How an interest rate rise affects prescribed loans

With the increases in the bank rate this summer, you’d be wondering what will happen to prescribed interest rates. If those rates rise, what will that mean for spousal loans and employee loans?

Fortunately, prescribed rates won’t rise this year, as I’ll demonstrate in the calculations below. Still, a bump up is inevitable, and it’s an issue worth watching so you are prepared.

How the prescribed rate is calculated

While the bank rate is set by policy decisions from the Bank of Canada, prescribed interest rates are set by formula. The procedure for a given calendar quarter is set out in Income Tax Regulation 4301(c). In brief, it is the average yield of Government of Canada three-month T-Bills auctioned in the first month of the preceding quarter, rounded up to the next whole percentage.

The prescribed rate has been at 1% since April 2009, other than in Q4 2013 when it rose to 2% (the reference figure had bubbled over to 1.02% that July).

Maintaining a spousal loan through a rise

First, let’s illustrate the loan operation generally. Assume Bill is at the top marginal bracket (50% for illustration purposes), and spouse Pat is at a 25% marginal rate, which is between $20,000 and $30,000 annual income on average. If Bill earns 3% interest on $100,000, his initial $3,000 becomes $1,500 after tax.

Instead, Bill could make a spousal loan to Pat and charge the current 1% loan rate. Pat will earn the same $3,000, but will then owe and pay $1,000 to Bill. Pat is taxed on the net $2,000 amount, leaving her $1,500. Bill pays tax on the loan interest, leaving him $500. Between the two of them, they have $2,000, which is $500 better than without the loan.

If the prescribed rate rises, it will have no effect in this spousal situation. We assume that, throughout the loan’s existence, the required interest has been paid during the year or within 30 days of year-end. Otherwise, the interest income will be attributed back to Bill. To avoid that, spouses must be conscientious about recordkeeping and paying the interest.

If Bill and Pat don’t already have a loan in place but would like to do so, it would be smart to enact one before rates rise.

Effect of a rate increase on employee loans

The prescribed rate also interacts with employee loans, but in a different way.

An employee who obtains a loan at preferential terms available because of their employment relationship may have a taxable benefit if the loan rate is lower than the prescribed rate. If a $10,000 loan was charged 1% while the prescribed rate was 4% over a given year, there would be a taxable benefit of $300 (3% of $10,000, the difference between the two rates).

In current times, such arrangements may simply be set up at the 1% prescribed rate. But if the prescribed rate rises to 2% while the employee loan remains at 1%, there will be a taxable benefit of 1% of the principal. Alternatively, if the loan rate rises to 2% in line with the prescribed rate, the employee’s out-of-pocket interest cost rises. The cost to the employee is the same either way.

Employees should be reminded that a rise in the prescribed rate will automatically increase the cost of employee loans, and work this in as a contingency in their cash budgeting.

Doug Carroll is practice lead, tax, estate and financial planning, Meridian.