Last chance for family loans: prescribed rates to rise April 1

There are only a few months left to take advantage of low prescribed interest rates for income splitting and other loans: the rate will double April 1, experts say.

Bank of Canada interest rate hikes, which have already prompted banks to raise their lending rates, will mean CRA’s prescribed rate will go from 1% to 2% in the second quarter, says Jamie Golombek, managing director for Tax and Estate Planning at CIBC Financial Planning and Advice.

And with most economists predicting further hikes in 2018, “we could be stuck at the 2% rate for many months, if not years,” Golombek tells Advisor.ca. Or the prescribed rate could go even higher.

Read: What an interest rate rise would mean for prescribed loans

Prescribed rate loans can be used to split investment income with a spouse or common-law partner with lower income. One partner in the highest tax bracket, for example, can loan money to the partner in the lower bracket to invest, with the dividends taxed at the lower bracket.

“The advice that we’re giving now is that if you’ve always thought about doing a prescribed rate loan, you need to act by March 31 to lock in the 1% rate,” says Golombek, who wrote about the implications in detail here. Otherwise, clients are “basically doubling the cost of the interest expense that the lower-income spouse or partner is paying to the higher-income spouse or partner.”

The prescribed rate is determined quarterly by a formula in the Income Tax Regulations that calculates the average of three-month Government of Canada Treasury yields for the first month of the preceding quarter. The formula rounds up to the next highest whole percentage point.

For the second quarter, beginning April 1, the calculation is based on January. Those yields were 1.17% on Jan. 9 and 1.2% on Jan. 23, making an average of 1.185% that will be rounded up to 2%, says Golombek. (Analysis by Kyle Westhaver and John Nicola, published Friday on Advisor.ca, draws the same conclusion.)

CRA will officially announce the prescribed rate for Q2 in March, typically on the 15th. It will be the first increase since the prescribed rate dropped to 1% at the start of 2014.

Read: How to keep splitting income with family members in 2018 and beyond

In addition to spousal loans, prescribed rate loans used to help fund trusts such as family trusts may be impacted, says Curtis Davis, senior consultant for tax, retirement and estate planning services at Manulife. Family trusts can be used for expenses including children’s private school tuition, he says.

Those using home purchase loans, home relocation loans and shareholder loans may also be impacted, he says.

The rate is also used in employee loans.

“An increase in the prescribed rate could affect the personal cash flow required to service the interest and, potentially, the tax benefit” of employee loans, wrote Doug Carroll, practice lead for tax, estate and financial planning at Meridian, in November.

Read: How the prescribed interest rate interacts with employee loans

Ensure clients structure prescribed rate loans properly. Interest payments for a given year are due no later than January 30 of the following year. A missed payment means income is thereafter taxed in the lender’s hands, as if the arrangement had never been made.

The loan should go from an account in one partner’s name to an account in a different name, rather than using a joint account. “Then you have to start proving whose money is it,” Golombek says.

The lender must also declare interest income.

More changes to come?

After the federal government’s controversial reforms to small business tax rules announced last year, the industry is waiting for the 2018 budget to see if more changes are coming. Golombek says he doesn’t foresee anything that would impact the rules around spousal loans.

“I don’t think a 2% rate is below market, so I don’t think there’s anything abusive here. That being said, we know the government has been targeting income splitting through private corporations,” he says.

“I don’t think it’s particularly at risk–although, you never know.”