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Canada has a progressive income tax system, which means that generally the more money a taxpayer earns, the more income tax he or she pays. As a result, higher income earners attempt to reduce their family’s overall tax burden by shifting their income and capital gains to their family members who earn less income and as such are subject to lower marginal tax rates. This concept is known as income splitting. The Income Tax Act[1] sets out rules, known as the “attribution rules”, intended to prevent income splitting.
The attribution rules apply where a taxpayer transfers or loans property, directly or indirectly, including by way of a trust, to a spouse (married or common-law), or to a minor child, grandchild or niece or nephew. In the case of transfers or loans to a spouse, any income or loss and capital gains or capital losses are “attributed” back to the taxpayer who made the transfer or loan (the “transferor”), such that the transferor’s income splitting strategy is thwarted. In the case of transfers or loans to minor children, grandchildren, nieces or nephews, any income or loss is “attributed” back to the transferor, but capital gains or capital losses are not.
It should be noted that the attribution rules apply to income (and capital gains) on the property transferred as well as substituted property. For example, if money is the property that is transferred, which is then used to purchase income-producing property, the income-producing property would be considered substituted property, thereby attracting the attribution rules. However, the attribution rules do not apply to income on that income (“secondary” income). The attribution rules also do not apply to income earned with business assets transferred or loaned, since such income is not income from property.
There are certain exceptions to the attribution rules, where income splitting is a permissible form of tax planning. For example, provided interest is charged at the prescribed rate in effect at the time the loan is made, a high income-earning spouse may make a loan directly to his or her lower income-earning spouse, or minor children, grandchildren, nieces or nephews, or to a trust, the beneficiaries of which are any of such family members. [2]
The Canada Revenue Agency sets the prescribed rate, which is equal to the average of the rates on Government of Canada three-month Treasury Bills during the first month of the prior quarter, rounded up to the next percentage. Beginning on July 1, 2020, the prescribed rate will be 1%, a decrease from the current 2%, creating an income splitting opportunity. The prescribed rate that is in effect at the time the loan is made will continue to apply for the duration of the loan, as long as interest on the loan is paid by the borrower to the lender no later than January 30 of each subsequent calendar year that the loan is in existence. If in any year there is a default in the payment of interest by this deadline, the exception from attribution no longer applies for that tax year or any future tax year.
The lender must pay tax on the interest income it receives, and the borrower deducts the interest expense paid and reports and pays tax on net income and capital gains from investments made with the borrowed funds which are excluded from the attribution rules. Where a trust is used, the trustees of the trust could distribute the net income and capital gains (after paying the interest to the lender) to its beneficiaries who report the income and capital gains on their own personal income tax return, presumably at lower marginal tax rates than the trust would pay if it were to retain the income and capital gains in the trust (as trusts are taxed at the highest marginal rate), and the trust is permitted to deduct the income and capital gains from its taxable income.
Where the trustees of a trust allocate income and capital gains for the benefit of a minor beneficiary by making a payment to his or her parent or legal guardian, or to a third party for an expenditure for the minor beneficiary’s benefit (i.e., amounts paid for the support, maintenance, care, education, enjoyment and advancement of the minor beneficiary, including his or her necessaries of life), the trustees should keep detailed records documenting that the amount was in fact paid for the sole benefit of the minor beneficiary. In order for indirect payments to be deductible by the Trust and included in the beneficiary’s income, they must be paid pursuant to the beneficiary’s direction or agreement. In the case of an adult beneficiary, the beneficiary may, in writing, request and direct the trustees to make a payment to a third party for the benefit of the beneficiary. In the case of a minor beneficiary, the legal guardian, or the parent of the minor beneficiary[3], must request and direct the trustees to make a payment to the appropriate person, who can include themselves, before the payment is actually made.
The following example aims to highlight the benefits of the prescribed rate loan strategy. Assume a taxpayer, Mary, is in a 40% marginal tax bracket and her spouse, John, is in a 25% marginal tax bracket. Mary loans $100,000 to John, which loan is payable on demand, at the prescribed rate of 1% with interest paid annually. John invests the $100,000 and generates an annual return of 5% (or $5,000) in income. If the loan is outstanding for a full year, John will pay $1,000 (1%) interest expense to Mary. This interest expense will be deducted on John’s income tax return and included on Mary’s income tax return. As a result, John’s taxable income is $4,000 ($5,000 – $1,000), and Mary’s taxable income is $1,000.[4] After tax, John’s income is $3,000 ($4,000 at 25% tax rate), and Mary’s income is $600 ($1,000 at 40% tax rate). The total after-tax income for John and Mary is $3,600 ($3,000 + $600). If Mary would have invested the $100,000 and earned the interest income herself, her taxable income would have been $5,000, yielding an after-tax income of $3,000 ($5,000 at 40% tax rate), which is lower than the $3,600 generated for the family unit when a prescribed rate loan is implemented.[5]
The more income and realized capital gains that can be generated by the borrower in excess of the prescribed rate of interest that must be paid to the lender, the greater the income splitting advantage. Using this income splitting strategy can reduce a family’s overall tax liability, leaving more financial resources available for expenditures. If you are considering making a loan to your spouse or a family trust, you may wish to wait until July 1, 2020 to take advantage of the lower prescribed rate of 1%. If you are contemplating refinancing a prescribed rate loan that you already have in place, in order to avoid triggering the attribution rules, consideration should be given to selling the initial investment, repaying the initial loan, borrowing new funds at the lower prescribed rate come July 1, 2020, and making a new investment with the new loan proceeds.
If you are interested in taking advantage of permissible income splitting opportunities, like prescribed rate loan planning, please contact a member of Miller Thomson’s Private Client Services Group.
[1] R.S.C., 1985, c. 1 (5th Supp.)
[2] For purposes of this article, it has been assumed that tax on split income does not apply.
[3] Note: In Ontario, a parent is not the legal guardian of his or her minor child’s property simply by virtue of being a parent. Nevertheless, the parent’s direction should be sufficient for these purposes.
[4] For purposes of this example, it has been assumed that neither Mary nor John have any other sources of income.
[5] This example simply aims to exhibit the mechanics of implementing a prescribed rate loan strategy. Where both the loan amount and the investment income generated are greater than those set out in this example, the tax advantages can become quite significant.
