Prescribed loan rate to rise July 1

Clients who could benefit from making family loans for investment purposes have until June 30 to lock in a 1% prescribed interest rate.

The prescribed rate, which is calculated based on a lagging indicator, is set at 1% until the end of the second quarter. But based on Government of Canada three-month Treasury bill yields from April 26, the rate is set to rise as of July 1.

“That 1% rate, if established now, will apply for the duration of the loan,” said Wilmot George, vice-president of tax, retirement and estate planning with CI Global Asset Management in Toronto. “Therein lies the opportunity if you’re able to generate income from investments from that arrangement that exceed that prescribed rate.”

Aaron Hector, vice-president and financial consultant with Doherty & Bryant Financial Strategists in Calgary, agreed that speaking to relevant clients — usually a couple or family with a large difference in marginal tax rates — is a good idea.

“You don’t want to miss a date like that and suddenly be back into 2% [as the prescribed rate], and say ‘I wish I had presented this idea earlier,'” Hector said.

A prescribed rate loan strategy involves someone in a high tax bracket loaning money for investment purposes to a spouse, common-law partner or adult child in a lower tax bracket so the investment income is taxed at that lower rate. The loan must be executed with a minimum interest rate as dictated by income tax regulations, known as the prescribed rate.

“Since we don’t allow income splitting or the filing of joint returns, you have to look for means to lower your overall tax bill for the family unit,” said Armando Minicucci, a tax partner with Grant Thornton LLP in Toronto. Prescribed rate loans are “one of those measures that’s legitimately permitted under our tax legislation.”

Interest deductibility is a key element of a prescribed rate loan strategy, George said.

“If a prescribed rate loan strategy is set up, but the borrower does not deduct the interest cost, there is double taxation,” he explained. “The lending spouse has to report (and pay tax on) the interest income received from the borrower, and the borrower will also pay tax on that amount if they do not deduct it.”

To be able to deduct interest, the entire loan amount must be used to invest in “any investment that has the potential to earn income,” George said, such as dividends and interest. He warned that for tax purposes, capital gains are not defined as income. Further, “interest is not deductible when you’re borrowing to invest in RRSPs and TFSAs.”

“Now is the time to take action, seek professional advice, get the funding in place and get the loan documented in writing,” said Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth.

Indeed, the family must follow certain rules to ensure the prescribed rate loan works as intended.

When set up, the loan can be payable on demand or have a fixed term. Interest on the prescribed-rate loan must be paid by Jan. 30 of the following year. Otherwise, the attribution rules apply and the income earned on the loan amount will be attributed back to the lending spouse — and the loan will stop working as a tool for income splitting. (The existing loan would need to be repaid and a new loan enacted, which could be at a higher prescribed interest rate.)

Hector said the loan administration required for this strategy may not be worthwhile when the loan amount or the tax savings are relatively small.

“It can be an aggravation. You have to stay on top of it, make the interest payments, understand how to report the interest income for one spouse and the deduction for the other,” Hector said, adding that his firm automates the payments for clients who have prescribed rate loans. “With any strategy, you need to weigh the complexity with the benefit it’s going to provide.”

Hector said he’s enacted prescribed rate loans with smaller amounts (e.g., $50,000) when the client expects they’ll have more to lend in future years.

“If you’ve got a higher income earner and one parent who’s not working at all, and every year there’s an extra $50,000 to save, you might progressively work those $50,000 increments into loans,” he said, noting that at a future date he may consolidate the loans for ease of management. “But if all you had was an extra $50,000 and [both spouses are] retired,” he said the strategy would make less sense.

Hector also advised considering the difference between the loan’s interest rate and the expected return from the investment. That difference “shouldn’t skew what you’re choosing to invest in,” he warned, but may influence who holds the asset. For example, the investments with higher expected income could be held by the spouse receiving the loan.

Locking in a loan at a low rate becomes more valuable as the prescribed rate increases, said Carol Bezaire, senior vice-president of tax, estate and strategic philanthropy with Mackenzie Investments in Toronto.

“If you look at the income-splitting opportunity and the tax savings, the longer the loan is in place with a high income earner and a low income earner, the compounding of the after-tax return [becomes] greater,” she said. “If you’re investing what you would have paid in tax, you can greatly increase the wealth over time.”

GIC opportunity?

The prescribed rate is 1% until June 30, but one-year rates for guaranteed investments such as GICs are well above 1%. According to RateHub.ca, eight banks are offering one-year GIC rates of 2.50% and above, going as high as 3.10%.

These rates will probably increase if the Bank of Canada hikes the policy rate again on June 1, as governor Tiff Macklem suggested may happen.

Until the prescribed loan rate catches up on July 1, clients with a spouse or child in a much lower tax bracket can “arbitrage” the spread between the loan rate and the GIC rate, said Minicucci.

The lower-income family member could invest in vehicles other than GICs and earn higher returns, but those returns would not be guaranteed. Regardless, Hector said advisors should consider whether GICs (or any investment) are suitable for their client before enacting this strategy.

Potential tax savings

George gave the example of a married couple, Bill and Claire. Bill is taxed at 25% while Claire is taxed at 54%. Claire lends $150,000 to Bill at 1% interest.

If Bill can invest the proceeds in a non-registered account and earn 5% in interest income, he will earn $7,500 and pay $1,500 in interest to Claire, for net income of $6,000. Claire must receive the $1,500 in interest income by Jan. 30 of each year and will be taxed on that amount. Bill will deduct the interest paid on his return because he was borrowing to invest.

Without the prescribed rate loan strategy, Claire investing the $150,000 at 5% would have paid $4,050 in taxes ($7,500 at 54%).

With the strategy, Bill pays tax at 25% on $6,000 (since he can deduct the $1,500 in interest paid), which equals $1,500. The $1,500 interest is taxed in Claire’s hands at 54%, which equals $810. In total, the couple pays $2,310 in tax.

That’s a tax savings of $1,740.

However, if the expected return is lower than 5%, or the amount invested is lower than $150,000, the savings diminish. For example, a 3% expected return, all other things being equal, results in only $870 in tax savings.

Why is the prescribed rate rising?

According to section 4301 of the Income Tax Regulations, the prescribed rate is based on the average yield of Government of Canada three-month Treasury bills auctioned in the first month of the preceding quarter, rounded up to the next whole percentage.

In April, the auction yields for three-month T-bills were 1.02% on April 12 and 1.38% on April 26, which averages out to 1.20%. Since the next highest whole percentage is 2.0%, the third-quarter prescribed rate should also be 2%.

The prescribed loan rate has been 1% since July 1, 2020.

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.

Rudy Mezzetta

Rudy is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on tax, estate planning, industry news and more since 2005. Reach him at rudy@newcom.ca.