Article written by Brad Berry, CPA at
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Before deciding whether a prescribed-rate loan is right for you and your family, it’s always best to know exactly what this type of loan entails. It’s a loan at the prescribed interest rate from the higher-income spouse to the lower-income spouse, a child over the age of majority, a minor child or a family investment trust. Such a loan can be used to transfer money from a high-income spouse to a lower-income spouse. The amount transferred is then subject to a lower tax rate, reducing the family’s overall tax burden.
This plan only works when the return on invested funds exceeds the prescribed interest rate on the loan. Here’s an example to help you understand the concept:
Suppose a taxpayer has $500,000 in investment capital, earning 5%, and his income is subject to a tax rate of 48%. This taxpayer would then pay taxes of $12,000 on this income.
Now let’s assume that this same taxpayer gives his spouse, a child or a family investment trust a loan of $500,000 with interest at the current prescribed rate of 1%. The funds are invested and generate a 5% return.
In this case, the loan recipient receives investment income of 5%, or $25,000, and pays interest charges of 1%, or $5,000. His net investment income of $20,000 will be subject to his regular tax rate. If this rate is 25%, the tax payable by the spouse or child will be $5,000. In addition, the taxpayer has investment income of 1%, or $5,000, which is still subject to a tax rate of 48%, or $2,400. Total taxes payable are reduced from $12,000 to $7,400, which translates into tax savings of $4,600 per year, which is not insignificant. As investments and yields increase, these savings grow exponentially.
Prescribed rate ARC
As mentioned earlier, this only works when investment returns exceed the prescribed interest rate. The Canada Revenue Agency sets the prescribed rate each quarter. However, the loan interest rate does not have to be adjusted every time the prescribed interest rate changes. The prescribed rate applicable to the loan is the rate in effect at the time the loan is taken out.
Current interest rate
Currently, the prescribed interest rate is 1%, but this is set to rise to 2% on July 1, 2022. For loans made before July 1, 2022, the prescribed interest rate of 1% will apply as long as the loan remains in good standing.
To ensure that a prescribed-rate loan is set up correctly :
- Interest on the loan must be paid no later than 30 days after the end of the calendar year;
- The loan must be documented with repayment terms, or it must be a demand loan.
With the prescribed rate set to rise on July 1, 2022, now may be the time to get a prescribed rate loan!
Don’t hesitate to contact our professionals at Demers Beaulne. They’ll be able to tell you what you need to do, but hurry, as this manoeuvre must be completed by July 1, 2022!
