Prescribed rate set to rise to 3% in Q4

Clients who could benefit from making family loans for investment purposes have until September 30 to lock in a 2% prescribed interest rate.

Based on Government of Canada three-month Treasury bill yields from July 19, that rate will rise to 3% as of Oct. 1.

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, thus achieving income splitting and tax savings. The loan must be executed with a minimum interest rate as dictated by income tax regulations, known as the prescribed rate.

As long as annual interest on the loan is paid by Jan. 30 of the following year, the rate remains the same for the life of the loan and the income earned on the loan amount will not be attributed back to the lending spouse for tax purposes.

“If you think a prescribed rate loan makes sense for your family, you’ll want to establish [it] as soon as you can,” said Wilmot George, vice-president of tax, retirement and estate planning with CI Global Asset Management in Toronto. “If interest rates continue to climb, and prescribed rates continue to climb, that’s fine from your perspective, because you’ve already established your loan at a lesser rate.”

The prescribed rate was 1%, the lowest possible, from July 1, 2020 to June 30, 2022. Over that two-year period, many advisors helped clients set up prescribed-rate loans, said Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth.

At a higher prescribed rate, the opportunity to achieve effective tax savings via a family loan narrows. But the strategy can still work as long as the loan amount is high enough and the rate of return on the investment exceeds the prescribed rate.

“It’s still worth talking about with clients,” Golombek said, “assuming you can get a rate [of return] significantly higher than 2%.” With the prescribed rate rising to 3%, however, the strategy will probably only benefit clients “with tens of millions of capital.”

“For [a] person doing these loans at $1 million or $2 million, it becomes not as advantageous; the dollar savings are not going to be as high,” Golombek said.

Other key factors in determining whether to set up a prescribed-rate loan are the difference in family members’ marginal tax rates and the type of investment income earned on the invested amount.

While the lower-income spouse can deduct the interest paid on the borrowed amount, the higher-income spouse must report the interest earned on the loan as fully taxable income, Golombek pointed out. If the investment income earned is in the form of tax-preferred dividends, for example, “you’d be getting dividend income and converting some of that, effectively, into interest income through the loan,” Golombek said. “There’s a bit of a tradeoff there.”

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.

The auction yields for three-month T-bills were 2.20% on July 5 and 2.70% on July 19, which averages out to 2.45%. Since the next highest whole percentage is 3.0%, the fourth-quarter prescribed rate should also be 3%.

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.