Earlier this month, the federal government announced their projected deficit for the year is expected to surpass $343 billion, driven by the fast and aggressive spending by governments in response to the havoc COVID-19 has wreaked on Canadians and the economy at large. There is no doubt in my mind that this enormous level of spending was needed to avoid a complete disaster. There is also no doubt in my mind that the Canada Revenue Agency (CRA) will be looking for ways to recoup the money spent over the next several years.
In Canada we have a progressive tax system, meaning the higher your income the higher your rate of income tax. Here in Manitoba the highest marginal tax bracket for individuals is 50.4%. For incorporated business owners, depending on how the cash gets into your hands, you could be looking at rates even higher when all is said and done. Even if we don’t see tax rates rise in the near term, these rates are already high and I know from experience, the majority of incorporated business owners and professionals will be looking for ways to help reduce the financial burden on themselves and their families. Income splitting is one of the ways in which they can do this.
Income splitting is a strategy that allows family members in high tax brackets to shift taxable income towards family members in lower tax brackets, resulting in less taxes being paid as a family. One income splitting strategy is when a high-income earner lends funds for investment purposes to a lower income earner in the family. In many cases it can make a lot of sense to gift funds or investments to a family member who is in a lower tax bracket as it effectively lowers the family's overall tax bill, leaving families with more in their pockets as a whole.
Although it sounds simple, families looking to utilize this strategy need to be aware of “attribution rules” and some other anti-avoidance rules which can prevent certain income splitting strategies from working the way they are intended to. The attribution rules state that when a high-income family member makes an investment loan to a low-income family member or family trust, that any income earned on that investment loan will be taxed to the high-income member who lent the funds.
There is an exception to the attribution rule, and this is when a family member makes an investment loan with a prescribed interest rate known as a “prescribed rate loan”. In these cases, the attribution rule is avoided and income earned on interest from the loaned funds will be taxed in the hands of the lender in high tax bracket, while any income earned on the investments borrowed are taxed in the hands of the borrower who is in a lower tax bracket.
What makes this strategy even more enticing today, is the fact that the CRA recently announced that the prescribed rate for the third quarter of 2020 (July – Sept), has dropped from 2% down to 1%. It’s an exceptional opportunity for Canadians to utilize this strategy for income splitting purposes, lowering the family’s overall tax bill. If the loan is put into place between July 1, 2020, and September 30th, 2020, families can take advantage of this extremely low 1% interest rate for the entire duration of the loan without worrying about any future rate increases.
Example: Michelle (high-income earner) lends $100,000 to her husband David (low-income earner) at a prescribed interest rate of 1% payable annually. David invests the funds he’s borrowed from Michelle and the investment earns David 5% in income, or $5000. Before January 1st of the following year, David will make an interest payment of $1000 to Michelle.
In this particular example, Michelle receives $1000 of interest income, and David will have $5000 of investment income with a $1000 deduction from the interest he paid to Michelle. For the year, Michelle was able to shift $4000 of taxable income to David the lower-income spouse effectively lowering the family's overall tax bill leaving them with 39.68% more in their hands than if they had not split income.
*Michelle is in the highest tax bracket and David is in the lowest
**Investment earnings in this example were taxed as income
There are a couple of items to note before readers go running out to loan lower-income family members funds for investment:
The borrower must pay the interest to the lender each year before the deadline
The deadline is January 30th of the following year in which interest accrued
If interest payments are not made by the due date, attribution rules will apply
Formal requirements will need to be met when establishing the loan, and the loan must remain legally enforced (A tax lawyer should draft a loan agreement and promissory note)
Lender and borrower should both be Canadian residents
In closing, income splitting using a prescribed rate loan requires careful planning. An accountant should ALWAYS be utilized in the process to ensure all conditions are met to avoid attribution rules. Considering CRA’s prescribed rate is sitting at a low 1%, there’s been no better time to evaluate whether this strategy might work for your family.
- Brandt Butt, Investment Advisor, CIM®
Brandt Butt is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Brandt Butt who is an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.