A low prescribed rate can provide plenty of tax-saving opportunities for you and your family. With the Canada Revenue Agency (CRA)’s prescribed rate currently at a historical low of 1% per annum and the expected increase of the prescribed rate to 2% starting July 1, 2022, now is an excellent time to take advantage of the prescribed rate loan family trust strategy. This article will discuss the characteristics of prescribed rate loan family trusts and how they can be used to achieve significant tax savings.
What is a Prescribed Rate Loan Family Trust?
A prescribed rate loan family trust is a structure that can be used to implement an income-splitting strategy to help reduce your family’s combined tax liability. If structured properly, this strategy will allow a high-income parent to split income with their low-income family members through a prescribed rate loan lent to a family trust. The beneficiaries of the family trust could include your spouse, children, and grandchildren. The investment income earned in the family trust from the prescribed rate loan can be shared among the lower-income family members to achieve overall tax savings for the family. The income allocated to children can be used to pay for private school tuition, camp fees and other expenses.
The Income Tax Act contains certain income “attribution” rules to prevent family income splitting in various scenarios. If applicable, these rules will attribute taxable income back to the family member that provided cash for the investment, eliminating the benefits of income splitting. The attribution rules can generally be avoided if the funds advanced to the family member or a family trust are through a loan with an interest rate not less than the prescribed rate set by the CRA.
How Prescribed Rate Loan Family Trusts Work
A prescribed rate loan is established when funds are advanced by a family member (the lender) to a family trust (the borrower) using a formal written loan agreement at an interest rate that is at least equal to the CRA’s prescribed rate in effect at the time the loan is established. The CRA sets the prescribed interest rate every quarter and the current prescribed rate for Q2 of 2022 is 1%. Once the loan is established, the prescribed rate is maintained for the life of the loan regardless of any subsequent increases to the prescribed rate. The family trust must pay interest to the lender at the CRA’s prescribed rate on or before January 30th of the following year. If payment is made late for any year, the prescribed rate loan family trust will lose its exemption from the attribution rules for not only that year, but all subsequent years.
The investment income earned by the trust from the advanced funds can be allocated to the beneficiaries of the family trust and taxed at their respective marginal tax rate. The lender will include the interest received as income on his or her tax return. The interest paid by the trust is deductible by the family trust as investment expenses.
An Example of Tax Savings
The potential tax savings from prescribed rate loan family trusts can be quite substantial. Take for example a parent with a $1,000,000 portfolio who is in the top tax bracket in Ontario. The marginal tax rate for this individual would be 53.53%. Let us also assume that the portfolio generates an annual return of 5%. If the parent has three children who have no other taxable income, the parent could take advantage of the prescribed rate loan family trust to save around $21,400 in taxes annually. The tax savings is calculated as follow.
If no income-splitting strategy is performed, the investment income of $50,000 ($1,000,000 x 5%) would be included in the parent’s tax return and taxed at 53.53%. This results in taxes payable of approximately $26,800.
If the family establishes a prescribed rate loan family trust, the tax consequences will be as follows:
- The parent that advanced the funds would include interest income of $10,000 ($1,000,000 x 1%) in his or her tax return. With a top marginal tax rate of 53.53%, this would lead to taxes payable by the parent in the amount of approximately $5,400 on the interest income.
- The aggregated investment income of $40,000 ($50,000 less $10,000 of interest expense) by the family trust would be allocated by the trust to the three child beneficiaries and included in their tax returns. With no other taxable income, the three children would have nominal taxes payable.
- In total, the combined family taxes payable would be $5,400.
As per this example, the prescribed rate loan family trust structure saves this family $21,400 ($26,800 – $5,400) in combined taxes, annually.
Assuming the same scenario above but with the exception that the prescribed rate has increased to 2% when the loan was made, the total combined tax savings for the family would be reduced to $16,000, a decrease in tax savings of $5,400, annually.
If you are thinking about carrying out family income splitting strategies for 2022 and onwards, you should act fast to have the strategy implemented before the prescribed rate is doubled on July 1, 2022. The tax savings achieved by the prescribed rate loan strategy depends on the timing of when the loan is made. Once the loan is established, the prescribed rate is maintained for the life of the loan regardless of any subsequent increases to the prescribed rate.
Setting up a prescribed rate loan family trust involves careful considerations to maximize the benefit without triggering negative tax implications. It is also crucial to administer the family trust properly to make sure you avoid the attribution rules and continue benefiting from the income-splitting strategy.
If you are looking to take advantage of the prescribed rate loan strategy, Grewal Guyatt has extensive experience in assisting clients with the implementation and administration of prescribed rate loan family trusts. For more information, please contact our tax team.