family member in a lower tax bracket. The lower-income individual is taxed at a lower marginal tax rate and the family pays less tax overall. The problem is that the Canada Revenue Agency (CRA) restricts most forms of income splitting through the Income Tax Act’s attribution rules. An individual can’t simply give their spouse $100,000 to invest and have the spouse declare the investment income in their tax return at their lower marginal tax rate. In such a situation, the investment income would be attributed back to the original individual and taxed at their higher marginal rate.
There are, however, a few legitimate and effective ways to split taxable income with a spouse or other family members. One of the most effective strategies in a low interest rate environment is through a loan directly to family members or, where minors are involved, to a family trust. Provided the loan is properly structured, the recipient can invest the proceeds from the loan with the income taxed at a lower marginal rate. Of course, one of the keys to a successful income-splitting strategy is to make sure that investment returns are higher than the interest rate charged on the loan.
If either the lender or borrower is a U.S. person (either a U.S. citizen, U.S. resident, or U.S. green card holder), this strategy can have adverse U.S. tax consequences. Speak to your tax advisor before undertaking this strategy
An in-depth look at the issue and the opportunities
Intra-family investment loans most commonly involve a loan between spouses, either married or common-law. But this strategy can also be effective for funding minor children’s expenses, such as paying for private school and extracurricular activities, by making a prescribed rate loan to a family trust with the minor children as beneficiaries.
To make sure the income attribution rules don’t apply to investment income earned by the loan proceeds, two loan conditions must be met:
- The loan must carry interest at a rate that’s at least equal to the prescribed rate (updated quarterly) as set by the CRA at the time the loan is made. If the commercial loan rate is lower than the prescribed rate at the time the loan is made, this lower commercial rate can be used. You can find the current prescribed rate on CRA's Prescribed interest rates web page.
- The annual interest owing on the loan must be paid to the lender no later than 30 days after the end of each year. Failure to do so will result in the attribution of the investment income from the associated investments in all future years.
Take advantage of today’s interest rate
If you loan your spouse money for the purpose of income splitting, the prescribed rate (the rate of interest you charge your spouse) remains fixed for the term of the loan. Taking advantage of today’s interest rate and locking in the current prescribed rate of 5% for the life of the loan can be attractive, especially if rates increase in the future.
Already have a prescribed rate loan?
You can still take advantage of today’s interest rate. If you and your spouse implemented this strategy in the past when the prescribed rate was higher, there’s a way to take advantage of the current lower rate to increase your tax savings opportunities. First, your spouse will need to repay the existing loan—it’s not enough to just re-sign the loan agreement. To repay the existing loan, investments may have to be sold, which may result in capital gains. However, any gains would be taxed to your spouse and, therefore, the tax would be less than if you held the investment yourself. You can then arrange a new loan at the current lower rate and new investments can be purchased.
If you implemented this strategy when the prescribed rate was lower and you want to increase your investments using this strategy, you can simply do so with a new prescribed loan. Your existing loan would remain in place at the lower rate. As a result, there‘s no need to sell the existing investments, so there is no immediate tax liability related to realizing capital gains. However, your new loan interest rate will be higher, and consequently, so will the interest cost as well as the tax liability for the lender.
Making it work—an example
Spouses John and Jill are looking for ways to lower their family tax bill. They’re in different tax brackets—John at 48% and Jill at 20%. John loans Jill $400,000 at a prescribed rate of 5%.¹ Jill invests the money and earns 6%, or $24,000. She then pays John the $20,000 loan interest and deducts the same amount as loan interest expense. Jill pays $800 in tax on the remaining $4,000, and John pays $9,600 on his interest income. Here’s how it stacks up: John would have had to pay $11,520 in taxes had he invested the $400,000 himself. By loaning the money to Jill for the purpose of income splitting, the family tax bill is reduced by approximately 10% to $10,400, representing savings of $1,120.
By income splitting using a loan, John and Jill save $1,120 in year one, compared to John investing the $400,000 and paying the tax on the income. However, the savings don't stop there. Based on their current situation, over 5, 10, and 20 years, their tax savings from this strategy would be $9,881, $32,575, and $135,199, respectively. Such tax savings can make this strategy a worthwhile option for lowering the family tax bill.
Income splitting through loans is best suited for those:
- with a pool of non-registered capital they’re willing to invest
- who have a spouse or other family members in a lower marginal tax bracket.
To take advantage of income splitting:
- Select an investment with expected returns that are higher than the current prescribed interest rate.
- Consider formalizing the intra-family loan through a demand promissory note. Also, make sure that the interest rate used is at least equal to the CRA prescribed rate at the time the loan is arranged and that, each year, the annual interest owing is paid by January 30 of the following year.
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1 This is a fictional scenario for illustration purposes only. Effective July 1, 2023, the CRA prescribed rate is 5%.
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