Family Income Splitting

Income splitting between family members typically involves shifting taxable income from a high-income earner to a lower-income earner to have the income taxed at a lower rate under the lower-income earner. The objective is to reduce the overall family’s tax liability.

While income splitting is appealing, Canada has “attribution rules” designed to limit an individual’s ability to income split with close relatives. Under the attribution rules, where an individual transfers or loans income-producing property to close relatives, either directly or indirectly, or to utilize a trust, the income from the property may be attributed back to the transferor. Without these rules, a taxpayer could derive a tax benefit by gifting or loaning the income-earning investment property to a lower-income spouse/ common-law partner, or minor children, grandchildren, nieces, or nephews.

A Prescribed Rate Loan (also referred to as PRL) arrangement enables income splitting outside the attribution rules. This arrangement involves transferring funds, using a formal loan agreement, to lower-income family members for investment purposes.

To prevent the attribution rules from applying, the following criteria should be met:

• An executed written loan agreement.

• At the time of the loan, the rate of interest charged is at least equal to the federal prescribed rate of interest. This rate can be obtained from CRA’s website, and it is updated every quarter.

• The loan interest for the current calendar year must be paid on or before January 30th of the following year.

Both the lender and borrower must be Canadian residents. Suppose the funds are used for investment purposes in a non-registered account. In that case, the lower-income family member may be able to deduct the interest paid on the loan against any investment income earned.

When considering a Prescribed Rate Loan arrangement, individuals should consider the following:

• the tax rates of the borrower and lender.

• the rate of interest tied to the loan agreement; and

• the anticipated rate of return generated from the borrowed funds.

Prescribed Rate Loan Example

Tom (higher bracket – high-income earner) lends $100,000 to his spouse Samantha (lower bracket – low-income earner) when the prescribed rate is 3%. Assume that Tom is in a 50% marginal tax bracket and Samantha is in a 25% marginal tax bracket. If Tom had kept and invested $100,000 for himself and earned a return of 6%, the total $6,000 of income would have been taxed in his hands, resulting in an after-tax income of $3,000 which is significantly lower than the $3,750 generated where a Prescribed Rate Loan is implemented. See the example in the below chart:

This would make sense if the borrower (i.e., Samantha) remained in a lower tax bracket than the lender (i.e., Tom), and the invested funds would need to generate a return that is greater than the interest on the loan and any other related (administrative/legal) costs.

Summary of Key Points

• The Canada Revenue Agency announces the prescribed interest rate every quarter. The prescribed interest rate is locked in; for example, if the prescribed interest rate when the Prescribed Rate Loan arrangement is entered into is 3%, this rate is locked in for as long as the loan exists.

• Regardless of any subsequent increases to the prescribed interest rate.

• There is no limit on the Prescribed Rate Loan amount or the length of time the Prescribed Rate Loan remains in place.

Before the implementation of a Prescribed Rate Loan arrangement, consider seeking the advice of a tax and legal advisor to ensure that it is correctly done and in line with the allowed framework.

Contact us for a consultation.

The content of this article is intended to provide general guidance on the subject matter. Professional advice must be sought about your specific circumstances.

By: Kamal Gawri, CPA, CA