Income splitting: Assets, prescribed rates and personal loans

The Canada Revenue Agency (CRA) recently announced that the prescribed rate, the rate at which your clients can lend cash or other assets to family members in order to sidestep attribution rules, is 1% for the second quarter of 2009, effective April 1, 2009.

The prescribed rate is set each quarter and is based on the average rate of 90-day treasury bills during the first month of the preceding quarter. The fact that interest rates have been steadily decreasing has caused the CRA prescribed rate to hit this unprecedented low rate for the second quarter of 2009. There is no telling how long the prescribed rate will remain at 1%. Hence, the time is right to consider setting up fair market value loans for clients, especially between spouses and common-law partners in disparate tax brackets, to obtain income-splitting benefits.

In its simplest form, income splitting legally shifts income from the hands of an individual who pays tax at a high rate into the hands of another individual who pays tax at a low rate.

Case study

Consider Grant and Shelley. Grant earns approximately $150,000 per year, paying taxes at his marginal rate of 46%. His wife, Shelley, earns $25,000, with a marginal tax rate of 20%. Grant has a $100,000, non-registered portfolio that generates $5,000 of taxable investment income, which results in an annual tax bill of $2,300.

It would be nice if Grant could simply give the portfolio to Shelley so that she could report the investment income and pay tax at the 20% rate, saving the family $1,300. Unfortunately, this is not possible, thanks to attribution rules that make income splitting a complex and intricate task.

Attribution rules state that all income or gains earned on assets that are transferred to some family members will be attributed back to and taxed in the hands of the transferor. In the above example, without careful planning, Grant will be caught by the attribution rules, and all investment income, including realized capital gains, will be taxed back to Grant.

Grant’s strategy

Grant may wish to consider lending cash or investment assets to Shelley, rather than simply transferring the assets. This, however, is not enough to sidestep the attribution rules. Grant must also charge interest on the loan at rates that are the least of either

• the current market interest rate (i.e., the rate you would receive from a bank) or • the prescribed rate of interest at the time the loan is made.

Of the two rates, the prescribed rate is commonly used since it is usually the lower of the two. Therefore, Grant (with your assistance) could lend Shelley his $100,000 non-registered portfolio at any time prior to June 30, 2009, and charge 1% interest on the loan. Any difference between the rate of return earned on the invested assets and the loan rate of 1% can be safely taxed in Shelley’s hands and not attributed back to Grant. It is important to note that to avoid attribution Shelley must actually pay the interest to Grant by January 30 of each year the loan remains outstanding.

Let’s say the loan to Shelley is properly established on May 1, 2009. At the prescribed rate of 1% a year, Shelley will pay $667 ($100,000 x 1% x 8 months from May to December 2009 inclusive) in interest to Grant. Since the interest is paid to earn investment income, Shelley will be entitled to an interest deduction equal to $667. If the portfolio generates $5,000 each year, Shelley’s taxable income, less her deduction, leaves her with a tax bill of $866.

Scenario: Grant “loans” Shelley $100,000 investment portfolio @ 1% (CRA prescribed rate) on May 1, 2009. Interest costs for Shelley: $100,000 @ 1% x 8 months (May to December 2009, inclusive) = $667.00* Portfolio income: $5,000 – $667.00 loan interest* = $4,333 Shelley’s tax bill: $4,300 @ 20% (Shelley’s marginal income tax rate) = $866.00 Family savings Grant receives $677 interest income from Shelley. Grant’s bill: $677 @ 46% = $307.00 (taxes owing) Total family bill on the portfolio’s earnings: $866 (Shelley) + $307 (Grant) = $1,173.00 (By comparison – portfolio income taxed in Grant’s hands: $100,000 @ 46% = $2,300) Total savings: $1,127.00 ($2,300 – $1,173) *Since the loan is for investment purposes, this amount is deductible.

Shelley’s interest payment to Grant is still taxable in Grant’s hands — the $667 of interest income will generate a tax liability of $307 ($667 x 46%). Grant and Shelley’s combined family tax bill will be $1,173 ($866 + $307). In the end, this strategy saves Grant and Shelley approximately $1,127 annually, which is better than Grant paying tax on all investment income at his 46% marginal tax rate.

Important loan strategy tips

• The loan should be documented with a promissory note. The note typically includes the date of the loan, the loan amount, interest rate charged and the terms of repayment. Ensure that Shelley signs the promissory note to make it bona fide.

• It is simplest to lend cash or cash-like assets to Shelley. Including fluctuating assets — stocks or equity mutual fund holdings — can trigger capital gains on transfer, creating undesired tax consequences. At the same time, capital losses will be denied if they arise on an in-kind transfer to Shelley. Careful planning with an advisor is important.

• Think long term. This loan strategy not only provides tax savings on an annual basis but also includes annual compounding benefits. That is, annual tax savings, reinvested, can help create a larger nest egg for the future. The best part is, regardless of what happens to prescribed rates in the future (they will likely increase at some point), Grant and Shelley have locked in the 1% prescribed interest rate for the duration of the loan agreement — the strategy continues to make sense for as long as Grant and Shelley have disparate tax brackets.

• Ensuring that the rate of return on investment exceeds the prescribed loan rate is what makes this strategy work. The greater this difference, the greater the tax savings.

Conclusion

There is no doubt that you have clients in a similar situation to Grant and Shelley’s. The historically low prescribed rate in effect at the moment is an opportunity to help many of your clients benefit by splitting their investment assets, using rates we may not see again for a very long time, if ever.