On October 1, 2022, the Canada Revenue Agency (CRA)’s prescribed interest rate is expected to increase from 2% to 3%. Despite the previous increase in the rate introduced on July 1, 2022, prescribed rate loans used with a family trust are still viable tax planning strategies. For more information on how prescribed rate loans work with a family trust structure, please refer to our previous article ‘Lock in Prescribed Interest Rate Loans by June 30, 2022’ (click here). This article will illustrate how a prescribed rate loan can still lead to significant tax savings when implemented prior to the rate increase on October 1, 2022.
Illustration of Tax Savings
Despite the previous increase in the prescribed rate introduced on July 1, 2022, the potential tax savings from prescribed rate loan family trusts are still significant. 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 investment 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 $16,100 in taxes annually.
The tax savings are calculated as follows:
If no tax planning is performed, the annual investment income of $50,000 ($1,000,000 x 5%) would be included in the parent’s tax return and taxed at 53.53%, resulting in taxes payable of approximately $26,800.
If the family establishes a prescribed rate loan family trust, the tax liabilities will be much lower. The parent that advanced the funds to the family trust, which holds the investment portfolio, would only need to include interest income of $20,000 ($1,000,000 x 2%) in his or her tax return. With a top marginal tax rate of 53.53%. The taxes payable on the interest income is approximately $10,700.
The aggregated net investment income of $30,000 ($50,000 less $20,000 of interest expense) 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. The total combined family taxes payable would be $10,700. As discussed in this example, the prescribed rate loan family trust structure saves this family $16,100 ($26,800 – $10,700) in combined taxes, annually.
Assuming the same scenario above, but with the exception that the prescribed rate has increased to 3% when the loan was made, the total combined tax savings for the family would be reduced to $10,700, a decrease in annual tax savings of $5,400.
With the prescribed rate set to increase yet again, consider acting fast to lock-in the existing prescribed rate by September 30, 2022. As mentioned previously, the tax savings achieved by the prescribed rate loan strategy depend on the timing of when the loan is made.
If you are looking to take advantage of the prescribed rate loan strategy, Grewal Guyatt LLP 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.