Low Rates, Big Take

With record-breaking low interest rates, borrowing to invest can be particularly effective right now. And in this low-interest environment, certain planning opportunities that relate to family income splitting, and certain employee loans become particularly attractive.

Generally, income arising from an investment that’s funded by a loan made to a spouse, partner, minor children and/or grandchildren, or to a trust for their benefit, is attributed to the lender and taxable in his or her hands. However, loans made at the CRA-prescribed interest rate will generally not be subject to various attribution rules.

The prescribed rate is determined quarterly based on the Government of Canada borrowing rate and applies for the subsequent three months. Right now, this rate is at an all-time low: For the period April 1, 2009 to June 31, 2009 the prescribed rate applicable to family loans and employer loans is a modest 1% per annum.

This means your client can loan funds to a lower-income spouse or partner or a trust for the benefit of minor children with an interest rate of 1%, and where those funds are reinvested to earn an annual return in excess of 1%, that excess will be taxable to the spouse/partner, trust or child, as the case may be, instead of your client. The interest rate will remain at 1% for as long as the loan is outstanding.

For this plan to work, though, it’s necessary for the annual interest charged on the loan to be paid within 30 days of the end of each calendar year. Otherwise attribution will apply and income earned on the investment of the loan proceeds will be taxable to the lender.

The loan can be either shortor long-term, and should have enough flexibility so that any portion is payable 30 days after demand. The borrower should also have the right to repay it at any time without notice or bonus. Ideally, the spouse or other transferee should have separate bank or broker accounts for the loan proceeds and related investments to preserve the identity of the source of funds and resulting income.

Keep in mind, if a client sells securities to provide funds for the loan, and his or her spouse or partner purchases the same security within 30 days, any capital loss realized on the sale will be denied under the superficial loss rules and added back to the cost base of securities now owned by the spouse.

Clients who have existing prescribed- rate loans and wish to take advantage of the 1% rate should be warned they cannot simply change the rate on an existing prescribedrate loan or repay the loan with a new loan at the current prescribed rate. These manoeuvres will result in the application of the attribution rules. So any new prescribedrate loan must be separate and distinct from any existing loan. The simplest thing to do is to advance new funds in exchange for a new 1% loan to average down on the overall interest.

Home Advantage If any of your clients work for employers who provide home purchase loans, make sure they know the related taxable benefit is computed using the lesser of the CRA prescribed interest rate(s) for the period in question— and the prescribed rate in effect at the time the loan was received— less any interest paid by the employee.

The date the loan was received is redetermined every five years. As a result, an employee is guaranteed his or her taxable benefit will not increase (over the five years) if the prescribed rates increase. However, he or she will benefit if the prescribed rates decrease.

That means the second quarter of 2009 is an opportune time for employees to negotiate or renegotiate home purchase loans, because the taxable benefit in relation to these loans will be limited to 1% for up to five years.

Gena Katz, FCA, CFP, an executive director with Ernst & Young’s National Tax Practice in Toronto. Her column appears monthly in Advisor’s Edge.